The ESOP conundrum

The Union Budget of 2024 was lauded by both, the Indian angel investors and the start-up community, for abolishing the much talked about ‘Angel Tax’. At the same time, the government’s decision to tweak some of the other tax-related laws has also given the sector much to cheer about. The changes in the long-term capital gains on shares or transfers have now been brought down from the earlier 20% bracket to 12.5% for both resident and non-resident taxpayers while taking away the indexation benefit.

Starting from July 23rd of this year, employees at startups looking to liquidate their ESOPs will face a significantly lower tax burden. Despite the indexation going away, this proposition remains attractive, says Nishant Shah, Partner and co-head of Tax practice at ELP.

“If you see the overall indexation implication, especially in the past few years, the economic rise that India has been seeing and larger profits being created, indexation benefit was marginal compared to it. With the rate going down, I believe especially in the case of startups where there has been a significant escalation in worth over some time, there is a huge benefit,” he adds.

Earlier employees who were given ESOPs mostly paid taxes both as a part of their salary when they were allotted and when the shares were sold. Especially now, in cases where ESOP allotments are linked to a sale event, Shabnam Shaikh, Partner in the Direct Tax and Private Client practice at Khaitan & co, sees senior executives at startups seeking a bit more leeway. “To take advantage of the LTCG rate, senior executives could demand to change the construct of the ESOP plan to allow holding of shares much before the liquidity event,” she says. She adds that startups may also likely revisit their stock option plans to balance out the interest/objective of the company, keeping in mind the ESOP holders’ tax implications.

In startups, ESOP share tendering usually happens when the company is looking at buying back its shares or providing an exit by bringing in investors to take over the ESOP stocks through a secondary market arrangement. The changes to direct taxes concerning buyback in the Union Budget now, make the earlier proposition expensive.

Presently, any amount paid by a company for buying back its shares is subject to a buy-back tax (BBT), while shareholders receive this amount tax-free. However, starting October 1, 2024, any payment made by the company for a buyback will be treated as a dividend for shareholders, subjecting it to applicable Income Tax rates. Further, no deduction from dividend income shall be allowed while determining income from other sources.

While for companies the BBT would be 20%, Rahul Charkha, a Partner in the tax practice at ELP, says now for those who fall above the 20-25% personal tax rates, ESOP buyback would become a more expensive exit. In certain scenarios, especially during promoter restructuring at startups, this new tax burden could also throw up some challenges. The attractiveness of buybacks is likely to take a hit, be it with ESOPs or even with promoter restructuring at startups.

“Buyback was one of the tools to rationalise the captable (capitalisation table) and shareholding and that was coming at a meagre 20-24%, which was acceptable. But now, if this is to be done with a promoter who is under the maximum personal tax rate slab, the tax of such a restructuring could go to 39-40% for companies. We are looking at an additional cost of 17-18%, which is significant”, he adds.

Many believe that this could also result in higher secondary transactions at startups. Apurva Kanvinde, Partner at JurisCorp says, post the budget announcement, “I see that a lot of transactions will move towards secondary sale exits to the employees where they are selling their shares either to an existing investor or incoming new investors. This would be more by way of transfer of shares and purchase by investors rather than a company buy back”.

Also going forward, ESOP documentation that may layout events of liquidation could now see being more tightly drafted with more obligations on the part of companies to provide exit, Apurva adds. Manmeet Kaur, Partner, Karanjwala & co, also agrees that companies may increasingly use secondary funding rounds as an exit option for employee ESOPs.

“Startups might adjust their ESOP programs to optimise tax benefits for employees. This could include timing the exercise of options and structuring buybacks to minimize tax liabilities,” she says. Most experts agree the attractiveness of ESOP not taking a hit despite a higher tax implication in the cases where company executives belong to higher tax brackets.