Mint Explainer: The budget, buybacks, and Esop taxation

It’s not just investors who will be affected by this. Employees, particularly of startups, could end up having to pay a higher tax if a company decides to buy back shares under section 68 of the Companies Act. This wouldn’t apply, however, if a company buys back employee stock options, Esops, to hand those over to a new investor. Mint explains:

 

How are ESOPs taxed?

Employee stock options are taxed in multiple tranches. First, these are taxed when an employee exercises the options and later when the shares are sold. 

When a company allots options, these need to ‘vest’, or become eligible to be transferred to the employee as shares, over a period of time. The employees then need to “exercise" the options; meaning, they need to exercise the right to secure the company’s shares at a pre-determined price.

At this point, the options become the shares of the company. The differential between the fair market value of the shares and the “exercise" price is taxed as a perquisite in the hands of the employee, forming part of their salary and taxable at the applicable rate of tax.

The next time Esops are taxed is when an employee sells their shares to an investor in the company or in the public market, (if a company gets listed on the stock exchanges). 

“The differential between the sale price of the shares and the fair market value on the date of exercise of options is taxed as capital gains, i.e., either short-term capital gains or long-term capital gains, based on the period of holding of shares, which has to be reckoned from the date of allotment of shares," said Ritesh Kumar, partner at BDO India, a tax and business advisory.

How do startups typically buy back ESOPs?

Several startups have undertaken buybacks, mostly in the form of a secondary purchase of Esop shares through an incoming investor.

For instance, Swiggy announced its fifth buyback last month, in which an investor would acquire a part of its employees’ shares. Urban Company, in May, undertook a buyback through an incoming investor, Dharna Capital. In November, Flipkart made a one-time payout to its employees against their options after PhonePe was carved out of the company. This payout was made to compensate for the decreasing value of the employee options and was treated as income.

“Secondary purchases of Esop shares were taxed as capital gains before this budget and will continue to be taxed as capital gains after this budget as well," Kumar said.

Capital gains that are long-term in nature for private Indian investors will now be taxed at 12.5%, but without the indexation benefit that allowed for adjusting against inflation. Prior to this, the tax was 20%, with an indexation benefit.

Employees too will now pay 12.5% without indexation benefit even if they hold on to their shares till their company goes public, provided the shares were allotted to them at least 24 months prior to the public-listing.

Can liquidity be offered to employees by cancelling Esops?

Startups sometimes undertake a so-called “buyback" by cancelling Esops and compensating employees in lieu of those options. Under section 17 (2) (6vi) of the Income-tax Act, 1961, this compensation would be taxed as a perquisite or according to an employee’s tax slab, according to BDO’s Kumar. 

How does the new budget proposal become relevant here? 

The budget proposes to remove section 115QA of the Income Tax Act on buybacks, which states that any domestic company that buys back its shares is liable to pay additional tax on the distributed income at a 20% tax slab (excluding a health and education cess).

Instead, the budget proposes to add a sub-clause (f) under section 2(22) of the IT Act on ‘deemed dividend’, which would apply to the distribution of debentures, bonus shares, deposit certificates to shareholders, distribution on liquidation, or reduction of capital.

The Finance Bill states that the sub-clause (f) would apply to “any payment by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 68 of the Companies Act, 2013".

(Essentially, a ‘deemed dividend’ is an income treated as a dividend, even if a closely held company does not distribute it. Earlier, a company could extend a loan or an advance to a shareholder, which would help the investor avoid dividend distribution tax. This which was plugged in 2018.)

How will this impact Esops?

A startup looking to buy back shares under section 68 of the Companies Act would require its employees to pay tax as if they were receiving a dividend. In other words, the payout would be taxed as salary under ‘Other income’. This would apply if employees had exercised their Esops and the shares were allotted to them.

“Many startups undertake Esop liquidity programs through a buyback (under section 68 of the Companies Act). Due to this change, these Esop liquidity programs will be taxed in the hands of the employee as ordinary income, thus denying them the lower capital gains rate of 12.5%," said Siddarth Pai, co-founder of venture capital firm 3one4 Capital.

High-earning employees holding company shares would be particularly affected, as earlier the company would have paid a 20% tax on the Esops it bought back. 

However, the original cost of the acquisition of Esops will become a capital loss that can be carried forward and set off against future capital gains, Pai said.

Typically, startups don't have enough free reserves to undertake a buyback under section 68.