Employee stock options: Postpone sale of shares if firm plans to list

Extend holding period so that you pay tax on long-term capital gains as it will reduce the outgo

Employee stock ownership plans (ESOPs) are in the news, what with current and former Paytm employees converting their ESOPs to shares worth Rs 182 crore and Ola expanding its pool to Rs 3,000 crore ahead of the firms’ initial public offerings (IPO).

ESOPs are an important employee retention tool for start-ups in their early days when they can’t afford to pay huge salaries. Many such start-ups have now turned into unicorns with valuations constantly on the rise. Their employees are now faced with the question of when to exercise their options and when to sell them, as each of these actions has tax implications.

Taxation of ESOPs 

ESOPs have four stages: The first is when the ESOP is granted; then comes vesting; the third is when the option is exercised and converted to shares; and the final stage is when the employee sells the shares. Says Lokesh Shah, partner, Saraf and Partners: “There is no tax event at the first two stages—the date of grant and the date of vesting.”

ESOPs are taxed twice. Says Manish P Hingar, founder of Fintoo: “When an employee exercises the option, i.e., the shares are allotted to him, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is taxed as perquisite in his hands.”

Union Budget 2019-20 removed the liability of employees of eligible start-ups from paying tax at allotment. Says Archit Gupta, chief executive officer, Clear: “Their employees can pay tax at the time of sale of shares, exit from the company, or five years from the date of allotment, whichever is earlier.”

Employees pay tax a second time when they sell the shares. Gains arising at this point are taxed as capital gains. The tax rate depends on the holding period and the company’s status—listed or unlisted.

If the company is listed and the gains are long term (holding period above 12 months) there is no tax on gains up to Rs 1 lakh, and 10 per cent on gains above that. Short-term capital gains are taxed at 15 per cent.

In the case of unlisted companies, long-term capital gains (holding period more than 24 months), are taxed at 20 per cent with indexation and short-term capital gains at slab rate.

Employees’ dilemma 

Employees belonging to non-eligible start-ups have to pay tax on exercise date. Gupta says, “The tax rate can range from 12-43 per cent. The employee has not realised any money, so he has to pay tax from his own pocket.” Employees have to arrange for the funds.

A bigger issue arises if the employee exercises the option, pays the tax, and then the valuation of the company’s shares declines. Says Ritesh Kumar, partner at IndusLaw, says: “The employee suffers a ‘capital loss’. If he does not have any income from capital gains, he will be forced to carry it forward with no opportunity for set off.”

The current provisions do not provide for set-off of capital loss against salary income, so employees are unable to use it to reduce the tax outflow on their overall income.

How to minimise tax impact 

Employees are allowed a time period within which they can exercise their options. Says Hingar: “The FMV of the share can fluctuate considerably during this period. Exercise options in parts to average out your acquisition cost.” This strategy is especially helpful in the case of listed shares.

If the start-up’s valuation is rising continuously, the employee should exercise the right to convert the ESOPs as soon as the vesting period gets over. An early exercise will enable him to plan and exit with significant potential gains later.

The holding period becomes important at the time of sale. Says Suvigya Awasthy, associate partner, PSL Advocates and Solicitors: “The tax rate on short-term capital gains is higher than on long-term gains.” Hold the stock for the required holding period so that you pay long-term capital gain.

Factor in the company’s listing status also. The tax rate on the sale of unlisted companies’ shares is generally higher. Says Awasthy: “If the company is going to get listed soon, then sell after the listing.”