India's ESOP tax rules need reform to ease employee burden

India's tax treatment of Esops rests on a flawed premise: that an unrealised, uncertain equity gain is equivalent to cash salary. It isn't. The difference between a share's fair market value on the date of exercise and its exercise price is treated as a perquisite and taxed at rates of up to 39% for employees in the highest tax bracket.

Consider an employee exercising 10,000 options at ₹100 when shares are worth Rs 1,000 makes a notional gain of Rs 90 lakh. Having paid Rs 10 lakh to acquire the shares, with no cash received, he could still face a tax bill of ~Rs 35 lakh on paper gain. The problem is worse in unlisted companies, where the Rs 1,000 valuation is based on a formula, not an actual market price. Employees are taxed on gains they may not be able to realise for years.

Eligible startups can defer Esop tax until a specified triggering event, acknowledging liquidity crunch caused by taxing gains at exercise. Why should this relief stop at startups? Employees of mature unlisted companies face the same problem: they are taxed before realising any economic gain.

Listed companies are no exception. Even when shares are liquid, employees receive no cash on exercising options. If they owe tax of around 39% on the Rs 900 spread between the exercise price of Rs 100 and market price of Rs 1,000, they may have to sell nearly 40% of their shares immediately to meet the liability.

This forces employees to sell part of their equity incentive before they choose to, potentially at a loss. Worse, any subsequent capital loss can be set off only against capital gains, not salary income. So, while notional Esop gain is taxed at slab rates, a loss on sale can't be offset against it.

Such losses can be set off only against capital gains, often taxed at lower rates. For Indian employees holding foreign parent company Esops, rupee appreciation between exercise and sale can also create a tax loss even if the share price remains unchanged. International practice does not support taxing employee equity as if it were indistinguishable from cash pay.

It would be inaccurate to claim that no other country taxes options at exercise. Britain taxes many non-tax-advantaged options as employment income. Singapore generally taxes Esop gains at exercise as well.

Major economies have built separate regimes for employee equity. Qualifying Incentive Stock Options (ISOs) in the US escape regular I-T at exercise, with favourable capital gains treatment available if the specified holding conditions are met.

Britain's EMI and Csop schemes offer materially better treatment for qualifying options, and only capital gain taxes apply on the eventual sale. Even Singapore, which taxes at exercise as a default, provides deferral mechanisms for qualifying arrangements, subject to application of an additional interest for the period of deferral.

The common thread is not that exercise is never a taxable event. It's that employee equity is treated as different from a cash salary, and taxed accordingly. India should adopt a similar principle. It need not cost the exchequer much, since this is fundamentally a question of timing rather than exemption.

For listed as well as unlisted companies, 3 approaches are worth considering:

Defer perquisite taxation until the earliest genuine liquidity event, as is currently contemplated under the Indian startup regime and in Singapore.

Tax both the exercise spread and subsequent appreciation only at the time of sale, as capital gains, similar to the approach under qualifying regimes in the US and Britain.

Tax the exercise spread at a concessional rate, while routing any subsequent appreciation through normal capital gains regime.

In each case, GoI can build in anti-avoidance provisions, defined triggering events and valuation rules to ensure the tax is eventually collected, just later and against actual cash. Separately, it should also consider allowing the set-off of losses from sale of Esops on account of value diminution and rupee appreciation against salary income.

There is a broader stake here than any individual employee's liquidity problem. India wants deeper capital markets, more competitive companies and a genuine culture of employee ownership. Esops are one of the main instruments through which that ownership is meant to be shared.

An employee who knows that exercising his options could trigger a 30-40% tax bill with no corresponding cash inflow will rationally delay exercise, reduce his participation, or simply prefer cash pay instead. That is the opposite of what a modern, ownership-orientated economy should want.