CBDT’s (lack of) proposal on ESOPs has Entrepreneurs worried

A recent proposal by Central Board of Direct Taxes (CBDT) has ruffled many feathers in the start-up industry, and forced entrepreneurs and financiers to sit up and take notice, says a news report. The bone of contention is a recent CBDT proposal that doesn’t explicitly mention ESOPs (Employee Stock Ownership Plans) – which happens to be a popular tool in the start-up community to attract talent – are exempt from long-term capital gains tax. 

Too much jargon in one sentence? Let’s break down the issue to simpler parts:

What are ESOPs, and why are they important?

Employee Stock Ownership Plan or ESOP is a tool to ensure that employees truly ‘own’ the company as it provides employees with stocks in the company, as bonuses, remuneration, rewards or other mechanisms. Esops are a widely used corporate finance strategy that not only gets tax benefits for the selling shareholder and the participant, but also give incentive to employees to work towards maximum growth of the company – since that happens to be in the best interest of the shareholder (i.e. the employee himself/herself). In 2016, 6,717 ESOP plans exist in the USA covering 14.1 million employees.

ESOPs are especially important for the start-up community as they frequently use the benefit to attract the best talent; particularly when they are just starting out, and cannot match remunerations offered by big organisations.

But even big organisations use ESOPs to reduce attrition, and build employee loyalty, promising them a solid return to the amount of work they put in. While Google is a famous example of how early employees turned millionaires when the company achieved success, other examples also show that ESOPs also provide a safety net, by providing exit, to the employees in cases of acquisition or sale of the organisation. Although risk-laden and rare, Indian start-ups have known to make their employees millionaires via ESOPs as well. 

What does the CBDT proposal mean, and why is it important?

The CBDT proposal on exempting genuine equity investments from long-term capital gains tax (a type of tax levied on capital gain) didn’t mention ESOPs, giving rise to ambiguity regarding the same. Entrepreneurs say that this could prove detrimental for employees to opt for ESOPs and would obscure its benefits in confusion. As a result, employees might not go for such plans, and this could result in the start-up community losing out on great talent. 

According to report, the notification says, “Genuine equity investments through IPOs as well as other public share sale and bonus and rights issues by listed companies won't face long-term capital gains tax even if no securities transaction tax was paid on their transfers”; but this doesn’t clearly mention off-market transactions, which includes ESOPs. Although, the proposal is being interpreted differently across the industry as some believe ESOPs would not be impacted; this is only adding to the confusion in the absence of clarifications from CBDT.

Since the issue is of great importance, not only to the start-up community, but businesses on the whole, one can expect clarifications from CBDT soon. It is believed that the same will clearly state that ESOPs are exempt from long-term capital gains tax; which will allow for organisations, big and small, to exercise such plans for the benefit of all.