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As India’s startup ecosystem matures, Employee Stock Option Plans (ESOPs) continue to be one of the most effective tools for attracting and retaining talent. For young companies operating with limited cash flows, ESOPs help balance ambition with affordability. However, how these stock options are taxed continues to play a decisive role in how valuable they are for employees.
How ESOP tax deferral works for startups today
ESOPs are generally taxed first as salary at the time of exercise of options and again as capital gains at the time of sale of shares. Since at the point of exercise, the tax is levied on a notional ga…
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As India’s startup ecosystem matures, Employee Stock Option Plans (ESOPs) continue to be one of the most effective tools for attracting and retaining talent. For young companies operating with limited cash flows, ESOPs help balance ambition with affordability. However, how these stock options are taxed continues to play a decisive role in how valuable they are for employees.
How ESOP tax deferral works for startups today
ESOPs are generally taxed first as salary at the time of exercise of options and again as capital gains at the time of sale of shares. Since at the point of exercise, the tax is levied on a notional gain (fair market value of the shares minus the price paid by the employee), it creates a liquidity crunch for the employees. To address this challenge, govt in 2020 introduced a targeted tax relief for employees of eligible startups to ease liquidity mismatch caused by ESOPs taxation at exercise.The benefit is applicable only for employees of eligible startups under Section 80IAC of the Income-tax Act, which prescribes conditions such as being incorporated as a Private Limited Company or LLP between April 1, 2016 and March 31, 2030, being less than 10 years old, having annual turnover not exceeding Rs 100 crore in any year since incorporation, certification from an inter-ministerial board, etc.
Under this provision, when an employee of an eligible startup exercises ESOPs, the tax arising at that stage is not required to be paid/deducted by the employer immediately. Instead, the tax is deferred and becomes payable within 14 days from the earliest of the following events:
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Forty-eight months from the end of the relevant Assessment Year (4 years)
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The date on which the employee sells the shares
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The date on which the employee leaves the company
The limitation: Who gets the benefit
While the intent behind the provision is widely appreciated, the benefit of ESOP tax deferral remains limited to a small pool of startups, specifically those recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) and certified by the inter-ministerial board.
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Currently, although nearly 197,000 startups are recognised by DPIIT, only a little over 3,700 are eligible to extend the relief to their employees.
Why wider coverage is needed
Startups today operate in an intensely competitive talent market, particularly in sectors such as technology, artificial intelligence, fintech and deep-tech. Cash compensation alone is often insufficient to attract and retain skilled professionals, making ESOPs a critical part of compensation structures.Looking ahead to the Budget, the priority should be on reforms that make ESOPs more practical and genuinely valuable for startup employees. One of the key measures would be to extend tax deferral to all DPIIT-recognised startups.In addition to startups, extending the tax-payment deferral benefit to all unlisted companies would go a long way in making ESOPs a far more attractive component of employee compensation.A broader objective should be to align tax payment more closely with genuine liquidity events, such as sale of shares or listings, wherever feasible.Collectively, these steps would help transform ESOPs into a true long-term wealth-creation mechanism rather than a short-term financial burden.(Chadha is tax partner, EY India; Shanmuga Prasad, senior tax professional, EY India, also contributed to the article. Views are personal)