Earlystage start-ups and unlisted companies are very sure of the value of ESOP programs. Most of them “get” it. They all want to use this powerful tool to attract top talent, drive up employee engagement and commitment, and share the fruits of their combined labour. Despite that, many end up with suboptimal ESOP programs that do more harm than good.

They have to grapple with curating successful ESOP programs and handling aspects related to ESOP design, documentation, rollout, and administration. That apart, some of the most enduring problems relate to taxation and compliance.

Tax regulations keep changing, and new standards emerge all the time. Keeping pace with these changes is crucially important and comes with large and potentially messy downsides. This is why taxation and compliance are areas that need additional (and constant) attention. But without the required expertise, most companies find it difficult to handle the taxation and compliance needs of their ESOP programs, putting them at the risk of lawsuits, enormous penalties, and lost business reputation.

Calculating tax on ESOPs depends on a number of factors including the term of your ESOPs, financial results, residential status of employees, foreign holdings, and more. If you want to ensure your ESOP program meets all the necessary obligations, here are the top taxation and compliance factors to consider:

Rate of tax at the time of taxable events: Tax rates generally change every year at the time of announcement of fiscal budget. ESOPs are subject to tax at the time of (i) exercise and (ii) sale of shares. Thus, these two transactions (i.e. exercise and/ or sale) should be planned when tax rate is lower or by arranging transaction so as to minimise the tax incidence. For example (if your ESOP Plan allows), ESOPs can be exercised early and resultant shares can be sold after holding for more than 2 years (assuming shares are still unlisted as on date of sale), then the capital gains tax is relatively at a lower rate.

Understand compliance requirements: When it comes to ESOPs, all companies need to comply with certain requirements as required by the law of the land they’re offered in: while listed Indian companies need to issue ESOPs in accordance with SEBI’s ESOP regulations, unlisted Indian companies need to do it in accordance with the provisions of the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014. Similarly, Indian companies that have interests in the USA and wish to offer similar plans they must ensure compliance with the rules of the Internal Revenue Service or the US Department of Labor for options granted there. Any tax withheld (pursuant to exercise of ESOPs) must be deposited with the Government within prescribed timeline.Further, prior to making of any grant of ESOPs to a non-resident employee, it must be checked as to what extent grant can be made and whether any prior approval of the Reserve Bank of India is required. Foreign Exchange Regulations require companies to report on grant and exercise of ESOPs by non-resident employees – which must be complied.

Evaluate if you qualify for tax concessions: Since ESOPs were designed to make it easier for startups to incentivize employees with ownership in the company if you are a startup company, employees opting for ESOP might qualify for tax concessions. For example, if your company is an eligible start-up in India whose ESOP holders can get a tax deferral at the time of exercise This could be an effective way of managing tax by early exercise with no instant tax payment and deferring the tax payment at the time of sale of shares or upon cessation of employment. This has higher chances of subjecting the capital gains to a lower tax rate as share can be held for more than 2 years without paying any exercise related tax.

Carry out a valuation of equity shares: If you have an ESOP plan running, either at the time of grant or exercise of ESOPs, you will have to account for the value of the options/ shares. Given the critical role of the exercise price payable by the employees, this valuation also helps determining the exercise price i.e. if a discount to the fair value is justified or not and if yes, to what extent with its accounting cost implications. Choose a valuation method that best fits the needs of your business and takes numerous variables into account including exercise price, risk-free interest rate, volatility etc. Equity valuation is relevant for (i) determination of exercise price & amortization of accounting cost, and (ii) tax withholding at the time exercise.

Given the benefits ESOPs provide to employees and employers alike, they are slowly gaining prominence across the business ecosystem. However, any company looking to introduce ESOP in India needs to understand the fundamentals, especially concerning taxation and compliance, so they can more effectively attract, reward, and retain employees – without stressing their cash reserves.

Engaging with an experienced ESOP design and implementation partner can allow you to get focussed attention and facilitate a tailor-made ESOP based on your objectives and expectations that stays compliant with the relevant laws of the land.