“Startup Esop Tax Clarity: Transfers Over Buybacks Shield Employees”

In an article by Anees Hussain dated July 25, 2024, titled “Esop sale: No tax worries for startup employees,” it was emphasized that recent changes in taxation laws related to share buybacks announced in the Union Budget will not significantly impact startup employees. The amendment, effective from October 1, treats share buybacks akin to dividend income, shifting the tax liability to recipient investors rather than the companies themselves. Analysts and tax experts highlighted that startups typically do not engage in share buybacks on the scale seen with large, listed companies. Instead, they generally facilitate share transfers to promoters, new investors, or specific entities. Consequently, the liquidation of Employee Stock Ownership Plans (Esops) within startups continues to be treated as a secondary sale, subject to applicable long-term capital gains tax rates, which have recently been revised to 12.5% from the previous 10%.

Anish Shah, a partner specializing in M&A tax and regulatory services at BDO India, affirmed that startup employees are unlikely to be affected by these changes, as shares are typically transferred rather than bought back due to startups’ usual lack of substantial cash reserves. He explained that startups often require funding from investors, and Esops serve as a means to compensate employees in lieu of higher salaries.

Shah further clarified that when Esops are liquidated, the shares are transferred to another entity, not bought back, thereby avoiding the implications of buyback-related tax provisions. This transfer is considered a third-party transaction and does not attract the newly revised tax provisions applicable to share buybacks.

Pallav Pradyumn Narang, a partner at CNK RK & Co, pointed out that startups typically manage Esop transfers through separate management entities specifically created for this purpose. When employees exit a company and wish to liquidate their Esops, the shares are transferred to these management entities rather than bought back by promoters.

In conclusion, while startups have the theoretical option to conduct share buybacks, they generally opt for share transfers, which are subject to long-term capital gains tax rates rather than income tax slab rates. This distinction ensures that startup employees are not unduly burdened by higher tax incidences arising from the recent changes in taxation laws concerning share buybacks.