ESOP Taxation in India: Why Most Startups Fail the Section 80-IAC Test for Deferred Tax on Employee Stock Options
Deferred tax for eligible startups helps, but most companies fail the eligibility test without realising it.
Key points
- Employee stock options are taxed at exercise as salary and again at sale as capital gains; the first charge falls when the employee has shares but no cash.
- Eligible startups may defer the exercise-stage tax for up to 48 months, or until sale or exit, but eligibility requires an Inter-Ministerial Board certificate under Section 80-IAC, not merely DPIIT recognition.
- Only a few thousand of the nearly two lakh recognised startups hold the certificate; employees of the rest are taxed on exercise like everyone else.
NEW DELHI — Six years after the Union Budget promised to end the "dry tax" on employee stock options at startups — the charge that falls when an employee exercises options and acquires shares that cannot yet be sold — most startup employees are still paying it. The deferral enacted in 2020 is confined to companies that qualify as eligible startups under Section 80-IAC, and the great majority of companies that call themselves startups, including most that hold recognition from the Department for Promotion of Industry and Internal Trade, do not.
"The benefit exists on paper. Few companies can actually use it," the chief financial officer of a Bengaluru software company that grants options to most of its staff told The Counsel.
How ESOPs are taxed
| Event | Tax treatment |
|---|---|
| Grant and vesting | No tax |
| Exercise (allotment of shares) | Perquisite under Section 17(2)(vi): fair market value on the exercise date, determined by a merchant banker for unlisted shares under Rule 3(8), less the exercise price. Taxed as salary at slab rates; the employer deducts tax at source under Section 192. |
| Sale | Capital gains: sale price less the fair market value taken at exercise. Long-term if held more than twelve months (listed) or twenty-four months (unlisted); long-term gains taxed at 12.5 per cent, short-term at slab rates for unlisted shares. |
The first charge is the problem. An employee who exercises options in an unlisted company receives shares that may not be saleable for years, yet owes tax on their paper value immediately, and the employer must deduct it from salary. Employees respond by not exercising, which defeats the purpose of the plan; or by exercising only at an exit, when the perquisite is taxed at slab rates on a value that could have been long-term capital gains had they exercised earlier.
The deferral, and who qualifies
The Finance Act, 2020 inserted provisions — Sections 192(1C), 140A, 156 and 191 of the Income-tax Act, 1961, now carried into the Income-tax Act, 2025 in force from 1 April 2026 — under which, for an eligible startup, the tax on the perquisite and the employer's obligation to deduct it are deferred until the earliest of three events: 48 months from the end of the assessment year in which the shares were allotted, the sale of the shares, or the employee ceasing to be employed. Tax is then payable within fourteen days, at the rates of the year of allotment. The capital gains charge on sale is unaffected.
"Eligible startup" means a startup within Section 80-IAC: a private company or limited liability partnership incorporated within the section's window, currently extended to 1 April 2030, with turnover of no more than ₹100 crore in the relevant year, working towards innovation or improvement of products, processes or services or a scalable business model with high potential for employment or wealth creation, not formed by splitting or reconstructing an existing business — and holding a certificate of eligibility from the Inter-Ministerial Board constituted by the DPIIT.
The benefit exists on paper. Few companies can actually use it.
A startup chief financial officer, to The Counsel
Why most startups fail the test
- Recognition is not certification. DPIIT recognition, which nearly two lakh companies hold, is obtained online on a self-declaration. The Inter-Ministerial Board certificate under Section 80-IAC requires a separate application, scrutiny of the innovation claim and the financials, and approval by the Board; a few thousand companies hold it. Founders routinely assume that the first confers the second.
- The innovation criterion. The Board applies the innovation and scalability test substantively. Companies that run a conventional business through an app, or that reproduce an existing service model, have been declined.
- Turnover. A company that crosses ₹100 crore in any year loses eligibility for that year, and with it the deferral for options exercised in that year.
- Timing. The company must be an eligible startup in the year of allotment. A certificate obtained after the shares are allotted does not reach back.
- Structure. Companies formed by hiving off a business from a group, or by converting a partnership that had been trading, fail the reconstruction condition however innovative the product.
What founders can do
- Apply for the certificate early, before the first exercise under the plan, and keep the turnover test in view when planning grants.
- Design around the exercise charge for companies that will not qualify: longer exercise windows, exercise at or near an exit, and cashless exercise arrangements in which part of the shares are sold to fund the tax.
- Get the valuation right. The perquisite depends on a merchant banker's fair market value at exercise; a defensible valuation is both a tax requirement and a protection for the employee.
- Tell employees what they hold. Grant letters should explain both charges and the deferral position of the company; the first many employees learn of the exercise tax is a deduction from their salary.
- Use buybacks and secondaries with care. Each has its own tax treatment for the employee and the company, and a buyback funded to pay exercise tax must comply with the Companies Act limits.
What employees should know
An employee of a company that is not an eligible startup owes tax on exercise whether or not the shares can be sold, and the employer will deduct it. An employee of an eligible startup should obtain written confirmation of the company's status and keep track of the three trigger events, because the deferred tax becomes payable within fourteen days of leaving the company — a point at which the shares are usually still unsaleable. In both cases the fair market value at exercise is the cost base for the eventual capital gains computation, and the valuation report should be retained.
When are ESOPs taxed in India?
At exercise, on the difference between fair market value and exercise price, as salary with tax deducted at source; and at sale, on the difference between the sale price and the fair market value at exercise, as capital gains.
What is the deferred tax benefit for startups?
For an eligible startup under Section 80-IAC, the exercise-stage tax and the employer's deduction are deferred until the earliest of 48 months from the end of the assessment year of allotment, sale of the shares, or the employee leaving, with payment due within fourteen days of that event.
What is an eligible startup under Section 80-IAC?
A DPIIT-recognised private company or LLP incorporated within the section's window, with turnover not exceeding ₹100 crore, engaged in innovation or a scalable business model, not formed by splitting or reconstructing an existing business, and holding an Inter-Ministerial Board certificate.
Is DPIIT recognition enough to claim the deferral?
No. Recognition is necessary but not sufficient; the Inter-Ministerial Board certificate is also required, and only a few thousand recognised startups hold one.
The Counsel will report any changes to the eligibility conditions in the next Budget. Founders designing an option plan, and employees deciding whether to exercise, should take advice from a qualified tax adviser on the company's eligibility and the timing of the charges.
Dev Patel
Dev writes on company law, FEMA and the compliance burden on growing businesses.
This report is for general information only and does not constitute legal advice. Readers should consult a qualified lawyer about their own circumstances. Case citations are to The Counsel Reports (TCR) unless otherwise stated.