Explained: Why Budget 2026 is Critical Moment for India’s ESOP Framework?

India’s start-up ecosystem witnessed a strong year in 2025, marked by innovation, fundraising activity and a growing number of companies tapping public markets.

The sector as a whole is currently in a transition phase, with start-ups shifting focus from rapid expansion toward sustainable and disciplined scaling. More than two lakh entities have been officially recognised as start-ups by the government as of December 2025, highlighting the sector’s expanding footprint in the economy.

Amid this, founders and investors are closely watching the upcoming Union Budget 2026 for clarity on long-standing ambiguities around Employee Stock Option Plans (ESOPs), which remain a key tool for talent retention and wealth creation in the start-up sector.

“Union Budget 2026 presents a critical opportunity to correct one of the most persistent structural frictions in India’s start-up ecosystem - ESOP taxation. Despite partial reforms in recent years, taxing ESOPs at the point of exercise rather than liquidity continues to undermine their very purpose,” Ashish Bhatia, Founder & CEO, India Accelerator said.

Current Tax Structure

In India, the biggest tax burden for employees holding ESOPs arises at the point of exercise. At this stage, the difference between the fair market value of the shares and the exercise price is treated as a prerequisite under “Income from Salary” and taxed immediately.

This often translates into a steep cash outflow, frequently 30% or more depending on the individual’s tax slab, even though the shares are unlisted and cannot be sold to fund the tax payment.

The tax liability does not end with exercise. When employees eventually sell their shares, they are taxed again under capital gains. For unlisted start-up shares, gains realised after a holding period of more than 24 months are typically taxed at around 12.5%, while shorter holding periods attract tax at the applicable income slab rate.

This dual taxation, once at exercise and again at sale, creates severe cash-flow stress and significantly weakens ESOPs as a tool for long-term wealth creation and employee retention.

As a result, start-ups and investors have been pushing for structural reform. One widely advocated solution is a “tax-only-on-sale” regime, under which ESOPs would be taxed only when employees actually realise cash by selling their shares. Eliminating tax at the exercise stage would remove the upfront liquidity squeeze and reduce incentives for skilled talent to relocate overseas purely to escape ESOP-related tax friction.

Dr Ajai Chowdhry, Founder of HCL and Chairman of EPIC Foundation states that India stands at a critical juncture in its journey to become a global innovation hub and ESOPs framework of a country plays a critical role in supporting the growth of the start-up ecosystem.

Chowdhry states that in contrast to other mature start-up ecosystems, India's dual taxation model on ESOPs, taxing employees at exercise and again at sale, creates significant friction that is actively pushing Indian start-ups and founders toward offshore relocation.

“I am hoping to see a simplified ESOP taxation for start-ups during this budget that will be critical for the country's growing start-up ecosystem,” he said.

Expectations from the Union Budget 2026 go beyond a shift toward tax-on-sale. The industry is also seeking a broadening of the existing four-year tax-deferral benefit, which is currently available only to a small subset of start-ups.

Extending this relief to the wider pool of government-recognised start-ups would make ESOPs more meaningful as a retention and wealth-creation mechanism and help keep talent and value creation within India.

Tax Deferral Benefit

The tax-deferral benefit itself was introduced in the Union Budget 2020 to address the problem of “dry tax,” where employees are taxed on paper gains at the time of ESOP exercise. Under Section 192(1C) of the Income Tax Act, employees of “eligible start-ups” can defer the deduction of tax deducted at source (TDS) on ESOP perquisites.

Instead of paying tax immediately, the liability becomes payable at the earliest of three events: five years from the end of the financial year in which the shares are allotted, the date the shares are sold, or the date the employee exits the company.

In practice, however, the relief is narrowly scoped. It applies only to start-ups that are not just recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) but also certified by the Inter-Ministerial Board (IMB) under Section 80-IAC.

While India has nearly two lakh DPIIT-recognised start-ups, fewer than 4,000 have secured IMB certification. As a result, most start-up employees remain exposed to upfront taxation at the exercise stage.

Parizad Sirwalla, Partner and Head of Global Mobility Services, Tax at KPMG in India, says the current deferral is far too narrow. He says, “this deferral is limited to a narrow subset of start-ups, leaving most outside its scope. Moreover, the risk and cash burden of paying tax, even if deferred, remains in cases where no sale or liquidity event occurs.

Hence, it has long been a wishlist that ESOPs be taxed only at the time of sale or liquidity. At the very least, expanding the benefit of tax deferral to all employees, or at least to those of all DPIIT-recognised start-ups, would ease cash-flow stress and better align ESOP incentives with long-term value creation.”

Another significant drawback is the “resignation trigger.” Because the deferred tax becomes payable immediately when an employee leaves the company, job changes can force individuals to make large out-of-pocket payments for shares that may remain illiquid for years.

This provision has become a major barrier to talent mobility within the start-up ecosystem and a key issue that stakeholders hope the upcoming budget will address.

Industry Expectations

Ahead of the Union Budget 2026, founders, investors and employees are looking for two key changes: extending the ESOP tax-deferral benefit to all DPIIT-recognised start-ups and removing the resignation trigger altogether. The industry’s preferred outcome is a framework where ESOP tax is paid only when real cash is realised from a sale, aligning tax liability with actual wealth creation rather than paper gains.

Padmaja Ruparel, co-founder of IAN Group, echoes Sirwalla’s view but is more cautious about expectations. She says the current deferral helps, “but it doesn’t solve the fundamental issue. Ideally, tax should be collected only when the ESOP holder actually sells the shares and realises money.”

Ruparel adds, “I’m hopeful they’ll extend the deferral period and widen eligibility. But I don’t realistically expect a shift to a simple ‘tax-on-sale’ framework. If more start-ups are covered, that’s good for the ecosystem. If the deferral period is extended, fewer employees will be forced to pay tax prematurely. It gives them more time and some insurance that, if the company does well, they’ll actually make money before paying tax.”

Beyond ESOP reform, stakeholders want Budget 2026 to accelerate India’s deep-tech and AI infrastructure. Raha Lahiri, Partner at Grant Thornton Bharat, says the country’s start-up economy is moving from design to execution.

With the ₹1-lakh-crore RDI Fund now onboarding managers and beginning disbursements, capital is starting to reach high-readiness deep-tech ventures. State-level AI hubs and institutional support such as the IAIRO at GIFT City are further strengthening the push toward sovereign AI capability.

“If the Budget accelerates IndiaAI infrastructure and fast-tracks RDI deployment, India can shift from promise to global product leadership,” Lahiri said.

In short, the sector is asking not only for tax fixes that make ESOPs usable and portable, but also for budgetary measures that convert national intent into the physical and institutional infrastructure needed to scale deep-tech start-ups.