Why Start-ups Want More ESOP Tax Reforms from FM Sitharaman in Budget

The taxation of ESOPs (employee stock option plans) has been a long-standing structural issue for start-ups. For the first time, the ESOPs taxation issue was partially addressed in Budget 2020, when the government announced measures to reduce the “dry tax” burden and introduced the tax deferral for employees. 

However, this relief was limited only to “eligible” start-ups, not all. After this, start-ups and investors revived calls for a system that taxes employees only when real wealth is actually realised. In short, the start-up ecosystem says that taxation should reflect realised gains, not paper valuations. 

At present, India taxes ESOPs as a perquisite at the time of exercise, even when there is no market for the shares and no liquidity event. Employees are then taxed again when they sell their shares, which creates a dual tax burden on the same compensation.

This structure, according to start-up founder and investors, is “misaligned” with the risk-reward dynamics of start-up careers, which is holding back both talent mobility and capital formation. They describe this as especially painful for unlisted start-ups, where exits can be years away, or may never materialise. 

As Padmaja Ruparel, co-founder of IAN Group, says, “you make money, you pay tax, which means that the ESOP tax should be tied to actual sale proceeds rather than speculative gains”.

In addition, start-ups are also urging the government to simplify ESOP taxation, expand deferral benefits beyond a narrow band of eligible companies, and align India’s regime with global norms to prevent talent flight and offshore locations.

The roots of these demands lie in India’s existing ESOP taxation structure, which imposes tax liabilities well before liquidity is realised.

India’s Current ESOPs Tax Structure

Primarily, India’s taxation framework for ESOPs is governed by the Income Tax Act, 1961. ESOPs are taxed at two points: one at the time of exercise and another at the time of sale. This creates a liquidity crunch in the hands of employees when they are liable to pay tax at the time of exercise of options even though there is no corresponding cash inflow at that time.

To explain it further, ESOPs are treated as a perquisite when an employee exercises their stock options under Section 17(2)(vi) of the Income-tax Act. At this stage, the difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price paid by the employee is taxed as “salary income”. 

A second tax liability arises at the time of sale of shares. Under Section 45, any subsequent appreciation in value is taxed as “capital gains”. The applicable rate depends on the nature of the shares (listed or unlisted) and the holding period. This effectively subjects ESOP-related compensation to taxation twice, albeit on different components of value.

To mitigate the cash-flow impact of upfront taxation, the government introduced the Finance Act, 2020, a tax deferral mechanism for employees of “eligible start-ups” as defined under Section 80-IAC. 

The reform was aimed at reducing the burden of immediate tax liability on employees receiving shares without realising actual monetary gains.  In addition, it eased the financial strain on start-ups, which often had to deduct and remit taxes that exceeded employees’ cash salaries. However, it remains unclear whether this measure has truly benefited start-ups.

Tax Deferral Benefit for Start-ups

The tax deferral scheme addressed 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. She 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.

The Industry’s Ideal Goal

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.

In its pre-Budget memorandum, NASSCOM has argued for preserving the intent of the 2020 ESOP tax-deferral policy while making it meaningfully accessible in practice. The industry body has proposed a calibrated approach to the Inter-Ministerial Board (IMB) process, suggesting a limited, time-bound track focused only on objective checks, such as active DPIIT recognition, compliance with age and turnover thresholds, and the existence of a board-approved ESOP scheme.

Importantly, NASSCOM has recommended that eligibility should apply from the date of application, so that ESOP grants are not stalled awaiting approval, with certifications valid for a defined period and subject to renewal. It has also suggested a simple electronic registry accessible to the Centralised Processing Centre (CPC) for withholding and reporting, while retaining post-facto audit powers.

Ruparel 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.”

“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,” she adds. 

Dr. Ajai Chowdhry, Founder of HCL and Chairman of EPIC Foundation, believes India is at a pivotal moment in its quest to become a global innovation hub. But according to him, the ESOP framework is central to supporting start-up growth. He also warned that the current tax structure is a major impediment.

“India’s dual taxation model on ESOPs - taxing employees at exercise and again at sale - creates significant friction that is actively pushing Indian startups and founders toward offshore relocation,” he says. 

Chowdhry argues that this contrast becomes especially stark when compared with more mature startup ecosystems. He adds that simplifying ESOP taxation is essential, and he hopes Budget 2026 will address this issue to protect and strengthen India’s expanding startup landscape.

Similarly, Raja Lahiri, Partner, Grant Thornton Bharat also echoes for clarity on ESOPs and exit taxation, and extended ESOP tax deferral. 

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.