Employee Stock Option Plans (ESOPs) and Compulsorily Convertible Preference Shares (CCPS) are common financing and employee incentive tools in startups. However, these structures present significant General Anti-Avoidance Rule (GAAR) risks under the Direct Tax Code (DTC) 2025. This guide analyses the GAAR implications of ESOP and CCPS structuring and provides practical guidance for founders.
The GAAR Framework
Section 178 — Applicability of GAAR
Section 178(1) provides that "an arrangement entered into by an assessee may be declared to be an impermissible avoidance arrangement and the consequence in relation to tax arising from it may be determined". Section 178(2) clarifies that GAAR "may be applied to any step in, or a part of, the arrangement".
Section 179 — The Impermissible Avoidance Arrangement Test
An arrangement qualifies as an impermissible avoidance arrangement where the main purpose is to obtain a tax benefit, and it:
- Creates rights or obligations not ordinarily created between persons dealing at arm's length
- Results in misuse or abuse of the provisions of the Act
- Lacks commercial substance or is deemed to lack commercial substance under Section 180
- Is entered into by means not ordinarily employed for bona fide purposes
Section 179(2) — The Presumption
Section 179(2) creates a presumption that an arrangement has been entered into for the main purpose of obtaining a tax benefit if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit.
GAAR Risks in ESOP Structuring
1. ESOP Valuation
ESOP valuation is a critical area of GAAR risk. If the ESOP exercise price is set significantly below the fair market value, the difference may be treated as a perquisite taxable in the hands of the employee. This could also be viewed as a tax avoidance arrangement if:
- The valuation is not supported by a proper valuation report
- The valuation is artificially low to reduce tax liability
- The valuation is not consistent with market practice
2. ESOP and Section 17(1)(d)
Under Section 17(1)(d), the value of any specified security or sweat equity shares allotted or transferred by the employer free of cost or at concessional rate to the assessee is included as a perquisite. The valuation of the perquisite is determined under Rule 15(6) and (7).
GAAR risk arises if the ESOP structure is designed to shift income from the employer (which may be in a high-tax jurisdiction) to the employee (which may be in a low-tax jurisdiction) or to avoid tax on the perquisite.
3. ESOP and Section 391(2)
Under Section 391(2), direct payment of tax for ESOP income is made in accordance with Section 289(3). The tax or interest on such income is payable by the assessee within fourteen days after the expiry of sixty months from the end of the relevant tax year, or from the date of sale of the specified security, or from the date of ceasing to be an employee, whichever is earliest.
GAAR risk arises if the ESOP structure is designed to defer tax liability artificially.
4. ESOP and Section 392(3)
Under Section 392(3), any person, being an eligible start-up responsible for paying any income of the nature specified in Section 17(1)(d) in any tax year, shall deduct or pay tax on such income within the time specified for the payee in Section 289(3).
GAAR risk arises if the ESOP structure is designed to avoid the TDS obligations or shift the tax burden to the employee.
GAAR Risks in CCPS Structuring
1. CCPS Valuation
CCPS valuation is a significant area of GAAR risk. The conversion price of CCPS must be at fair market value. If the conversion price is artificially low, the difference may be treated as income in the hands of the investor.
2. CCPS and Section 56
Under Section 56, the receipt of CCPS at a price below fair market value may be treated as income under Section 92(2)(m)(iii) if the aggregate fair market value of the shares exceeds the consideration paid by more than ₹50,000.
3. CCPS Conversion
The conversion of CCPS into equity shares may raise GAAR concerns if:
- The conversion is designed to shift income from the investor to the startup
- The conversion is designed to avoid tax on the appreciation of the shares
- The conversion is not at arm's length
What Founders Should Do
1. Document Commercial Rationale
Document the commercial rationale for the ESOP and CCPS structuring decisions:
- Why was ESOP chosen as an employee incentive tool?
- Why was CCPS chosen as a financing instrument?
- What are the commercial terms of the arrangements?
2. Ensure Proper Valuation
Obtain proper valuation reports for ESOP and CCPS:
- The valuation must be done by a qualified valuer
- The valuation must be supported by proper documentation
- The valuation must be consistent with market practice
3. Maintain Arm's Length Terms
Ensure all terms of the ESOP and CCPS arrangements are at arm's length:
- Exercise price of ESOP must be at fair market value
- Conversion price of CCPS must be at fair market value
- All terms must be consistent with market practice
4. Avoid Artificial Steps
Avoid steps that serve no commercial purpose other than tax optimisation:
- Unnecessary intermediaries
- Artificial pricing
- Round trip financing
5. Seek Expert Advice
Given the complexity of GAAR, seek expert legal and tax advice:
- Obtain tax opinions on the GAAR implications
- Consider advance rulings for significant structures
- Review structures regularly for GAAR compliance
Consequences of GAAR Invocation
Section 181 — Consequences
If an ESOP or CCPS structure is declared to be an impermissible avoidance arrangement, Section 181 empowers the tax authorities to:
- Disregard, combine, or recharacterise any step in the arrangement
- Treat the arrangement as if it had not been entered into or carried out
- Disregard any accommodating party
- Reallocate income, expenditure, deduction, relief, or rebate among parties
Practical Implications for ESOP
- Recharacterisation of ESOP as salary or fee income
- Disallowance of deductions claimed by the employer
- Reallocation of income to the employer
- Denial of tax deferral benefits
Practical Implications for CCPS
- Recharacterisation of CCPS as debt rather than equity
- Disallowance of deductions claimed by the startup
- Reallocation of income to the investor
Expert Legal Guidance
Anuj Desai & Associates provides comprehensive legal advisory services on GAAR compliance for startup ESOP and CCPS structuring. Our direct tax experts help founders evaluate structures for GAAR risk, document commercial rationale, and navigate the regulatory framework. We assist in structuring defensible arrangements, preparing documentation, and representing clients before income-tax authorities.
Disclaimer: This article provides general information and does not constitute legal advice. For specific guidance on GAAR compliance or any other direct tax matter, please consult qualified legal professionals.
Need Expert Legal Guidance?
Navigating the complex GAAR framework for startup ESOP and CCPS structuring requires experienced legal counsel. At Anuj Desai & Associates, we provide comprehensive direct tax advisory services, including:
- Structure Review: GAAR risk assessment for ESOP and CCPS structures
- Documentation: Assistance with commercial rationale documentation
- Valuation: Guidance on proper valuation
- Representation: Representation before income-tax authorities
Contact us for expert legal guidance on your startup structuring matters.