Startup Founders at Risk: Are You Hiding Foreign ESOPs? Shocking Tax Consequences Revealed!

In a significant turn of events, several co-founders and top executives of unlisted start-ups in India are now under income-tax scrutiny due to alleged non-disclosure of foreign shares acquired through Employee Stock Options (ESOPs). Individuals with direct knowledge of the situation report that these start-ups previously established companies in Singapore, which are often referred to as externalization structures, in pursuit of foreign listings. These Singapore-based entities typically own operating businesses based in India.

A concerning trend has emerged as some ESOP holders from these start-ups failed to disclose their foreign holdings, prompting the Central Board of Direct Taxes (CBDT) to issue notices under its Nudge initiative. This initiative aims to encourage compliance regarding undisclosed foreign assets. The notices reportedly involve executives from at least two financial services firms and one business-to-business (B2B) platform. These executives acquired their foreign shares during the period spanning from the fiscal year 2020 to fiscal year 2024.

In India, foreign shares are taxable upon disclosure, which includes capital gains tax ranging from 12.5% to 20%. However, if the transactions are unreported and later uncovered by the tax department, individuals could face a steep tax rate of 30% categorized under “Undisclosed Foreign Income.” The consequences of failing to disclose foreign holdings extend beyond financial penalties; they also encompass potential legal repercussions.

Many Indian start-ups have established structures where a foreign holding company is created, with the Indian entity serving as a subsidiary. This circumvention is due to Indian regulations that prohibit unlisted companies from directly listing abroad. By establishing overseas holding companies, start-ups can seek to list their entities outside India directly. In a related maneuver known as ‘reverse flipping,’ some companies have since merged their overseas entities back into their Indian operations, creating a corporate headquarters in India.

As noted by a tax expert, “Some specific cases have come to light during the reverse flip transactions, and these residents may not only face tax penalties but also consequences for violating anti-money laundering rules. Given the amount of data the Indian government is receiving from foreign governments through global treaties, it is advisable for individuals to proactively disclose such holdings.”

The CBDT announced the second phase of its ‘Nudge’ initiative on November 27, targeting taxpayers with undisclosed foreign assets and income. This effort is built on data received from international frameworks, particularly through the OECD, emphasizing the importance of transparency in disclosing foreign shareholdings, including ESOPs.

Failure to disclose such foreign holdings can lead to severe penalties under the Black Money Act, which allows the Assessing Officer to impose a flat penalty of ₹10 lakh for the relevant year. If the holding is classified as an ‘undisclosed foreign asset,’ it can be taxed at 30% of its value, in addition to attracting penalties that could equal three times that tax amount, alongside potential prosecution exposure. Tax experts urge individuals receiving these notices to respond promptly and correct any deficiencies in their disclosures.

Interestingly, this issue is not limited to start-ups; top executives at large multi-national companies (MNCs) in India also receive foreign ESOPs. However, compliance seems to be better among MNC employees, as these companies are often listed globally and adhere to transparent disclosure norms. According to another tax expert, “Individuals who have received Nudge Notices should treat them as an opportunity for voluntary compliance rather than adversarial proceedings. A comprehensive review of tax returns should be the first step to identify gaps in the disclosure of foreign shares, ESOPs, or related income.” This kind of proactive approach can mitigate potential legal and financial repercussions for those involved.

In conclusion, as Indian start-ups navigate complex tax regulations and the global financial landscape, the implications of non-disclosure are becoming increasingly significant. The scrutiny faced by these executives serves as a reminder of the critical importance of transparency and compliance in an era where cross-border financial transactions are under heightened scrutiny.