Synopsis

A recent ITAT decision clarified ESOP repurchase taxation. The tax tribunal ruled that repurchased options are capital assets, not perquisites. This decision provides significant relief and clarity for employees and startups. Substance over form prevails, ensuring correct tax treatment regardless of filings. Employees should understand vesting, exercise, and repurchase rules for ESOPs.

In Benjamin Franklin’s famous words, nothing is certain except death and taxes. While the above statement remains factually correct, some might argue that for taxes, while the certainty remains of being taxed, the quantum remains uncertain.



A recent Income Tax Appellate Tribunal (ITAT) decision involving taxation of ESOPs has brought some relief and clarity on this aspect, and which should find favour with employees, start-ups, promoters and other stakeholders.



The concept of ESOPs is unique. ESOPs are intended to provide employees with an incentive to join an early stage or growth stage startups. Since the early joiners believe in the growth story and may not be fully compensated in monetary terms, ESOPs are a manner of compensating them by offering them a share in the growth of the company that they helped build and contributed to.

While the concept seems simple, the policy and applicable legal provisions governing issuance/ grant, vesting, exercise, repurchase are to be carefully documented to ensure that the end intent is achieved and the benefit is ultimately received by the employees. There are also provisions under FEMA, Companies Act and Income Tax Act that have to be duly borne in mind while structuring ESOPs as a compensation for employees. The actual benefit is received by the employees either when they sell the shares in an IPO, or by way of secondary transfer, or where the issuing company itself repurchases the shares or stock options.

What did ITAT held?

In a recent decision, the Tax Tribunal held that where a company repurchases the stock options from an employee, the nature of tax would be as applicable to capital assets, and not perquisites.



The issue in hand was whether the amount received by the employee upon repurchase of the options would be taxed as a perquisite or a capital asset. While it was initially held that tax would be payable considering the amount received as a perquisite, the Tax Tribunal (ITAT) concluded that since no ‘specified security’ had come into existence, and the repurchase was of the option itself, the vested stock option represented a capital asset.



The assessing officer, while originally examining the case, took into consideration the fact that the filings made by the employer reflected the payment as a perquisite, and other consequential actions also were consistent with such a position. However, the employee had sought to treat the receipt as “long term capital gain”. The inconsistency and the view taken by two levels of tax authorities against the employee led the matter to the Tribunal.



Two key aspects were examined. Firstly, whether the filings made and consequential actions would change the fundamental nature of the payment. The Tax Tribunal decided otherwise, rightfully, remarking that TDS is merely a procedural action, and cannot alter or determine the ultimate tax liability.



Secondly, since the options were never exercised by the employee, the repurchase of options amounted to relinquishment of the right to subscribe to shares. Such a right to subscribe to shares being considered property, falls within the definition of “capital asset”, and the Tribunal held that it should be taxed accordingly.

How the Tax Tribunal’s decision provides greater clarity on the tax treatment of ESOPs

The decision taken reiterates the fundamental principle that substance prevails over form. This should come as a huge relief to employees who can be reasonably certain that even where filings or categorisations/ tax deductions are incorrectly made, the examination of the matter will be on the substance of the transaction as per applicable law.



The statutory provisions governing ESOP taxation in the ordinary course stipulate that “specified securities” be taxed equal to the concessional value at which the securities are allotted or transferred to employees. In this case the ESOPs only vested, but had not been exercised, and no shares were allotted. The options were repurchased prior to exercise and hence the provisions applicable to ‘specified securities’ were not applicable in this case.

What employees should keep in mind while understanding their ESOP plans

In many instances, employees restrain from exercising their options to avoid facing tax liability when they have not been able to encash their ESOP entitlement and choose to exercise their options only when an immediate sale is possible. This is for the reason that the tax liability arises immediately upon exercise even if the shares have not been sold, and such tax liability will have to be settled from the employees’ personal savings. The risk is also that if employees exercise the options and make tax payment upon exercise of the options as per a certain value of the shares, a subsequent lower valuation of the shares at the time of sale does not provide any set off.



Needless to say, the various triggers and actions applicable for vesting and exercise should be duly reflected in the ESOP documentation while also ensuring that the filings and consequential actions are consistent with the applicable provisions. The ESOP policy should also adequately address the scenarios of taxable events, since the obligation to deduct tax is that of the employer entity.



Employees on their part should seek appropriate legal advice to ensure that they get the full benefit of the stock options granted to them and not suffer premature tax liability while also continuing to abide by the terms of the ESOP. Accordingly, employees will need to duly examine not only the timing of exercise but also the nature and quantum of tax liability that will accrue. The clarity in position should help stakeholders appropriately structure and document their ESOPs in a robust manner.

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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