Gains From Unexercised ESOP Buybacks Taxable As Capital Gains: ITAT

The Income Tax Appellate Tribunal (ITAT) has ruled that gains from the repurchase of unexercised, vested employee stock options (ESOPs) are subject to long-term capital gains (LTCG) taxation rather than being classified as salary perquisites. This decision could potentially lower the tax burden for employees, as LTCG are generally taxed at a flat rate of 12.5% in India, without indexation, as opposed to higher rates applicable to salary perquisites.

The ITAT held that stock options are rights to purchase shares at a predetermined future date, and until such an option is exercised, no value can be assigned to it. Therefore, the repurchase of unexercised options, constituting a transfer of capital assets, falls under Section 45 of the Income Tax Act, making any resulting gains taxable under the LTCG regime.

The ruling, which pertains to a case involving a senior executive at Flipkart, arises from a discrepancy in income tax returns. While the executive reported a gross salary of ₹1.90 Cr along with LTCG of ₹2.45 Cr, derived from the repurchase of 2,653 vested stock options, the assessing officer argued that the proceeds should be classified as a salary perquisite under Section 17(2) of the Income Tax Act, thereby subjecting them to higher income tax rates.

This ruling applies to a limited set of scenarios, primarily where ESOPs have been vested but not exercised and subsequently cancelled in exchange for payment, such as in instances of a company acquisition by a larger entity that chooses not to maintain the existing ESOPs. However, tax experts have highlighted that this ruling could lead to inconsistencies in the tax treatment of similar transactions, where exercising the options to sell shares versus cancelling them and receiving a payment results in different tax implications.

The distinction is significant, as exercising the options and selling the shares would be taxed as salary, while cancelling them and receiving compensation would be taxed at the lower LTCG rate. While the ITAT ruling provides clarity on the tax treatment of unexercised but vested ESOPs, it also raises questions about the disparity in how companies report such transactions versus how employees are taxed.

Specifically, companies typically treat share buybacks as a tax-deductible expense, while the ruling implies that the transaction should be viewed as the acquisition of a capital asset. This discrepancy may create inconsistencies in the financial disclosures made by companies. Moreover, the ruling is likely to heighten the number of disputes surrounding the taxation of ESOPs, as various High Courts in India, including the Delhi, Karnataka, and Madras High Courts, have delivered conflicting judgments on similar issues in the past.

As ESOP schemes become increasingly common, particularly in the startup ecosystem, these tax-related ambiguities could persist until policymakers or administrative authorities provide clear guidance.