Repurchase of Stock Options: Perquisite v/s Capital Gains

1.1 The taxation of employee stock options has long been a subject of debate under the Income-tax Act, 1961 ("ITA"), particularly in situations where the transaction does not follow the conventional lifecycle of grant, vesting, exercise and subsequent sale of shares. One such issue relates to the tax treatment of consideration received by an employee upon the repurchase or cancellation of vested but unexercised stock options. While the taxpayers contend that vested but unexercised stock options constitute an independent capital asset, any consideration received on their repurchase ought to be taxed under the head ‘Capital Gains’, the Revenue seeks to tax such receipt as a perquisite under the head ’Salaries’. 

1.2 Against this backdrop, the Bangalore Bench of the Income-tax Appellate Tribunal ("Tribunal") in Pramod Kumar Jain v. DCIT [1]  had the occasion to examine the head of income under which consideration received on the repurchase of vested but unexercised stock options is taxable. The Tribunal analysed the scope of section 17(2)(vi) vis-à-vis the capital gains provisions under the ITA and established the distinction between the taxation of stock options at the stage of exercise and the taxation of rights embedded in vested stock options.

1.3 Before delving into the facts of the case and the issues adjudicated by the Tribunal, it is pertinent to understand the lifecycle of an ESOP and the significance of each stage from a tax perspective. A brief overview of the various stages involved in the lifecycle of an ESOP, along with the relevant tax implications, is set out below.

2.1 An employee stock option plan generally progresses through multiple stages, namely: 

i. Grant of options: The grant of options represents the initial stage of an ESOP lifecycle, wherein the employer grants eligible employees the right to acquire shares of the company at a predetermined price, subject to the terms and conditions of the ESOP scheme.

ii. Vesting of options: The vesting stage refers to the period during which the employee earns the right to exercise the options granted to them upon fulfilment of the prescribed vesting conditions, which may typically include continued employment and completion of the specified vesting period.

iii. Exercise of options: The exercise stage occurs when the employee chooses to exercise the vested options by making the requisite payment of the exercise price, thereby expressing their intent to acquire the underlying shares.

                                                               OR

Cancellation / repurchase of vested options: Certain ESOP schemes may provide the company with an option to offer consideration to employees for cancelling or repurchase their vested options prior to exercise. In such cases, instead of proceeding with the exercise of options and acquisition of shares, the employee may opt to cancel their vested rights by accepting the consideration offered by the company.

iv. Allotment of shares: Upon exercise of the options by the employee, the company allots or transfers the underlying shares to the employee, resulting in the employee becoming the shareholder of the company.

v. Sale of shares: The final stage involves the subsequent sale or transfer of the allotted shares by the employee.

2.2 Upon vesting of stock options, the employee merely acquires a right, and not an obligation, to subscribe to the underlying shares at a predetermined exercise price. It is only upon the exercise of the vested stock options that the employee becomes entitled to the allotment of shares.

2.3 The significance of these stages assumes importance from a tax perspective. Section 17(2)(vi) [2] of the ITA provides that the value of specified securities or sweat equity shares allotted or transferred to an employee pursuant to an ESOP shall be taxable as a perquisite in the hands of such employee. The value of such perquisite is determined with reference to the fair market value of the shares on the date of exercise of the stock option, as reduced by the amount, if any, paid by the employee for acquiring such shares.

2.4 Accordingly, the tax implications under the ITA arise at the stage of exercise of the ESOPs and the consequent allotment or transfer of shares to the employees. Thereafter, any appreciation in the value of such shares, realised upon their subsequent sale or transfer by the employees, is subject to taxation as capital gains in accordance with the applicable provisions of the ITA.

3.1 Pramod Kumar Jain ("the assessee") is an individual and was employed with Flipkart Internet Private Limited ("FIPL"), an Indian company. FIPL is a step-down subsidiary of Flipkart Private Limited, Singapore ("FKS"). During the course of his employment with FIPL, the assessee was granted 40,536 stock options by FKS under the Flipkart Stock Option Scheme, 2012 ("Scheme").

3.2 During FY 2019-20, FKS repurchased 2,653 vested stock options from the assessee for an aggregate consideration of INR 2,33,80,616. While making the payment, the consideration was treated as a taxable perquisite under section 17(2)(vi) of the ITA, deducted tax at source under section 192, and reflected the amount as salary income in Form 16.

3.3 While filing his return of income, the assessee took the position that the consideration received on repurchase of the vested stock options was taxable under the head "Capital Gains" and not under the head "Salaries". Accordingly, the assessee offered the gains to tax as long-term capital gains.

3.4 The case was selected for reassessment proceedings, and the tax officer recharacterised the receipt as salary income taxable under section 17(2)(vi) of the ITA.

3.5 Aggrieved against the reassessment order, the assessee preferred an appeal before the Learned Commissioner of Income-tax (Appeals) ["Ld. CIT(A)"]. The Ld. CIT(A) upheld the tax officer’s findings following which the assessee filed a further appeal before the Tribunal.

4.1 The principal issue before the Tribunal was whether the consideration received by the assessee on the repurchase of vested stock options by FKS was taxable under the head "Salaries" as a perquisite under section 17(2)(vi) of the ITA, or under the head "Capital Gains" as consideration received on the transfer of a capital asset.

5.1 The principal contention of the assessee was that the stock options granted under the Scheme had never been exercised, and consequently, no shares had ever been allotted to him. Therefore, the conditions prescribed under section 17(2)(vi) of the ITA, for taxation of employee stock options as a perquisite were not satisfied. Accordingly, it was contended that the consideration received on the repurchase of the vested stock options could not be brought to tax under the head "Salaries".

5.2 It was further contended that the vested stock options conferred upon him a right to subscribe to the underlying shares at a future date, which constituted a capital asset within the meaning of section 2(14) of the ITA. Consequently, the repurchase of such vested stock options amounted to a transfer of a capital asset, and the consideration received therefrom was liable to tax only under the head "Capital Gains" and not under the head "Salaries”.

6.1 The Revenue contended that the stock options were granted to the assessee by virtue of his employment with FIPL and, therefore, the requisite employer-employee relationship existed. In support of its contention, the Revenue relied upon Form 16, wherein the consideration received on the repurchase of the vested stock options had been treated as a perquisite and subjected to tax deduction at source under section 192 of the ITA. 

6.2 The Revenue also placed reliance on the Letter of Offer for Repurchase of Vested Options, which indicated that the consideration received on such repurchase would be taxable under the head "Income from Salaries". Accordingly, it was contended that the consideration could not be taxed under the head "Capital Gains”.

7.1 The Tribunal observed that the charging provision under section 17(2)(vi) is attracted only upon the exercise of the stock options and the consequent allotment of specified securities / shares. Since the assessee had neither exercised the stock options nor had any shares been allotted to him, the conditions prescribed under section 17(2)(vi) were not satisfied. Accordingly, the consideration received on repurchase of the vested stock options could not be brought to tax under the head "Salaries".

7.2 The Tribunal further held that a vested stock option represents a right to subscribe to shares, which constitutes a capital asset within the meaning of section 2(14) of the ITA.

7.3 Consequently, the repurchase of such vested stock options amounted to a transfer of a capital asset under section 2(47) of the ITA, and the resultant gains were chargeable to tax under the head "Capital Gains" under section 45 of the ITA.

7.4 The Tribunal also clarified that the tax treatment adopted by the employer in Form 16 or the withholding of tax at source under section 192 does not conclusively determine the nature of income in the hands of the employee, and the correct taxability must be determined in accordance with the provisions of the ITA.

8.1 The decision of the Tribunal is a welcome ruling, particularly in light of the continuing litigation surrounding the tax treatment on account of cancellation / repurchase of vested but unexercised stock options. 

8.2 It provides much-needed clarity on the principle that taxation under Section 17(2)(vi) of the ITA is triggered only upon the exercise of options and the consequent allotment of shares to the employee. The ruling reinforces the distinction between vesting of options, which merely confer a contractual right upon the employee to acquire shares in the future, and the actual acquisition of shares, which constitutes the relevant taxable event for the purposes of perquisite taxation.

8.3 Further, from a capital gains perspective, the ruling supports the principle that stock options constitute capital assets in the hands of the employee and, accordingly, any transfer, including cancellation, repurchase or surrender of such options, would fall within the ambit of transfer of a capital asset and be subject to taxation under the head “Capital gains”.

8.4 However, it is pertinent to note that the provisions of Section 46A of the ITA were not brought before the Tribunal for its consideration. Section 46A of the ITA provides for the taxation of consideration received by a shareholder on the purchase of its own shares or other specified securities by a company. The term “specified securities” has been defined to include employee stock options. Accordingly, an argument could potentially have been raised before the Tribunal that there exists a provision which specifically provides for the taxability of repurchase of stock options by a company, and therefore taxable under the head “Capital gains” pursuant to Section 46A of the ITA. 

8.5 Further, Section 46A provides that the capital gains arising from such transaction shall be computed as the difference between the cost of acquisition of the shares or specified securities and the consideration received by the shareholder. In this regard, in the absence of a specific cost of acquisition of such stock options in the hands of the employee, an argument may be advanced that the computation mechanism prescribed under Section 46A of the ITA fails. Accordingly, relying on the principles laid down by the Hon’ble Supreme Court in CIT v. B.C. Srinivasa Shetty, it may be contended that where the machinery provisions for computation of capital gains cannot be applied, the charging provision itself would fail, and consequently, no capital gains ought to be chargeable to tax. 

8.6 While the provisions of Section 69 of the New ITA broadly capture the same principles as contained in Section 46A of the ITA, there is one significant departure in the case of prescribed promoter shareholders. The New ITA provides for an additional tax liability in respect of such promoter shareholders, which is broadly aligned with the tax rates applicable to salary income. Accordingly, the potential tax arbitrage arising from the characterization of such income as capital gains, instead of employment income, may not be available in the case of such promoter shareholders. 

8.7 Going forward, employees holding stock options should evaluate the potential tax implications arising from such arrangements in light of the principles laid down by the Tribunal in the present ruling, as well as the specific provisions contained under Section 69 and the general provisions relating to capital gains under the New ITA. In particular, employees should carefully assess the tax consequences at each stage of the ESOP lifecycle, including the vesting, exercise, cancellation or transfer of options, and the subsequent sale of shares, to determine the appropriate tax treatment and associated compliance obligations.