Taxability of compensation in relation to diminution in value of ESOPs

Employee Stock Option Plan (ESOP) is a scheme under which a company offers its employees an opportunity to participate in the profits of the company by allotting them shares of the company at a future point in time, subject to certain conditions. At the time of granting or vesting of ESOPs, the company is transferring to the employee, merely the right to purchase the shares of the company at a future date, thus, no taxable event arises. The first tax instance occurs when the securities are allotted to the employee, upon exercise of the ESOPs, and at that point in time, the fair market value of the shares allotted to an employee less any amount paid by such an employee will be chargeable to tax as “perquisite” under the head “salaries”. When the securities allotted under the ESOP scheme are later sold by the employee, any resulting gains will be subject to taxation under the head of “capital gains”. Now, another situation that may arise is the taxability of the consideration received by the employee at the pre-exercise stage, when the employee has not exercised his right under the ESOP scheme.

Recently, the Hon’ble Madras High Court (High Court) in the case of Nishithkumar Mukeshkumar Mehta v. DCIT^[i], has dealt with the question of taxability of compensation in relation to ESOPs received by the employee at a pre-exercise stage, when the employee had not exercised the options under the ESOP scheme.

In this article, we have discussed the ruling of the High Court in the ensuing paragraphs:

Facts:

The taxpayer is an employee of Flipkart Internet Private Limited (FIPL), which is a wholly owned subsidiary of Flipkart Marketplace Private Limited (FMPL). FMPL is a wholly owned subsidiary of Flipkart Private Limited Singapore (FPS). FPS implemented the Flipkart Stock Option Scheme, 2012 (FSOP), under which the taxpayer was granted stock options, wherein a portion of the options had already been vested into the taxpayer, and the balance was unvested. In the year 2023, FPS divested its stake in PhonePe business, which resulted in diminution in value of the stock options. Pursuant to such diminution, FPS announced compensation to all the stock option holders, although there was no legal or contractual right to make such compensation under the FSOP.

Such compensation was paid to the taxpayer after deducting tax at source under section 192 of the Income-tax  Act, 1961 (IT Act). However, the taxpayer argued that the compensation received was a capital receipt, which is not liable to tax. Thus, the taxpayer applied for a ‘nil’ tax deduction certificate. This application was rejected on the ground that the compensation has been paid to the taxpayer for relinquishing the right to sue its employer and thus, is taxable under the head capital gains. Thus, the taxpayer filed the present writ petition before this High Court.

Ruling of the High Court:

Nature of ESOPs under the IT Act

The taxpayer argued that ESOPs are rights in relation to the shares of the entity, and thus, should be treated as capital assets. The receipts from capital assets are taxable as capital gains, only if there is a transfer of capital assets. However, in the given case there was no transfer of capital assets as the taxpayer was holding the same number of stock options even after receipt of the compensation. In the absence of transfer of capital assets, the compensation in relation to diminution of value will not be chargeable to tax under the head capital gains.  

In response to this, tax authorities argued that the taxpayer has the right to sue for diminution of value of the stock options. Thus, the compensation paid by FPS was for relinquishment of the right to sue, and such relinquishment qualifies as transfer of a capital asset. Therefore, the receipt of compensation will be chargeable to tax under the head capital gains.

The High Court rejected the contention of both the parties and observed that stock options are not property held by the asessee within the meaning of section 2(14) of the IT Act. ESOPs are merely rights in relation to  capital assets i.e., right to receive capital assets (shares) as per the ESOP scheme. Further, the taxpayer does not have the right to receive compensation under the terms of FSOP, thus, it cannot be said that the compensation was paid for relinquishment of a non-existent right to sue.  

Whether the compensation received is a Capital receipt, not chargeable to tax  

The High Court also observed that any compensation paid for either loss of profit-making apparatus or sterilization thereof, will be considered a capital receipt. On the other hand, compensation paid for cancellation of contract, which neither affects the trading structure of the business nor deprive the taxpayer of his source of income, will be considered as revenue receipt.

The High Court held that “in case of ESOPs, the capital assets come into existence only upon allotment of shares and revenue generation from the capital asset is possible only thereafter. In this case, the compensation was not towards the loss of or even sterilization of a profit-making apparatus but by way of discretionary payment towards- potential, as regards Unvested Options, or actual, as regards Vested Options – diminution in value of contractual rights.” Thus, and compensation received towards diminution of value of ESOPs is not a capital receipt, as there is no loss or sterilization of any profit-making apparatus.

Taxability of the compensation as “perquisite” under the head of “salary”

The High Court observed that under clause (vi) of section 17(2) of IT Act, “perquisite” is defined inclusively as covering the value of a specified security. The High Court observed “that “specified security”, in the context of ESOPs, is not confined to allotted shares, but includes securities offered to the holder of ESOPs”.

The High Court accordingly held that “the expression “the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee” under clause (vi) of Section 17(2) of IT Act, is wide enough to encompass the discretionary compensation paid to ESOP holder for the potential or actual diminution in value thereof”.

The High Court next discussed the issue on how the compensation can be valued. Explanation (c) to clause (vi) to section 17(2) prescribes that the value of the specified security is the difference between the fair market value of the shares on the date of exercise of the option and the price paid by the option holder.

However, the compensation for diminution of value was received at the pre-exercise stage by the taxpayer. Thus, the High Court held that “since, the taxpayer did not make any payment towards ESOPs and continue to retain all the ESOPs even after the receipt of compensation, the entire receipt qualifies as the perquisite and becomes liable to be taxed under the head salaries”.

Conclusion:

The receipt of compensation will be chargeable to tax as “perquisite” under the head of “salary”, given the wide ambit of clause (vi) of section 17(2) of the IT Act. Therefore, the High Court was of the view that the taxpayer is not entitled to a ‘nil’ certificate of deduction and the rejection of request for a ‘nil’ certificate of deduction by the tax authorities was therefore affirmed.

Our thoughts:

On the same issue, two conflicting rulings have been passed by different High Courts. Interestingly, both the views are extremely opposite to each other.

The Hon’ble High Court of Delhi in the case of Sanjay Baweja v. DICT^[ii] has held that the compensation received on diminution of value of stock options is not taxable as a perquisite and directed for refund of the taxes deducted. An important observation made by the Hon’ble High Court of Delhi is that the compensation paid firstly is not linked to the employment. Secondly, the value of specified securities or sweat equity shares is dependent upon the exercise of option by the employee. Therefore, for an income to be included in the inclusive definition of “perquisite”, it is essential that it is generated from the exercise of options, by the employee.