Unfolding the ESOPs’ taxation conundrum

shalini_jain_in_ey_com_LThumbEmployees’ Stock Option Plans (ESOPs) form an integral part in the overall reward framework of an organization. In a typical ESOP, the company grants options to the employees. These options vest over a period of time, subject to certain conditions. On fulfilment of the vesting conditions, the employees get the right to exercise the options and thereafter, shares are allotted to the employees by the employer.

From a taxation perspective, there are two stages of taxation of ESOPs. First, on allotment of shares, the difference between the fair market value of the share and the exercise price is taxed as perquisite and subsequently on sale of shares, the difference between the sales proceeds and the cost of acquisition (i.e., the fair market value considered for the purpose of perquisite valuation) is taxed as ”capital gains”.

The holding period of shares for capital gains commences from the date of allotment of shares and not from the date of grant of the stock options.

In this article, we will discuss two recent rulings of the Chennai and Bangalore Tribunals on taxability of ESOP.

Gains arising on sale of shares allotted under ESOP – taxable as “capital gains”, not “perquisite”

The taxpayer, an individual working in India, filed his tax return for financial year (FY) 2010-11, which was picked up by the India revenue authorities for audit.

The individual had worked outside India for a foreign parent company during the previous years, when he was granted some stock options, which were vested to him, and exercised by him while working outside India.

During the FY 2010-11, the parent company sold these shares on behalf of the individual and remitted the proceeds to the individual’s bank account through the Indian employer (subsidiary company). The Indian employer, while issuing the Form 16 for FY 2010-11 reported the entire amount of sale proceeds as perquisite. While filing the tax return, the taxpayer excluded the amount of sales proceeds from his income and offered the appreciation in the value of shares post allotment as capital gains.

The assessing officer (AO) passed an order disregarding the capital gains and considering the entire amount of sale proceeds as a perquisite income as per the Form 16, as he was of a view that the amount received from the employer (present or former) is a taxable perquisite. The taxpayer appealed before the Commissioner of Income-tax Appeals (CIT-A) who upheld the order of the AO. Aggrieved by both, the taxpayer appealed to the Chennai Appellate Tribunal.

The tribunal observed that any taxpayer qualifying as a non-resident would be subject to tax only on income accruing/arising in India. As per the Indian tax laws, in case of salary income, only salary for services rendered in India is considered to accrue in India. In this case, the taxpayer had exercised his stock options and the shares were allotted to him while he was working outside India and qualified as a non-resident. Accordingly, the trigger for perquisite taxation arose in the prior years. Therefore, the perquisite value forming a part of the salary income is not subject to tax in India. It was only the subsequent sale of shares that took place while he was working in India during FY 2010-11. Merely because the consideration was routed through the employer, the proceeds from the sale of shares do not partake the nature of employment income.

Further, the tribunal also noted that since the shares were already allotted to the taxpayer in the past and the taxpayer held them at the beginning of the relevant FY, the gain due to appreciation in the value of the shares is capital gain. The amount of capital gain is the difference between the sales proceeds and cost of acquisition, where the latter is the value of the shares at the time of allotment to the taxpayer.

The tribunal further mentioned that the income needs to be assessed in the hands of the taxpayer based on the evaluation of facts and circumstances, while keeping the tax provisions in regard instead of being merely based on the reporting of the same in the Form 16. Accordingly, the tribunal deleted the additions made by the AO and the case was remanded to the AO to verify the accuracy of the amounts based on the facts and provisions of law.

The tribunal has reiterated the settled position that fair value appreciation in the shares allotted by way of ESOP is taxable as “salary” up to the date of allotment and further appreciation till date of sale is to be treated as a “capital gain”. Further, there is an added clarity on the position that exercise of stock options outside India by a non-resident does not trigger taxability.

Capital gains arising from buy-back options – holding period from date of grant or vesting?

The taxpayer was granted 6,000 stock options on different dates, under an ESOP by an Indian company, of which, he held 3,750 options for more than three years. Prior to the exercise, the company bought back these options. The taxpayer claimed that the gain on sale of 3,750 options were long term in nature, as he held them for over three years and claimed an exemption u/s 54EC of the Income-tax Act, 1961 by reinvesting the gains in specified bonds, which is available only for long-term capital gains.

The AO contended that the gains were short term as the holding period of the options, prior to vesting should not be taken into account, as the taxpayer had no right to exercise.

The taxpayer placed reliance on various tribunal rulings and contended that the date of vesting and exercise of the options were not relevant as the buy-back took place before the exercise and hence, the period of holding needs to be reckoned from the grant date.

The AO held on to the view that prior to the vesting date, the taxpayer could not have exercised the right to buy the options and hence, the capital asset being the “right” came into existence only on the date of vesting and accordingly, the capital gain is short term. The CIT-A upheld the order of the AO. Aggrieved by both, the taxpayer appealed to the Bangalore Appellate Tribunal.

The Bangalore Tribunal held that the gains were long term as the options constituted a right to the taxpayer (to exercise), which is a capital asset in itself and hence, the options were considered as “capital asset”, thereby, the period of holding commences from the date of grant. Further, as the options were bought back from the taxpayer prior to their exercise, the tax authority’s contention that the taxpayer cannot exercise the options is not relevant. Accordingly, the tribunal allowed the exemption claimed by the taxpayer.

In this ruling, there was no dispute that the gains on the transfer of stock options represented capital gains. The dispute was only restricted to whether such capital gains are long term or short term in nature.

The author of the blog is Shalini Jain, Partner, People Advisory Services, EY India

The blog is co-authored by Vijayalakshmi PG, Manager, People Advisory Services, EY India



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