ITAT holds buyback of vested but unexercised ESOPs taxable as capital gains, not perquisite

Mr. Promod Kumar Jain was an employee of Flipkart Internet Private Ltd. and had been granted stock options by the overseas group company, Flipkart Private Limited, Singapore (Flipkart Singapore), under the Flipkart Stock Option Scheme, 2012. During assessment year 2020-21, 2,653 of his vested stock options were repurchased by Flipkart Singapore for INR 2.4 crore. The options had not been exercised, and no shares had been allotted to him.

In the return of income, the taxpayer reported the consideration as long-term capital gains. The tax officer, relying on Form 16 and the tax note contained in the repurchase offer letter, treated the amount as a perquisite taxable under Section 17(2)(vi) of the IT Act under the head “Salaries.” The first appellate authority upheld this treatment.

The Tribunal identified five stages in the ESOP lifecycle – grant, vesting, exercise, allotment and sale of shares. It noted that, in this case, only grant and vesting had occurred. The Tribunal held that:

1. Section 17 (2)(vi) does not apply to the option itself. The provision taxes the value of the “specified security” allotted or transferred pursuant to exercise of the option, and not the option itself. Since the taxpayer had not exercised the options and no specified securities had come into existence, the provision could not be invoked.

2. The valuation mechanism in Explanation (c) to Section 17(2)(vi) could not operate. Since the statutory valuation is based on the fair market value on the date of exercise and no exercise had taken place, the prescribed computation mechanism was unavailable. Relying on CIT v. B.C. Srinivasa Setty,² the Tribunal held that the charge could not operate where the computation provisions failed.

3. A vested stock option is a capital asset. The Tribunal treated the vested stock option as a right, not an obligation, to subscribe to shares on a future date at a predetermined price and held that such right constitutes a capital asset under Section 2(14), read with Explanation 1(i)(e) to Section 2(42A). It relied on Miss Dhun Dadabhoy Kapadia v CIT³ and the Karnataka High Court’s decision in Chittharanjan A. Dasannacharya v CIT⁴ to reach this conclusion.

4. Buyback of vested options constitutes a transfer. The repurchase was held to amount to a “transfer” within the meaning of Section 2(47) of the IT Act, being a sale, exchange or relinquishment of a capital asset. The resulting gains were therefore chargeable under Section 45.

5. Tax deduction at source (TDS) treatment does not determine the character of income. The Tribunal rejected the tax officer’s reliance on Form 16, Form 26AS and the tax note in the repurchase offer letter. It observed that contractual descriptions and TDS under Section 192 are not conclusive of the correct head of income in the hands of the recipient, which must be decided by applying the provisions of the IT Act.

The Tribunal distinguished the Madras High Court’s decision in Nishithkumar Mukeshkumar Mehta v DCIT, TDS,⁵ noting that the factual circumstances differed. In that case, the taxpayer had retained his stock options and the payment related to compensation for divestment of the PhonePe business by Flipkart, while in the present case, the vested options were repurchased from the taxpayer by Flipkart Singapore.

The decision may have decided the immediate controversy before it, but the significance of the ruling lies equally in what it leaves unresolved.

1. Potential application of Section 46A

   Section 46A brings within the capital gains framework any consideration received on a company’s purchase of its own shares or other specified securities. The Explanation to Section 46A adopts the definition of “specified securities” under Section 68 of the Companies Act, 2013, which expressly includes employee stock options. Seen this way, the legal route seems almost pre-mapped: vested options are specified securities; their buy-back by the issuer should therefore fall naturally within Section 46A. Yet, the potential interaction between Section 46A and the Tribunal’s capital gains analysis was not examined in the ruling.

2. Why the employment relationship does not determine the character of the receipt on surrender of options

   The tax officer’s instinct to characterise such receipts as employment income is understandable, since employee stock options originate in the employment relationship. However, that background, by itself, cannot determine the character of every subsequent receipt connected with the option. The legal analysis must instead focus on the immediate source from which the consideration is derived.

   Employment explains the grant of the option. It does not necessarily explain the nature of a later payment received on its buy-back, cancellation or surrender. Once the option has vested, the employee is no longer merely a recipient of a contingent incentive linked to future service. The employee holds an existing right, which, even if subject to limitations prior to exercise, is capable of being surrendered, relinquished or extinguished for consideration. In such a case, the proximate cause of the receipt is not the rendering of services in the year of receipt, but the giving up of that vested right.

   This distinction is legally significant. Where the consideration arises on account of the surrender or extinguishment of a vested option, the immediate legal source of the receipt is the transfer of a proprietary entitlement and not the contract of employment as such. The receipt is therefore more appropriately characterised by reference to the capital asset that is parted with, rather than by reference to the historical circumstance in which that asset was originally granted.

   Viewed in this manner, the Tribunal’s reasoning is persuasive. It correctly directs attention to the operative legal event that gives rise to the payment. The employee is compensated not for services rendered, but for parting with an already accrued right. The broader doctrinal point that emerges is that, in the context of ESOP taxation, a distinction must be maintained between the historical origin of the asset and the immediate legal source of the receipt. While the former may lie in employment, the latter may lie in the transfer, surrender or extinguishment of a capital asset.

3. Limits of perquisite taxation under Section 17(2)(vi): Why did the tax department not trigger Section 15 to tax the income?

   Although the Tribunal found that Section 17(2)(vi) did not apply, the broader salary provisions raise a separate question.

   Section 15 is the charging provision for income under the head “Salaries,” while Section 17 contains an inclusive definition of salary. It was therefore at least open to the tax officer to explore whether the receipt could be brought within the wider salary framework through another limb of Section 17, even if Section 17(2)(vi) itself did not apply. Section 17(1)(iv), in particular, includes within salary any fees, commissions, perquisites or profits in lieu of or in addition to salary or wages. The Tribunal’s reasoning nevertheless supports the view that, once an option has vested, the immediate source of consideration received on its surrender or extinguishment may be the transfer of an existing right rather than the employee’s services.

4. Cost of acquisition and the statutory silence

   The ruling also does not examine the cost of acquisition of the vested options, although this may prove to be one of the most contested computational questions in future cases.

   One possible view is that the cost of acquisition should be treated as nil, since the employee does not ordinarily incur any separate monetary outlay to acquire the option. While this approach has a certain simplicity, it is not entirely satisfactory in principle. A vested option is not ordinarily received as a gratuitous accretion; it is earned over the vesting period as part of the overall compensation arrangement between the employer and the employee. It may therefore be argued that the option carries an embedded cost represented by the value of the services rendered by the employee.

   The difficulty with this argument is not conceptual but statutory. The IT Act does not contain any express provision that translates the value of services rendered into a legally cognisable cost of acquisition for an unexercised option that is subsequently surrendered or extinguished. Neither does Section 55(2)(a) provide a clear basis for treating the matter otherwise. That provision deems the cost of acquisition to be nil only for a specified and closed category of self-generated business-related intangibles. An employee stock option does not naturally fall within that enumeration, and there is no clear warrant for extending the deeming fiction by analogy.

   The result is a degree of computational uncertainty. Although there is force in the argument that the option is not acquired without consideration in an economic sense, the absence of a specific statutory mechanism makes it difficult to support any definite cost base. Therefore, practically, taxpayers may find it difficult to sustain a position that attributes a cost of acquisition other than nil, notwithstanding the conceptual limitations of that approach.

5. Period of holding: From what date does the clock start?

   The ruling also leaves open the technically important question of the holding period of ESOP rights. The issue is whether the holding period should be measured from the date of grant of the option, when the employee first receives the right to subscribe to shares at a predetermined price, or only from the date of vesting, when that right matures into a presently enforceable entitlement.

   The answer to this question may be determinative of whether gains arising on transfer, surrender or extinguishment of the option are to be treated as short-term or long-term capital gains. The earlier decision of the Tribunal in N.R. Ravikrishnan v ACIT,⁶ supports the view that the option constitutes a capital asset from the date of grant. That approach also finds some support in Explanation 1(i)(e) to Section 2(42A) of the Act, which, in relation to a capital asset being a right to subscribe to any financial asset, directs the holding period to be reckoned from the date on which such right is offered.

   At the same time, caution may be necessary in cases where the vesting conditions are substantial or where the terms of the plan suggest that no meaningful enforceable right comes into existence prior to vesting. In such cases, the tax officer may contend that the holding period should commence only upon vesting.

6. GAAR and anti-avoidance considerations

   The ruling did not discuss GAAR, and rightly so, on the facts. There is a tendency in difficult tax cases to ask whether anti-avoidance principles ought to have been invoked whenever a taxpayer-friendly result emerges. GAAR is meant to address arrangements where tax benefit is the main purpose and where the structure carries one or more tainted features such as lack of commercial substance, misuse of the statute, or creation of rights and obligations not ordinarily found in arm’s length dealings.

   A genuine, group-wide liquidity or restructuring event, such as a repurchase or cancellation of options undertaken uniformly across the employee pool, would ordinarily be less likely to raise GAAR concerns. Where the arrangement is driven by a bona fide commercial objective and is not selectively designed to secure a tax advantage for a particular category of employees, the mere fact that it results in a tax-efficient outcome should not, by itself, invite an anti-avoidance inquiry.

   The position, however, may be different where a buy-back or cash-settlement arrangement is structured for a narrow group of executives, particularly close to the exercise of their options, and lacks a discernible commercial rationale beyond achieving a favourable tax outcome. In such circumstances, the GAAR analysis may become difficult to avoid. The commercial rationale, substance and manner in which the arrangement is implemented would therefore remain important. The stronger the underlying commercial rationale and the more consistently the arrangement is applied, the lower the potential anti-avoidance risk.

The Tribunal’s decision is an important and well-reasoned ruling on the taxation of vested but unexercised ESOPs. Its central contribution lies in recognising that a vested stock option is distinct from the underlying specified security that may arise only upon exercise. Where no exercise takes place and no shares are allotted, the statutory basis for taxation under Section 17(2)(vi) of the IT Act appears absent. In such cases, consideration received on the buyback or extinguishment of the option is more appropriately analysed under the capital gains framework.

The ruling is also significant from a compliance and documentation perspective. In practice, employers often adopt conservative withholding positions for operational simplicity or out of an abundance of caution. The Tribunal’s reasoning usefully reinforces the point that such withholding positions, including Form 16 treatment and TDS under Section 192, do not by themselves determine the correct head of income in the hands of the employee; that question must ultimately be resolved by applying the charging provisions to the facts.

For employers, the decision underscores the importance of ensuring that tax notes in offer letters are drafted as indicative, non-advisory summaries, and that plan documentation does not inappropriately lock participants into a tax position that may not be supported by law. For employees, the ruling supports the proposition that a considered position may still be taken in the return of income despite contrary Form 16 treatment, provided that the position is properly disclosed and supported.

At the same time, the ruling should be read within its factual limits. It offers strong support where vested but unexercised options are actually bought back or extinguished and no shares are ever allotted. However, it does not settle all questions arising in relation to ESOP-linked cash payments. Issues such as the possible relevance of Section 46A, the scope of the wider salary provisions, cost of acquisition, period of holding, and anti-avoidance concerns remain open. Overall, Pramod Kumar Jain materially strengthens the position that genuine pre-exercise buyback consideration should, on the right facts, be taxed as capital gains rather than salary.