Three employees, one ESOP plan, three tax outcomes: A tale of divergent judicial interpretations

Partner: Komal Dani

The Indian tax treatment of compensation paid for the reduction in value of unexercised employee stock options (ESOP) has landed in the spotlight. Three high-profile rulings across three High Courts—Delhi, Karnataka, and Madras—delivered sharply contrasting conclusions.

The common thread was that all three petitioners were either current or former employees of Flipkart Internet Private Limited (Flipkart India) and recipients of ESOPs issued by its Singapore parent, Flipkart Private Limited (Flipkart Singapore), under its 2012 global stock option plan (FSOP).

The trigger for these disputes was Flipkart Singapore’s demerger of its PhonePe business in December 2022, which led to a significant fall in the value of its ESOPs. To compensate for this, Flipkart Singapore made a voluntary one-time payment of USD 43.67 per option to ESOP holders. When Indian tax authorities sought to tax this compensation, under different heads, three taxpayers took the matter to court, leading to divergent judgments and a fragmented legal landscape.

Delhi High Court: provided relief to employee taxpayer, held payment not a perquisite

The first case was initiated before the Delhi High Court by Sanjay Baweja, a former Flipkart India employee who had not exercised his ESOPs at the time he received compensation. When Flipkart Singapore proposed to deduct tax on the payment, he approached the Assessing Officer under Section 197 of the Income-tax Act, 1961 (ITA), seeking a Nil Tax Deduction Certificate (Nil Certificate). The officer rejected the request, characterising the compensation as a perquisite under Section 17(2)(vi) of the ITA.

A ‘perquisite’ typically refers to a non-cash benefit arising from employment, such as rent-free accommodation, car allowance, or shares allotted under an ESOP. Section 17(2)(vi) specifically brings into the tax net the value of any specified security or sweat equity shares allotted to an employee at a discount at the time of exercising the option. Employers must withhold taxes on the perquisite value of such compensation. However, non-resident employees can apply to the tax authorities under Section 197 for a Nil Certificate, which requests authorisation to have no tax withheld (or tax withheld at a reduced rate). Once issued, this certificate allows the employer to deduct tax at source at the specified lower rate, or not at all. The Delhi High Court quashed the order, holding that since the stock options were unexercised, the perquisite tax had not triggered, and thus the compensation received was not taxable. The compensation was a voluntary payment, not a contractual right or part of employment income. ESOPs become taxable only after they are exercised, and the benefit is derived from the allotment or transfer of specified securities.

The revenue department’s order was set aside, and the department was directed to issue a Nil Certificate.

Madras High Court: Contrary verdict, held payment taxable as perquisite

The Madras High Court took a revenue-friendly view in Nishithkumar Mehta v DCIT. Like Mr. Baweja, Mr. Mehta was a Flipkart India employee who received compensation on unexercised FSOPs. However, Flipkart Singapore had deducted tax from the salary income. Mehta challenged the tax treatment, and he too sought a Nil Certificate under Section 197, claiming that the amount was a capital receipt (which is not taxable unless it falls within the scope of the ITA).

The High Court rejected the claim, holding that:

• ESOPs are not capital assets, as no actual rights to shares accrue until exercise and allotment.
• The compensation was not for the relinquishment or transfer of an enforceable or monetisable right. Actual benefits accrue only upon transfer, provided there is a capital gain.
• The receipt was directly attributable to Mr. Mehta’s employment and qualified as a perquisite despite the options being unexercised. The scope of the term ‘specified security’ in Section 17(2)(vi) of the ITA is not confined to allotted shares, but also includes securities offered to the holder of ESOPs. This was a key difference of interpretation. Unlike the Delhi and Karnataka High Courts, which held that taxability under Section 17(2)(vi) arose only upon actual exercise of the option and allotment of shares when a determinable benefit crystallises, the Madras High Court held that even an unexercised option could give rise to a taxable perquisite. In doing so, it expanded the tax net to include unexercised ESOPs, which are vested and can be cancelled on the occurrence of specified events.

The Court upheld the rejection of the Nil Certificate and expressly declined to follow the Delhi High Court ruling in Sanjay Baweja, calling its reasoning inapplicable.

Karnataka High Court: Another win for the taxpayer, held payment was non-taxable capital receipt

In Manjeet Singh Chawla v Deputy Commissioner of TDS, the Karnataka High Court dealt with an almost identical factual matrix: Mr. Chawla was also a Flipkart India employee, held unexercised FSOP options, and received compensation due to value erosion following the PhonePe demerger. His request for a Nil Certificate under Section 197 was also rejected.

The Karnataka High Court agreed that one-time compensation is not a salary, perquisite, or income from other sources. It was instead a capital receipt, not chargeable under any head of income, particularly since the petitioner had neither exercised his stock options nor received any shares. The Court directed the revenue department to issue a Nil Certificate within six weeks.

The Court further distinguished the contrary ruling of the Madras High Court (in the Mehta case) by pointing out that it was based on faulty reasoning and was also under appeal before the Division Bench of the Madras High Court (i.e., two judges over a single bench judge). The Court referred to and expressly relied upon the earlier decision of the Delhi High Court, treating it as binding precedent on materially identical facts. The Court noted that the revenue department had not challenged the Delhi High Court ruling, thereby allowing it to attain finality, and held that its reasoning squarely applied to the case at hand. It contrasted this with the Madras High Court ruling, which had been challenged and therefore had not yet reached finality.

What do these differing views mean for taxpayers?

These decisions highlight the uncertain and evolving jurisprudence around the taxation of ESOP-related compensation. Two key themes emerge:

1. Exercise of options is critical to taxing the compensation as salary: Both Delhi and Karnataka High Courts have reaffirmed that perquisite taxation is triggered only when the ESOPs are exercised and shares are allotted. The Karnataka High Court went a step further, ruling not only that perquisite taxation was inapplicable absent exercise, but also that the receipt itself was a capital receipt, not income at all. Despite differing final characterisations, both courts agreed that without the actual exercise of ESOPs, Section 17(2)(vi) cannot apply.
2. Nature of payment is crucial: In both rulings, the voluntary and discretionary nature of the compensation played a central role in favouring the taxpayer. In contrast, the Madras High Court held that a mere employment nexus was sufficient to bring such payments within the ambit of perquisite taxation.

It is interesting that in all three cases, the revenue department had denied the Nil Certificate, showing their inherent instinct to impose taxes wherever possible. Notably, none of the courts have fully analysed whether such compensation, not qualifying as a perquisite or capital gains due to computational challenges, should be taxed under the residual head, “income from other sources.” Section 56 of the ITA serves as a catch-all head but cannot be invoked casually. Courts have consistently held that when a receipt does not fit into any specific head due to lack of a computation mechanism, as in the case of unexercised options, the residuary head should not be triggered unless the receipt itself is inherently income. By not addressing this question squarely, the rulings leave ambiguity on whether voluntary compensation for diminution in ESOP value can be taxed at all, even outside the salary or capital gain framework.

Given the confusion, the matter is ripe for authoritative determination by the Division Bench or the Supreme Court. Until then, employees receiving such payments must evaluate applicable precedents in their jurisdiction and factor in the potential litigation risk.

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