A 30 July tax ruling involving a Flipkart employee could have implications for how employees cash out vested employee stock options (Esops).
The Bengaluru bench of the Income Tax Appellate Tribunal (ITAT) ruled that ₹2.33 crore received by Flipkart executive Pramod Kumar Jain when the company repurchased his vested but unexercised Esops should be taxed as long-term capital gains (LTCG), rather than as salary perquisite.
This distinction is important because the tax treatment of the two routes differs significantly. While perquisites are taxed at slab rates, which are over 30% for such large payouts, LTCG tax is just 12.5%.
The case file
The Flipkart employee held vested Esops and had the right to buy shares in the future at a predetermined exercise price. But he never exercised the options, and Flipkart repurchased 2,653 stock options in a buyback, paying him ₹2.33 crore. The employee declared the sale consideration as capital gains instead of a salary perquisite.
The tax department objected, treating this payment as a salary benefit because the options had been granted to him as an employee. The employee argued that he had not received shares and had instead given up a valuable right, which is the right to buy shares in the future.
The ITAT sided with the employee. The court said the salary-perquisite rule for Esops applies when an employee exercises the option and receives the shares. It added that Section 17(2)(vi), especially Explanation (c), links the tax on an Esop benefit to the date the employee exercises the option. So, until the date of exercise, the employee holds only the right to buy the shares, not the shares themselves.
Since the employee never exercised his options and no shares were allotted to him, that rule did not apply.
“The ITAT’s decision is based on the literal wording of Section 17(2)(vi), which treats the Esop benefit as salary only when an employee exercises the option and receives the shares. Until then, the employee holds a contractual right to buy shares in the future. The tribunal treated this right as a capital asset under Section 2(14) and held that the employee’s relinquishment of that right amounted to a transfer under Section 2(47). Hence, the payout was taxed as capital gains, not salary,” explained Ankit Jain, partner, Ved Jain and Associates.
The implication
Let's understand by an example. An employee has an Esop with an exercise price of ₹100, and the share is worth ₹500. If the employee exercises the option, the ₹400 difference is treated as a salary perquisite and taxed as part of salary income, which, let us assume, is 30%. So, the employee pays the ₹100 exercise price as well as ₹120 perquisite tax. The employee then owns the share and may incur capital gains tax if it is sold later.
A buyback of the unexercised option is different. The employee does not first pay ₹100 to acquire the share. Instead, the company pays the employee to give up the option. According to the ITAT's reasoning, the payment is a capital gain rather than a salary and will be taxed at 12.5%. “The exercise route can attract tax at the employee’s peak slab rate, while the buyback route can fall under the lower capital-gains rate,” said Supriya Majumdar, partner at Elarra Law Offices.
But experts say employees cannot simply choose whichever route yields the lowest tax bill.
The catch
Majumdar said a company has to structure the transaction as a repurchase and cancellation of the options themselves, rather than a buyback of shares, for this tax structure to follow. “Employees may not have the absolute independence to choose this tax-efficient route.”
So, while the ruling could provide a roadmap for Esop liquidity programmes, it does not automatically make every unexercised Esop buyback tax-efficient.
Jain cautioned that it may not be easy for employers either. “The tax department could also invoke special provisions under Section 46A/Section 69, which deal with the tax treatment of buybacks by companies to argue that the Esop repurchase should be taxed under these specific buyback rules rather than simply treating the employee's Esop right as a capital asset,” he said.
“The tax department can also invoke issues surrounding GAAR (General Anti-Avoidance Rules)."
GAAR allows the tax authorities to challenge an arrangement if they believe it was structured mainly to obtain a tax benefit, rather than for a genuine commercial purpose.
Experts said most employers may continue to deduct tax from such payouts as salary to avoid risk. However, the employees can declare these as capital gains and seek a refund on the tax deducted at source.