Sold ESOP shares after moving abroad? ITAT Mumbai says exercise-date FMV can be treated as cost of acquisition

A UK-based employee who sold shares acquired through an employee stock option plan (ESOP) for nearly ₹26 lakh has won a tax dispute after the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) ruled that the fair market value (FMV) of the shares at the time of exercising the options should be treated as their cost of acquisition.

The case involved Rajesh R. Hemrajani, a non-resident and UK tax resident who was employed with the UK branch of L&T Infotech Ltd. He had exercised 1,540 ESOPs at ₹1 per share and later sold the shares for about ₹25.99 lakh.

While filing his capital-gains computation, Hemrajani treated the FMV of the shares on the exercise date, about ₹1,754 per share, as the cost of acquisition. This resulted in a short-term capital loss of around ₹1 lakh.

The tax department disputed this treatment and argued that the cost should instead be restricted to the ₹1-per-share amount actually paid to exercise the options.

The ITAT Mumbai, however, allowed Hemrajani's appeal and directed the assessing officer to recompute the capital gains by adopting the FMV as the cost of acquisition.

Why the tax department rejected the employee's calculation

According to the ITAT order, Hemrajani had been granted 7,700 ESOPs relating to shares of L&T Infotech. During the relevant year, he exercised the first tranche of 1,540 options at an exercise price of ₹1 per share.

The FMV of the shares on the date of exercise was determined at approximately ₹1,753.58 per share under the valuation mechanism prescribed under the Income-tax Act and Rules.

Hemrajani subsequently sold all 1,540 shares through a recognised stock exchange for an aggregate consideration of approximately ₹26 lakh.

For calculating capital gains, he relied on section 49(2AA) of the Income-tax Act. The provision deals with the cost of acquisition of specified securities or sweat equity shares acquired under an ESOP and refers to the FMV taken into account for determining the value of the perquisite under section 17(2)(vi).

Using the exercise-date FMV as his cost of acquisition, Hemrajani reported a short-term capital loss of ₹1,00,650.

The assessing officer disagreed.

The Revenue's position was that the ESOP benefit was not taxable in India because Hemrajani was a non-resident and the relevant employment services were rendered outside India. Therefore, according to the tax authorities, the FMV could not be treated as the cost of acquisition under section 49(2AA).

The assessing officer instead restricted the cost to the actual exercise price of ₹1 per share. The Dispute Resolution Panel subsequently upheld the department's position.

Hemrajani then challenged the order before the Mumbai ITAT.

What the Mumbai ITAT ruled on ESOP taxation

The tribunal focused on the wording of section 49(2AA).

The provision states that the cost of acquisition of specified securities or sweat equity shares acquired through an ESOP is the FMV that has been taken into account for the purposes of section 17(2)(vi).

The ITAT held that the provision does not contain a requirement that the FMV must actually have been subjected to tax in India or included in the taxpayer's total income.

In other words, the tribunal distinguished between determining the value of an ESOP perquisite and whether that perquisite is ultimately taxable in India.

The fact that Hemrajani's ESOP perquisite was not taxable in India did not mean that the FMV determined under the statutory valuation mechanism could be ignored when calculating the cost of the shares.

The tribunal also rejected the Revenue's attempt to introduce an additional condition into section 49(2AA). According to the order, if Parliament intended the benefit of the provision to depend on the perquisite having actually been taxed in India, such a condition would have had to be incorporated into the law.

The ITAT therefore held that Hemrajani was entitled to use the FMV of the shares on the date of exercise as the cost of acquisition.