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Tax on Employee Stock Ownership Plan is as perquisites or capital gains?

By Chirag Nangia

Employee Stock Ownership Plan (ESOP) refers to an employee benefit plan that offers employees an ownership interest in the organisation. Employers offer shares under ESOPs to their employees for buying a specified number of shares of the company at reduced/ concessional prices.

After completion of a specified period of service, the employees can exercise the option to get the shares. Organisations often use ESOPs as a tool for retaining their employees and rewarding loyalty. It is a suitable option for companies, especially startups, that have high attrition rate or cash crunch.

Under the I-T Act, ESOPs are taxable at two instances. Firstly, such incentives are taxed as perquisites in the hands of the employees when shares are allotted to them. Secondly, taxation arises at the time of sale of such shares in the form of capital gain.

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Taxation of ESOPs
Though taxation of ESOPs has been specified under the Act, there have been situations where judiciary has twisted the application of these provisions depending on the facts in different cases. One of those, is the ruling delivered by the Bangalore Income Tax Appellate Tribunal (ITAT), wherein ESOPs were not taxed as perquisites but directly as capital gains in the hands of the employees since the option was not exercised by the them.

In the given case, employees were granted ESOPs at different instances by the employer s holding company. Even though the ESOPs had vested, the employees had not exercised the same. The holding company, thus, bought the shares back from the employees. The employee treated such gains arising from such transfer as long term capital gains (LTCG) in his hands and invested the same in specified bonds to claim exemption from the said LTCG. Whereas, the tax officer treated the gains as short-term capital gains (STCG), treating ESOPs as having been exercised on the date of transfer of shares to the holding company.

However, the Bangalore ITAT accepted the taxpayer s contention and treated such gains as LTCG on the premise that such gains were arising on transfer of the right to exercise the options, which were given three years ago, i.e., on the date of grant of such rights.

An important point made by Bangalore ITAT is that taxation as perquisite or capital gain would depend on the exercise of the option. ESOPs shall be taxed as perquisites only when the option given by the company gets exercised by the employees.

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Transfer without exercise
In case of transfer without exercise, ESOPs shall be considered as valuable right to exercise the option and any income arising from transfer of such rights be considered as capital gains. While Bangalore ITAT states that exercise of the option is a key determinative factor in taxing ESOPs as perquisite, Hyderabad ITAT observed that it is only a determinative factor and not a sole consideration.

In the case before Hyderabad ITAT, the promoter of the company quit his organisation but exercised ESOPs, which would have expired upon his leaving the organisation. The shares were allotted to him after six months from the date of exercise, upon satisfaction of the conditions mentioned in the separation agreement. The company deducted tax at source on the date of allotment on the value of perquisite.

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The taxman challenged that tax should have been deducted at source on the date of exercise of the ESOP and not on the date of allotment of the shares. Hyderabad ITAT settled the case by holding that the requirement of deducting tax at source arises only upon allotment of shares, since the same was subject to satisfaction of the conditions of separation agreement.

Indian tax laws proficiently incorporate law on taxation of ESOPs. However, peculiar facts of certain cases make the intrusion of judiciary inevitable. The facts and circumstances of a case are decisive of the taxability while keeping in mind the intent of law. These tribunal judgements have established admirable and legally justifiable principles of taxability of ESOPs, which will provide necessary guidance to the taxpayers and the taxmen.

  • The writer is director, Nangia Advisors LLP. Inputs from Radhika Arora