Direct Tax Alert

BACKGROUND

In order to motivate and align the interests of employees with those of the company and its shareholders, companies often resort to an ‘employee stock option plan’ (ESOP) or ‘sweat equity’.  Under ESOP, employees obtain the right to purchase a specified number of shares of the company at a pre-determined price after the expiry of the grant period. Further, under ESOP, shares of the ultimate parent company are granted to the employee of the subsidiary.

Taxation of ESOPs is governed by section 17 of the Income-tax Act, 1961 (IT Act). As per Section 17(2)(vi) of the IT Act, the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at a concessional rate to the taxpayer is taxable in the hands of employees as ‘perquisite’. The differential value between Fair Market Value (FMV) and exercise price shall be regarded as perquisite.

As there is a time gap between the vesting date and the exercising date, the possibility of fluctuation in FMV cannot be ruled out. It may so happen that there might be a substantial drop in the value due to events like demerger, dividend, buybacks etc. Pursuant to such diminution, the company may provide for some voluntary compensation (though it may not be required to compensate its employees). In this regard, recently, the Delhi High Court¹ had an occasion to examine whether such one-time compensatory payment on account of diminution in the value of ESOP could be treated as perquisite under Section 17 of the IT Act or not.

We, at BDO in India, have summarised this ruling and provided our comments on the impact of this decision hereunder:

FACTS OF THE CASE

• The taxpayer, an ex-employee of Flipkart Internet Private Limited (FIPL) which is a step-down subsidiary of Flipkart Pvt. Ltd., Singapore (FPS).

• In the year 2012, FPS rolled out a Flipkart Stock Option Plan (FSOP) wherein, FPS granted certain ESOPs to eligible persons, including employees of its subsidiaries. The taxpayer was granted 1,27,552 stock options on and from 1 November 2014 to 31 November 2016 with a vesting schedule of 4 years.

• On 23 December 2022, FPS announced the disinvestment of its wholly-owned subsidiary, PhonePe. Pursuant to the disinvestment, the value of the stock options of FPS fell.

• In order to compensate the option holders for the loss in the value of options, on 21 April 2023, FPS granted the option holders a one-time payment of USD 43.67 per option based on the number of options held on 23 December 2022. Further, in the communication sent by FPS, it was stated that the compensation would be subject to tax withholding.

• On 29 April 2023, the taxpayer made an application under Section 197² of the IT Act seeking a ‘Nil’ tax withholding certificate in respect of the payment by FPS on the ground that one-time compensation was a capital receipt and did not constitute income under section 2(24)³ of the IT Act.

• The tax officer rejected the application on the ground that since one-time compensation is linked to the vested ESOP, it would be taxable as perquisite under Section 17(2)(vi) of the IT Act irrespective of the fact that it is received from a former employer, directly or indirectly.

• Hence, the taxpayer had already suffered tax withholding on the compensation.

• Aggrieved by the Order of the tax officer, the taxpayer filed a writ before the Hon’ble Delhi High Court.

DELHI HIGH COURT RULING

The Hon’ble Delhi High Court held that voluntary payment received in lieu of diminution in the value of unexercised ESOP is not a perquisite, but rather a capital receipt. While coming to this conclusion. the Hon’ble Delhi High Court made the following observations:

• From the detailed calculation of the vesting of options, it is undisputed that the taxpayer has not exercised his vested right with respect to stock options under ESOP to date, which signifies that the right of holding the stocks under his name had not been exercised.

• The determination as to whether a particular receipt would be tantamount to a capital receipt or revenue receipt is dependent on the facts of a particular case. The Hon’ble Supreme Court in Saurashtra Cement Ltd⁴. has laid out a similar principle while ruling on capital receipt vis-à-vis revenue receipt.

• Reliance placed by the taxpayer on the Hon’ble Supreme Court’s decision in the case of Shrimant Padmaraje R. Kadambande⁵ is affirmed wherein a one-time voluntary cash allowance was given to the taxpayer and it was held that it was a capital receipt not liable to tax.

• Reliance was also placed on the Hon’ble Supreme Court’s decision in the case of Godrej and Co.⁶ wherein it was held that one-time payments given to the taxpayer in lieu of a change in contractual terms between the taxpayer and the management company are capital receipts and thereby not taxable.

• The tax officer’s contention that the facts pertaining to the exercise of the options held by the taxpayer were not apprised to him in the proceedings is incorrect since the taxpayer had duly placed the details relating to ESOP in the application made under Section 197 of the IT Act.

• Reliance placed by the tax authorities on the Hon’ble Supreme Court’s decision in National Petroleum Construction Co⁷. is misplaced since the issue, in that case, pertained to the determination of permanent establishment in Section 197 proceedings.

• It is pertinent to note that the manner or nature of payment, as comprehensible by the deductor, would not determine the taxability of such transaction. It is the quality of payment that determines its character and not the mode of payment. Unless the charging Section of the Act elucidates any monetary receipt as chargeable to tax, the tax authorities cannot proceed to charge such receipt as revenue receipt and that too on the basis of the manner or nature of payment, as comprehensible by the deductor.

• Reference was also made to the decision of the Hon’ble Supreme Court in the case of Empire Jute Co. Ltd⁸. wherein it was held that the fact that a certain payment constitutes income or capital receipt in the hands of the recipient is immaterial in determining whether the payment is revenue or capital disbursement qua the payer. Whether a particular expenditure is capital or revenue should be determined on the basis of the nature of transaction and other relevant factors.

• Explanation (c) to Section 17(2)(vi) of the IT Act provides that the value of specified security could only be calculated when the option is exercised. A literal understanding of the provision would provide that the value of specified securities or sweat equity shares is dependent upon the exercise of the option by the taxpayer. Therefore, for an income to be included in the inclusive definition of ‘perquisite’, it is essential that it is generated from the exercise of options, by the employee.

• However, the present facts of the case suggest that the stock options were merely held by the taxpayer and the same were not exercised to date therefore, they do not constitute income chargeable to tax in the hands of the taxpayer as none of the contingencies specified in Section 17(2)(vi) of the IT Act have occurred.

• FPS was under no legal or contractual obligation to provide compensation for loss in current value or any potential losses on account of future accretion to the ESOP holders. FPS, at its own discretion, has estimated and decided to pay USD 43.67 as compensation for each stock option as held on the record date.

BDO COMMENTS

The Hon’ble Delhi High Court has reiterated that the mode of payment is not determinative of whether a particular payment is capital or revenue in nature. This ruling has emphasised that merely because a payment is linked to ESOP, it cannot be tantamount to perquisite under section 17(2) of the IT Act. Further, in the instant case, the compensation was voluntary and not under a legal obligation. Hence, one will need to evaluate the tax impact if the compensation was paid under a legal or contractual obligation.

Furthermore, while the Court has held that the transaction should not be regarded as perquisite under section 17 of the IT Act, it is silent on whether section 56(2)(x) of the IT Act will get attracted or not.