Karnataka High Court Ruling on Tax Treatment of Voluntary ESOP Compensation

Karnataka High Court Ruling on Tax Treatment of Voluntary ESOP Compensation

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  • Karnataka High Court Ruling on Tax Treatment of Voluntary ESOP Compensation

In a recent judgement, the Karnataka High Court in the case of Manjeet Singh Chawla v. Deputy Commissioner of Income Tax1 dealt with the contentious issue of the taxability of compensation received for the diminution in the value of such options by employees holding ESOPs. 
This decision holds significant implications for both employers and employees, especially in structuring ESOP schemes, where such discretionary payouts are more prevalent due to corporate restructuring and cross-border regulatory hurdles, which often preclude employees from reaching the exercise stage of their stock options.

 

Background

Employee Stock Option Plans (ESOPs) are commonly used by companies to attract and retain talent, but their tax treatment has often been a matter of dispute. Challenges typically arise when employees receive payments linked to their stock options without actually exercising them. 
In this case, the controversy centred on whether compensation paid to an employee, in lieu of the loss in value of granted options, should be treated as taxable income or not.

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Facts of the Case

  • 01

    Mr. Manjeet Singh Chawla was employed with Flipkart Internet Private Limited (FIPL), an Indian subsidiary of Flipkart Marketplace Private Limited (FMPL), wholly owned by Flipkart Private Limited, Singapore (FPS).

  • 02

    Under the Flipkart Stock Option Plan (FSOP) introduced in 2012, Mr. Chawla was granted 2,232 stock options. As of 31 March 2023, 1,983 stock options (comprising both vested and unvested) remained outstanding in Mr. Chawla’s name.

  • 03

    Following the divestment of PhonePe into a separate entity, the value of the granted stock options reduced.

  • 04

    To address this diminution in stock options, FPS voluntarily paid Mr. Chawla a lump sum amount of INR 71.01 lakhs (computed as 1,983 × USD 43.67 × 82) as compensation, without any shares being allotted, transferred, or options exercised.

  • 05

    Mr. Chawla applied for a Nil TDS Certificate under Section 197, asserting that the amount was capital in nature.

  • 06

    The Assessing Officer (AO) rejected the application, treating it as a taxable perquisite under Section 17(2)(vi)

Issue Involved

Whether a one-time voluntary payment made towards loss in value of unexercised stock options is taxable as a perquisite under Section 17(2)(vi) or constitutes a capital receipt not chargeable to tax.

Outcome of the case

The Karnataka High Court ruled in favour of the assessee, holding that:
The payment constituted a capital receipt not chargeable to tax.

Section 17(2)(vi) applies only when stock options are exercised and shares are allotted; since neither condition was satisfied, no perquisite taxation could arise.

The AO's order under section 197 was quashed, and Revenue was directed to issue a Nil TDS Certificate within 6 weeks.

Key matters discussed in the judgment 

Nature of Compensation Received – Why It Constitutes a Capital Receipt:

  • Section 2(14) defines “capital asset” broadly as property of any kind, which includes rights in shares. Further, Supreme Court precedents confirm that rights related to shares or subscriptions are capital assets2.
  • The divestment of PhonePe caused a permanent reduction in value and profit-making potential, and consequently, the compensation received in lieu of such reduction is capital in nature.
  • Also, the payment was made without any contractual obligation, and the number of ESOPs remained unchanged, confirming it is not a revenue receipt.

Taxability of the compensation received: 

  • Under Section 17(2)(vi), taxability arises only on exercise of ESOPs. Since Mr. Chawla has not exercised his options and no shares were allotted, the condition precedent for perquisite taxation is not satisfied.
  • The compensation is not taxable under Section 45 of the Act as well, as there was no transfer or sale of a capital asset; consequently, a capital receipt, not chargeable under Section 45, cannot be taxed under any other head.
  • In any case, the absence of a computation mechanism for taxation further reinforces non-taxability3.

Comparative Jurisprudence : 

  • The Karnataka High Court relied on the Delhi High Court's ruling4, which dealt with identical facts and held such compensation to be capital in nature and non-taxable.

Rationale for Distinguishing the Madras High Court Judgment : 

  • The Madras High Court judgement in Nishith Kumar’s case5 was noted to be further challenged and is still under appeal and has not attained finality.
  • The Karnataka High Court found the ruling erroneous on several prominent points, including
    • mischaracterising ESOPs as not being a source of revenue
    • excluding them from the definition of capital assets, and
    • treating the one-time compensation as taxable perquisites despite the absence of exercise of options and a computation mechanism for perquisite determination.

Advith's Comments

This ruling provides clarity and certainty to both employers and employees regarding tax implications for non-contractual, one-time stock-based compensation. 

The ruling also prevents unjustified TDS obligations on capital receipts which are not taxable.

Unexercised ESOPs with no allotment of shares, where compensation is paid voluntarily and not pursuant to any enforceable right, do not attract perquisite taxation. 

Further, the compensation cannot be treated as capital gains, as there is no transfer of a capital asset that has occurred. 

However, litigation risk persists where divergent views, such as Nishith Kumar Mehta v. DCIT5 are relied upon by the department. Until settled by the Supreme Court, each case will turn on factual nuances.'

This principle should not be applied straightaway into all possibilities of compensation but should be carefully thought out for its applicability into a given fact pattern. 
 

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References

  1. Mr. Manjeet Singh Chawla was employed with Flipkart Internet Private Limited (FIPL), an Indian subsidiary of Flipkart Marketplace Private Limited (FMPL), wholly owned by Flipkart Private Limited, Singapore (FPS). 

  2. Brothers Private Limited vs. ITO - [1964] 54 ITR 399; Chitranjan A. Dasann Acharya vs. CIT-05 - [2020] 429 ITR 5702Hari Brothers Private Limited vs. ITO - [1964] 54 ITR 399; Chitranjan A. Dasann Acharya vs. CIT-05 - [2020] 429 ITR 570

  3. CIT v. B.C.Srinivas Setty [1981] 128 ITR 294 (SC)

  4. Sanjay Baweja v. DCIT [(2024) 163 taxmann.com 116 (Delhi)]

  5. Nishithkumar Mehta v. DCIT [(2024) 165 taxmann.com 386 (Madras)]