Introduction
The Madras High Court, in the case of Nishithkumar Mukeshkumar Mehta v. Deputy Commissioner of Income Tax[i], recently examined the tax treatment of discretionary compensation received by an assessee in lieu of a diminution in value of contractual rights in respect of employee stock option plans (‘ESOPs’) under the provisions of the Income-tax Act, 1961 (‘ITA’). In this case, the assessee was an employee of a step-down subsidiary and held ESOPs under the scheme of the holding company. The holding company announced divestment in one of its business arms, in which the option grantees were paid discretionary compensation by the holding company by a diminution in the value of contractual rights.
Brief Facts
The Petitioner filed a writ petition in the High Court against the order of rejection for the grant of a certificate of ‘nil’ deduction of tax at source and consequential directions for issuance of such certificate.
The Petitioner was employed by Flipkart Internet Private Limited (FIPL), an Indian-incorporated company and a wholly owned subsidiary of Flipkart Market Place Private Limited (FMPL), a Singapore-based entity. FMPL, in turn, is wholly owned by Flipkart Private Limited Singapore (‘FPS’).
FPS implemented the Flipkart Stock Option Scheme, 2012 (‘FSOP 2012’), under which ‘employees’ were granted the ESOP. As defined in the FSOP 2012, the expression' employee' inter alia includes a permanent employee of a ‘Group Company’ working in or outside Singapore. Further, the expression ‘subsidiary’ was defined in the FSOP, 2012, as all companies owned and controlled by FPS, including the four entities expressly enumerated in the definition.
In 2023, FPS announced a compensation of USD 43.67 per share[ii] in view of the divestment of its stake in the PhonePe business. This compensation was offered to all option grantees regardless of whether their options had vested. However, former employees were not eligible for this compensation if their options had not been vested.
In the case of the Petitioner, out of the 2137 ESOPs that had vested as of the date, 3787 had not vested, thereby aggregating to 5924 ESOPs of FPS.[iii] Therefore, the Petitioner received an aggregate compensation of USD 258,701, equivalent to INR 2,09,54,787.
The said compensation was paid to the option grantees pursuant to divestment by FPS in PhonePe, which resulted in the loss of opportunity to share in future accretion in the value of PhonePe shares.
The Petitioner paid this compensation by deducting tax at the source and treating the same under the head ‘salary’. However, because the compensation received was a capital receipt and not liable to income tax, the Petitioner applied for the ‘nil’ tax deduction certificate, which was rejected by the concerned authority.
Notably, the FPS board resolution approving the said compensation clearly recorded that the compensation was being paid to provide compensation for loss in current value or potential losses for future accretion as a matter of discretion. At the same time, there was no such legal or contractual right.
Held
Issue 1: the FSOP 2012 and the petitioner’s ESOP
Pursuant to the examination of the terms of FSOP, the High Court concluded that the Petitioner was granted stock options in the capacity of an employee.
Issue 2: Nature of ESOPs under the I-T Act
The Petitioner contended that the compensation received was a capital receipt as it did not involve the transfer of a capital asset, thus not liable to taxation under the provisions of the ITA.
In this context, the High Court, upon analysing the definition of ‘capital asset’ as enumerated in s. 2(14) of the ITA, concluded that to qualify as a capital asset, it should be property of any kind, including rights in or in relation to an Indian company, such as the rights of management or control.
Shares are indisputably ‘capital assets’ because they qualify as movable goods under the Sale of Goods Act, 1930, the Companies Act, 2013 and fall within the scope of property under ITA. However, ESOPs, by contrast, are rights in relation to capital assets, i.e. rights to receive capital assets (shares) subject to terms and conditions of the ESOP scheme.
The High Court, upon analysis of various judicial pronouncements, concluded that where any compensation is received either for loss of the profit-making apparatus or, at a minimum, for the sterilisation thereof, such compensation was a capital receipt.
Based on the above, the High Court concluded that ESOPs are contractual rights to receive shares subject to the exercise of options in terms of the applicable scheme. As per the terms of FSOP 2012, the Petitioner would have a right to sue for compensation or specific performance only in case of breach of the obligation to allot shares upon exercise of the option.
Interestingly, the High Court concluded that ESOPs are actionable claims incapable of generating revenue or monetisation until shares are allotted. Even at the time of allotment, there is a notional benefit but no actual benefit. Actual benefit accrues at the time of transfer, provided there is capital gain.
In the present case, compensation was received not for loss or even sterilisation of profit-making apparatus but by discretionary payment for diminution in the value of contractual rights. Therefore, in this case, where there was no contractual right to compensation, it cannot be said that such a non-existent right was relinquished.
Hence, it was concluded that ESOPs do not fall within the ambit of ‘property’ under the ITA and, consequently, are not capital receipts. As a corollary, the compensation received was not a capital receipt.
Issue 3: Nature of Receipt
To determine the nature of receipt, the High Court examined whether the compensation received would qualify as ‘perquisite’ under the provisions of ITA.
The High Court noted that the term ‘salary’ is broadly defined to include ‘perquisites’, and ‘perquisite’ is further defined to encompass the value of specified securities. The term ‘specified security’ refers to securities as defined under s. 2(h) of the Securities Contracts (Regulation) Act, 1956, and in the context of ESOPs, it pertains to securities offered through such plans. Additionally, the definition of ESOP is provided under the Companies Act, 2013.
Hence, based on the above, the High Court concluded that ESOPs granted to the Petitioner as an employee of the step-down subsidiary qualify as ESOPs under the Companies Act, 2013 and, consequently, fall within the scope of the definition of ‘perquisite’ under the ITA. It was held that the compensation was paid in a discretionary manner to restore the status quo ante regarding the value of ESOP. Hence, as such, it fell within the ambit of specified security.
On the question of whether the compensation received by the Petitioner can be taxed as a perquisite, the High Court observed that to tax ESOP as a perquisite, the benefit flowing to the employee must be ascertained.
The benefit under an ESOP is the difference between the fair market value of shares and the price at which shares are offered to the ESOP holder. Since such benefit being realisable at the time of exercise of option remains non-monetisable, the fair market value on the date of exercise is reckoned, and the price paid by the option holder is deducted therefrom to ascertain the value of perquisite in the form of ESOP.
However, in the present case, the Petitioner received substantial monetary benefit at the pre-exercise stage by way of discretionary compensation. Thus, it has to be analysed whether the value of perquisite can be determined in these circumstances.
The High Court, relying on the settled judicial position, concluded that since the Petitioner did not make any payment towards the ESOPs and continued to retain the same even after the receipt of compensation, the entire receipt qualified as ‘compensation’ and was liable to taxation under the head ‘salary’. Hence, it was concluded that the compensation qualified as perquisite and not a capital receipt.
As a corollary to the above, it was concluded that the Petitioner was entitled to a ‘nil’ certificate of deduction.
Our Analysis
The High Court, dealing with the specific circumstances of this case, held that discretionary compensation received by an assessee for diminution in value of contractual rights in respect of ESOPs would be taxable as ‘perquisite’ under the head salary. The High Court, in the case, has rejected the arguments of the Petitioner that such compensation was a capital receipt and not liable to taxation under the ITA because it is non-computable. Further, rejecting the argument of the Petitioner that such receipts were not computable and thus not liable to taxation under the provisions of the ITA, the High Court held that as no amounts were payable by the petitioner in respect of such receipt and the Petitioner retained all rights with respect to ESOPs, the entire amount was subject to taxation.
The High Court, in this case, has disagreed with the judgment of the Delhi High Court in Sanjay Baweja v. DCIT[iv], wherein on the same facts in respect of another assessee, it was held that discretionary payment received in lieu of diminution in value of unexercised ESOP is not a perquisite but a capital receipt. The Delhi High Court further held that for an income to be included in the definition of perquisite, it is essential that it is generated from the exercise of the option by the employee. However, where the assessee held the ESOPs and the same were not exercised, they did not constitute income chargeable as perquisite. It was also held that the character of payment is determined based on the quality of payment and not the manner or nature of payment. Unless the charging provision elucidates monetary receipt as chargeable to tax, the authorities cannot proceed to tax such receipt based on the manner and nature of the payment.
The above two pronouncements on the same facts with respect to different assesses would result in contradictory treatment of such compensation depending upon the jurisdiction of the assessee and leave ambiguity on the treatment of such amounts. Further, both the pronouncements have interpreted the settled position in Godrej & Co., Bombay v. CIT[v] and Commissioner of Income-tax, Gujarat v. Saurashtra Cement Ltd.[vi], differently. The High Court, in the case of Nishithkumar (supra), drew a distinction upon factual matrix that in the above cases, the amount received resulted in relinquishment or sterilisation of the profit/income generating machinery. While in Sanjay Baweja (Supra), the Delhi High Court, relying on these pronouncements, has held that one-time voluntary compensation received by the assessee for change in contractual terms would constitute capital receipt. At this juncture, a pertinent question arises – whether a one-time voluntary payment received by the assessee without relinquishing all rights would be treated as a change in ‘contractual terms?’
Until the Apex Court decides on the said issue, the position regarding the treatment of such compensation will be ambiguous.
At this juncture, it is pertinent to highlight another pronouncement of the Delhi High Court in Akash Poddar v. ACIT[vii], wherein the assessee received a lump sum towards a full and final settlement of all disputes and differences and unconditionally and irrevocably relinquished all his rights in respect in respect of registration of shares held by him. It was held that such payment was not liable to be construed as payment connected to the termination of the assessee’s employment and, thus, liable to be recognised as capital gains.
A perusal of this judgment in light of the pronouncement in Nishithkumar (supra) reveals that the inherent distinction in both cases arises on account that payment of compensation in the former resulted in relinquishment of all rights in respect of shares which was not the case in later. Further, in Nishithkumar (supra), the High Court has clearly enunciated that such compensation(s) will be treated as capital receipt in case there is relinquishment or sterilisation of the right to generate income/profit, which was not the case in the said case. However, in Akash Poddar (supra), the compensation amount received resulted in the relinquishment of all rights with respect to such shares.
End Notes
[i] [2024] 165 taxmann.com 386 (Madras).
[ii] This amount was the difference in valuation of each option prior to and subsequent to divestment in PhonePe, respectively.
[iii] The Petitioner was a current employee as of the date.
[iv] W.P. (C) 11155/2023.
[v] (1970) 1 SCR 527.
[vi] [2010] 192 taxman 300.
[vii] [2024] 165 taxmann.com 271 (Delhi). Case analysis by our associate Aishwarya Pawar: [Delhi HC] Settlement for Dispute Regarding Sweat Equity Shares Taxable as Long-term Capital Gains, Not Salary
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