The Bengaluru Income Tax Appellate Tribunal has ruled that proceeds from buybacks of unexercised, vested ESOP options qualify as capital gains rather than salary. This decision provides significant tax relief for startup employees, as capital gains are typically taxed at lower rates than salary income slabs.
In a significant development for startup employees, the Bengaluru bench of the Income Tax Appellate Tribunal (ITAT) has provided clarity on the tax treatment of Employee Stock Ownership Plan (ESOP) buybacks. The tribunal ruled that when a company repurchases vested but unexercised stock options, the income earned by the employee should be classified as capital gains instead of salary.
Impact on Tax Liability
This ruling addresses a long-standing point of contention between taxpayers and the Income Tax Department. Previously, tax authorities often treated these buyback proceeds as salary income, which meant they were taxed according to an individual’s applicable income tax slab—which can be as high as 30% or more plus surcharges. By classifying these proceeds as capital gains, employees may benefit from a significantly lower tax rate, typically 20% for long-term assets after indexation benefits, depending on the specific holding period and nature of the asset.
Case Context and Tribunal Logic
The decision stems from a dispute involving a former Flipkart employee whose vested stock options were repurchased following the company's acquisition by Walmart. The tax department argued that because the company deducted tax at source (TDS) and reported the payment in Form 16, it should be treated as salary. However, the ITAT rejected this view, noting that TDS is an administrative mechanism for collecting advance tax and does not determine the final legal character of the income.
The tribunal further explained that ESOPs are taxed as salary perquisites only when an employee exercises the option and receives actual shares. Because the employee in this case did not exercise the options, no shares were allotted. Therefore, the tribunal concluded that the vested options acted as a capital asset, and their buyback represented the transfer of that asset.
Strategic Importance for Startups
ESOPs are a primary tool used by Indian startups to attract and retain talent, often serving as a form of wealth creation that is realized during secondary share sales, mergers, or acquisitions. For many employees, these corporate events represent the only opportunity to achieve liquidity from their holdings. This ruling provides a more predictable tax framework, which could improve the attractiveness of ESOP schemes as a compensation component.
Next Steps for Investors and Employees
While this ruling offers immediate relief, taxpayers should consult with financial advisors regarding their specific cases, as tax departments may still challenge similar filings in other jurisdictions or at higher appellate levels. Investors and employees should monitor whether the Central Board of Direct Taxes (CBDT) issues any circulars or clarifications to align the tax department's assessment procedures with this tribunal ruling. Furthermore, maintaining clear documentation regarding the vesting and repurchase of options remains essential for claiming the correct tax treatment during annual filings.