Big Tax Relief For Startup Employees On ESOP Buybacks, ITAT Says Payouts From Unexercised Options Are Capital Gains

Bengaluru: The Bengaluru bench of the Income Tax Appellate Tribunal (ITAT) has delivered an important ruling on the taxation of Employee Stock Ownership Plan (ESOP) payouts.

The tribunal held that money received from the buyback of vested but unexercised ESOP options should be taxed as capital gains and not as salary income.

The decision could benefit startup employees who receive ESOP payouts during company acquisitions, mergers or other exit opportunities.

Flipkart Case

The ruling came in a case involving a former Flipkart employee. The employee’s vested stock options were repurchased after Walmart acquired the e-commerce company.

The employee reported the buybackThe employee reported the buyback proceeds as long-term capital gains. However, the Income Tax Department argued that the payment should be treated as salary.

The department relied on the tax deducted at source by the employer and the amount reported in Form 16.

The ITAT rejected this argument because the employee had not exercised the options and no shares had been allotted.

Tax Trigger

The tribunal explained that ESOPs are taxed as a salary perquisite only when an employee exercises the options and receives shares.

Until the options are exercised, they merely give the employee a right to purchase shares in the future. This right is considered a capital asset.

Since the vested options were repurchased before exercise, the transaction involved the transfer of a capital asset. Therefore, the resulting income must be assessed under capital gains, the tribunal held.

TDS Treatment

The ITAT also clarified that an employer’s decision to deduct TDS does not decide the final nature of an employee’s income.

TDS is only a method of collecting tax in advance. Similarly, an indicative tax calculation in ESOP repurchase documents cannot override the Income Tax Act.

Employee Relief

The ruling could reduce the tax burden for eligible startup employees because salary is taxed according to applicable income-tax slabs, while capital gains follow separate tax rules.

However, the actual tax treatment and rate will depend on factors such as the holding period, nature of the asset and applicable law.

The decision is particularly important as startups increasingly use ESOPs to attract employees and offer liquidity during acquisitions or secondary transactions.