The Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) has ruled that the fair market value (FMV) of ESOP shares on the date of exercise must be treated as the cost of acquisition for computing subsequent capital gains under Section 49(2AA) of the Income-tax Act, 1961, even where the corresponding ESOP perquisite was not subjected to tax in India but was taxed as salary income in the United Kingdom.
The Bench of Beena Pillai (Judicial Member) and Arun Khodpia (Accountant Member) addressed an important question concerning the taxation of Employee Stock Option Plans (ESOPs) held by non-resident employees, particularly the interaction between the perquisite taxation mechanism under Section 17(2)(vi), the cost-of-acquisition rule under Section 49(2AA), and the India-UK tax treaty.
The assessee was a non-resident and a resident of the United Kingdom, employed with the UK branch of L&T Infotech Ltd. During the relevant year, he exercised ESOPs relating to shares of an Indian listed company.
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The assessee had originally been granted 7,700 ESOPs at an exercise price of Re.1 per share, with the options scheduled to vest in five equal installments. During the relevant previous year, the first tranche of 1,540 options vested and was exercised by the assessee on September 3, 2018 by paying the stipulated Re.1 per share. The corresponding shares were subsequently credited to his demat account.
The assessee later sold all 1,540 shares through the recognised stock exchange for an aggregate consideration of approximately ₹25.99 lakh.
The central dispute arose over how the cost of those shares should be determined for the purpose of calculating capital gains.
Assessee Claimed FMV as Cost of Acquisition
According to the assessee, although the exercise price was only Re.1 per share, the fair market value of the shares on the exercise date was substantially higher.
The opening market price was stated to be ₹1,734 per share and the closing price ₹1,773.15 per share, resulting in an FMV of ₹1,753.58 per share based on the prescribed methodology.
The difference between the FMV and the exercise price represented the ESOP perquisite value. On 1,540 shares, the aggregate perquisite value was calculated at approximately ₹26.99 lakh. The assessee contended that this value had already been subjected to tax in the UK as part of his salary income.
For the subsequent sale of the shares, the assessee therefore adopted the FMV of the shares on the date of exercise as the cost of acquisition under Section 49(2AA) and computed a short-term capital loss of ₹1,00,650.
The Assessing Officer disagreed with the assessee’s computation.
According to the AO, since the ESOP perquisite did not accrue or arise in India, the FMV could not be treated as the cost of acquisition under Section 49(2AA). The AO instead held that the actual consideration paid by the assessee—Re.1 per share, or ₹1,540 in total—represented the cost of acquisition.
On that basis, the AO proposed an addition of ₹25,98,323 as short-term capital gains, as against the short-term capital loss of ₹1,00,650 declared by the assessee.
Following the DRP proceedings, the final assessment ultimately resulted in an addition of ₹29,59,332 as unexplained short-term capital gains. The assessee challenged the assessment before the ITAT.
The Tribunal identified the controversy as having two principal components.
First, it had to consider whether the transfer of shares of an Indian company by the non-resident assessee resulted in capital gains chargeable to tax in India.
Second, assuming the capital gains were taxable in India, the Tribunal had to determine whether the cost of acquisition should be the FMV of the shares on the date of exercise under Section 49(2AA), or merely the actual ESOP exercise price of Re.1 per share.
The Tribunal ultimately decided the second issue in favour of the assessee.
The Tribunal placed significant emphasis on the statutory language of Section 49(2AA).
It observed that the ordinary concept of cost of acquisition generally refers to the amount incurred for acquiring a capital asset. However, Parliament has created specific deeming provisions under Section 49 for cases where the asset is acquired through mechanisms other than a conventional purchase.
For ESOPs and specified securities covered by Section 17(2)(vi), Section 49(2AA) specifically provides that the cost of acquisition shall be the fair market value taken into account for determining the perquisite value.
The Tribunal therefore held that Parliament had consciously departed from the general rule of actual cost in the case of ESOP shares.
A crucial observation of the Tribunal concerned the expression “taken into account” appearing in Section 49(2AA).
The Bench held that the provision does not say that the FMV must have actually been subjected to tax in India or included in the assessee’s taxable income under Section 17.
According to the Tribunal, the expression refers to the FMV determined through the statutory mechanism under Section 17(2)(vi) read with Rule 3. The determination of the value of a perquisite and the question of whether that perquisite is ultimately chargeable to tax are separate matters governed by different provisions.
The Tribunal accordingly refused to read an additional condition into Section 49(2AA) requiring the ESOP perquisite to have actually suffered Indian tax.
It observed that adding such a requirement would effectively mean supplying words to the statute which Parliament had not included.
The department had relied upon the fact that the ESOP perquisite was not taxed in India but was subjected to tax in the UK.
The Tribunal rejected the proposition that this difference in the jurisdiction of taxation could determine whether Section 49(2AA) was available.
The Bench specifically noted that the AO had recorded the assessee’s contention that the perquisite had been taxed as part of his salary in the UK, and that this factual assertion had not been disputed by the AO in the assessment order.
The Tribunal further held that the judicial precedents relied upon by the Revenue primarily dealt with issues concerning the taxability of salary and perquisites of non-residents under Sections 5 and 9. Those decisions did not directly examine the interpretation of Section 49(2AA) in determining the cost of ESOP shares.
They were therefore held to be distinguishable.
The assessee had relied upon the Bangalore ITAT’s decision in Biplab Adhya v. DCIT.
The DRP had distinguished that decision on the ground that, in Biplab Adhya, the perquisite had suffered tax in India, whereas in the present case it had suffered tax in the UK.
The Mumbai ITAT disagreed with this reasoning.
It held that the applicability of Section 49(2AA) cannot depend upon the country in which the perquisite was subjected to tax, because the statutory provision itself makes no such distinction.
Once the FMV has been determined and taken into account for the purposes of Section 17(2)(vi), the statutory requirement under Section 49(2AA) is satisfied.
After examining the statutory scheme, the Tribunal categorically held that the assessee was entitled to adopt the FMV of the shares as on the date of exercise, determined in accordance with Section 17(2)(vi) read with Rule 3(8)(ii), as the cost of acquisition under Section 49(2AA).
The contrary approach adopted by the AO and affirmed by the DRP—restricting the cost to the Re.1 exercise price—was held to be contrary to the plain language of Section 49(2AA).
The AO was consequently directed to recompute the capital gains by adopting the FMV as the cost of acquisition.
The assessee had also raised arguments under the India-UK Double Taxation Avoidance Agreement, including reliance on its non-discrimination provisions.
The assessee argued that denying him the benefit of Section 49(2AA) merely because the ESOP perquisite was taxed in the UK could result in discriminatory treatment when compared with an Indian resident employee.
However, having decided the matter in the assessee’s favour on the interpretation of Section 49(2AA), the Tribunal held that it was not necessary to give a conclusive finding on the alternative Article 26 DTAA argument.
Thus, the ruling is principally founded on the interpretation of Section 49(2AA) rather than on a definitive adjudication of the treaty-based non-discrimination claim.
The assessee had also challenged the validity of the reassessment proceedings, including the notice issued under Section 148 and the jurisdictional issue concerning the assessment process.
Since the Tribunal had already decided the substantive ESOP capital-gains issue in favour of the assessee, it left the jurisdictional challenge as academic.
The grounds relating to interest under Sections 234A, 234B and 234F were treated as consequential and premature and therefore did not require adjudication.
The Mumbai ITAT allowed the appeal.
The Tribunal’s operative conclusion is that where ESOP shares are subsequently transferred, Section 49(2AA) requires the FMV taken into account for determining the ESOP perquisite under Section 17(2)(vi) to be treated as the cost of acquisition, irrespective of whether the corresponding perquisite was actually taxed in India.
The AO has therefore been directed to recompute the capital gains using the FMV on the exercise date rather than the nominal ESOP exercise price of Re.1 per share.
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