1. INTRODUCTION

Incentivizing key personnel through equity participation is an internationally accepted practice. Grant of stock options ("ESOPs") or sweat equity in the employer company has significant value attached to it and, consequentially, a huge tax outgo.

In a recent judgement of the Hon'ble Mumbai Income Tax Appellate Tribunal (the "ITAT") in Unnikrishnan VS vs. ITO [ITA Nos. 1200 and 1201/Mum/2018], the issue under consideration was the taxability of ESOPs in India. The ITAT ruled against the non-resident assessee, and held income to be taxable in India, denying the benefit under Article 15 of the Double Taxation Avoidance Agreement between India and UAE (the "DTAA").

2. FACTS

The matter before the ITAT pertained to assessment years ("AY") 2013-14 and 2014-15. The assessee, in this case, was an individual employed with HDFC Bank Limited, Mumbai. The chronology of events is tabulated below:

Date / Year Event
27th June 2007 Options granted for 18,500 shares of HDFC Bank Limited at INR 219.74 per share.
From 1st October, 2007 The assessee started working at HDFC Bank Representative Office in Dubai, UAE, on deputation. The assessee was a non-resident for the relevant AYs.
27th June 2008 50% options vested
27th June 2009 Balance 50% options vested
AYs 2013-14 and 2014-15 The assessee exercised the options while he was a non-resident of India. The perquisite value of ESOPs was calculated at INR 72,77,320 for AY 2013-14 and INR 83,59,125 for AY 2014-15. The employer deducted tax at source ("TDS") on the perquisite value.

While filing his income tax return for the relevant AYs, the assessee sought to claim a tax refund of TDS.

Having obtained an order against the refund of TDS at various judicial levels, the assessee preferred an appeal before the ITAT.

3. ISSUE

There were two issues raised before the ITAT:

  1. The first issue was in connection with taxability of the perquisite value of ESOPs under Section 5(2) of the Income-tax Act, 1961 ("ITA"). Section 5(2) is the charging section for taxation of income of non-residents in India. It provides that the total income of a non-resident includes income which is (a) received or is deemed to be received in India; or (b) accrues or arises or is deemed to accrue or arise in India.
    Thus, the question raised before the ITAT was whether the perquisite value of ESOPS exercised during the relevant AYs is taxable in India under Section 5(2), considering that the assessee did not render any services in India.
  2. The second issue was whether, even assuming that the income was taxable in India under Section 5(2), the assessee is entitled to relief under Article 15 of the DTAA.
    Article 15 of the DTAA provides for the determination of taxability in case of Dependent Personal Services. It states that "salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State."

4. ASSESSEE'S ARGUMENTS

  1. The ESOPs were received for employment services rendered in the UAE, and, therefore, do not accrue or arise in India. Hence, the amount is not taxable in India under Section 5(2) of the ITA;
  2. Even assuming that the perquisite value of ESOPs is taxable in India, the assessee is entitled to the benefit of Article 15 of the DTAA since:
    1. the term 'other similar remuneration' in Article 15 covers ESOPs; and
    2. the said Article envisages the taxability of ESOPs in the State where the employment is exercised. Since the assessee exercised his employment in the UAE, the perquisite value of the ESOPs was taxable in the UAE and not in India.
  3. The assessee relied on the following case laws to support the view that income cannot be taxed in India if the employment services over the period from years of grant to years of vesting/exercise are rendered outside India:
    1. CIT vs. Robert Arthur Keltz [ITA No. 57/2014 dated 23 July 2014] [Delhi];
    2. CIT vs. Robert Arthur Keltz [59 SOT 2037] [ITAT- Delhi]; and
    3. Anil Bhansali vs. ITO [53 taxmann.com 367] [ITAT- Hyderabad].

5. REVENUE'S ARGUMENTS

  1. ESOPs were granted to the assessee in consideration of services rendered in India, when the assessee was a resident of India. They pertained to his services rendered in India prior to his deputation to the UAE; and
  2. Hence, income from ESOPs, calculated in the year of exercise, should be taxable in India.

6. HELD

The ITAT held that the perquisite value of ESOPs is taxable in India for the relevant AYs on the following grounds:

  1. The right to exercise ESOPs was granted to the assessee in 2007, and was in consideration for the services which were rendered by the assessee prior to the rights being granted (i.e., in India all along);
  2. Section 17(2)(vi) of the ITA decides the timing of the taxation of income, but it does not dilute or negate the fact that the benefit had arisen much earlier, i.e., at the point of time when the ESOP rights were granted;
  3. The ITAT relied on the Supreme Court of India's verdict in the case of ED Sassoon & Co Ltd vs. CIT [(1954) 26 ITR 27 (SC)], which states that the accrual or arising of an income "represents a state anterior to the point of time when the income becomes receivable and connote a character of the income, which is more or less inchoate."
  4. The ITAT relied on the United Nations Model Conventions Commentary 2017, which states that "an employee stock option should only be considered to relate to services rendered before the time when it is granted to the extent that such grant is intended to reward the provision of such services by the recipient for a specific period";
  5. The ITAT also relied on the OECD Centre for Tax Policy and Administration's publication by the name of 'Cross Border Income Tax Issues Arising out of Employee Stock Option Plans' which suggests that the said income must relate back to the source jurisdiction, i.e., the jurisdiction in which the related services were rendered;
  6. The cases referred by the assessee were distinguished on factual grounds;
  7. While Article 15 covered the taxable value of ESOPs under 'other similar remuneration', it is taxable only in the jurisdiction in which the related employment is exercised. Hence, the assessee is not entitled to the benefit of Article 15 of the DTAA.

7. INDUSLAW VIEW

Taxation of ESOPs depends a lot on the factual aspects of a given case. Generally, vesting of options is subject to the satisfaction of certain conditions, such as being in employment till the exercise of options, achievement of a certain performance measure, etc. In the given case, there do not seem to be any vesting conditions for the exercise of ESOPs.

In case the ESOP agreement requires the satisfaction of certain conditions prior to the exercise of ESOPs, one could possibly build an argument that income from ESOPs accrues in the year of vesting and, therefore, the residential status of the assessee at the time of vesting would be considered relevant. This is an argument that could be developed in extending the ITAT's view that Section 17(2)(vi) of the ITA determines only the timing of taxation.

However, capital gains on the sale of shares would still be taxable in India under Section 5(2) of the ITA. It is likely that the cost price of such shares may be considered the exercise price (and not the fair market value of the date of exercise) since the perquisite value was not taxable in India. Thus, the quantum of capital gains might be much higher, even though the benefit of a lower tax rate is available (tax rate on capital gains being lower than the slab rate applicable to perquisite income).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.