Startup ESOP Buybacks: ITAT Order Opens Gateway for Capital Gains Tax Relief
Decoding the Landmark ITAT Order and Karnataka High Court Precedent
Why Vested but Unexercised Option Payouts Challenge Traditional Perquisite Taxation Rules
By Legal Editor
New Delhi: August 04, 2026:
The taxation of Employee Stock Option Plans (ESOPs) in startup ecosystems has long been a complex issue. For tech workers, early startup joiners, and corporate professionals, stock options constitute a core component of compensation. However, how these instruments are taxed—specifically during cash-outs, buybacks, or restructuring events before public listing—remains a subject of intense legal scrutiny.
A recent order by the Bengaluru bench of the Income Tax Appellate Tribunal (ITAT) has brought fresh momentum to this debate. By remanding the case of an ex-Flipkart employee back to the Commissioner of Income Tax (Appeals), the tribunal directed tax authorities to re-evaluate ESOP buyback payouts in light of the landmark Karnataka High Court ruling in Manjeet Singh Chawla vs Deputy Commissioner of TDS.
At the center of this legal battle is a fundamental question of tax classification: Should payouts for vested but unexercised options be taxed as Salary Perquisites under Section 17(2)(vi), or do they qualify for lower taxation under Capital Gains (or even exemption as capital receipts)?
Anatomy of the Legal Dispute: Salary vs. Capital Asset
The controversy typically arises when a corporate entity undergoes restructuring, divestment, or offers buybacks before options are formally exercised into equity shares.
In the disputed case, an employee received approximately ₹39.74 lakh as a payout linked to stock options. The taxpayer declared the receipt under capital gains provisions, seeking a lower tax rate or beneficial holding period treatment. However, the Income Tax Department reclassified the entire sum as salary income taxed at marginal slab rates (up to 30% plus surcharge). The revenue department based its stance on two procedural points:
The employer had deducted Tax Deducted at Source (TDS) under Section 192 (Salary provisions).
The payment was reflected in the employee's Form 16.
The ITAT observed that procedural dismissal by lower tax authorities without addressing the core legal character of the payout was flawed. The tribunal instructed appellate authorities to apply the principles set out by the High Court.
Key Laws, Sections, and Statutory Framework
To understand the broader implications of this ITAT order, one must examine the specific statutory provisions under the Income-tax Act, 1961:
The Judicial Reasoning: Two-Stage ESOP Taxation Model
In standard corporate practice, the Income-tax Act contemplates a clear two-stage taxation mechanism for stock options:
Stage 1 (Stage of Exercise): When the employee exercises the option, the difference between the Fair Market Value (FMV) of the underlying shares on that date and the exercise price paid is taxed as a perquisite under Section 17(2)(vi) under the head Income from Salaries.
Stage 2 (Stage of Transfer): When the employee subsequently sells the allotted shares, the difference between the final sale price and the FMV on the date of exercise is taxed under Section 45 as Capital Gains (Short-Term or Long-Term depending on holding period).
Why Buybacks of Unexercised Options Create a Dilemma
When a startup buys back options before the exercise stage—or pays compensation for the reduction in option values due to corporate spin-offs—neither stage is neatly triggered:
No shares are formally allotted or transferred, so the statutory prerequisite for a salary perquisite under Section 17(2)(vi) is missing.
The Revenue Department frequently attempts to default to salary perquisites simply because the payout flows from an employer-employee context.
The Karnataka High Court in Manjeet Singh Chawla, alongside similar precedents set by the Delhi High Court in Sanjay Baweja vs DCIT, held that where no exercise or share allotment occurs, Section 17(2)(vi) fails.
Furthermore, where payments are made to compensate for the diminution in value of a capital asset (or profit-earning apparatus), such receipts constitute capital receipts. Under settled Indian jurisprudence (including Supreme Court rulings in B.C. Srinivasa Setty and D.P. Sandu Bros), if a specific charging provision fails or a capital receipt does not fall within the explicit definition of income under Section 2(24), it cannot be forcibly taxed under another head.
Implications for Startup Employees and Corporate Restructuring
This emerging line of jurisprudence provides important strategic clarity for the startup community:
Form 16 and TDS are Not Final: The mere fact that an employer deducted TDS under Section 192 and listed the sum in Form 16 does not prevent the taxpayer from claiming that the receipt is capital in nature before assessment officers or appellate tribunals.
Impact of Holding Period Rates: If buybacks or option cancellations are assessed under capital gains rather than salary, employees can benefit from preferential capital gains tax rates rather than being pushed into maximum marginal slab rates.
Structuring Corporate Liquidity Events: Companies planning secondary sales, option cancellations, or cross-border restructurings must carefully draft option agreements and payout documentation to accurately reflect whether payouts are compensatory capital receipts or performance-linked revenue incentives.
Searchable FAQ Index: Key Legal Points on ESOP Taxation
Category A: Fundamentals of ESOP Taxation
Q1: What is the primary difference between how ESOPs and capital gains are taxed in India?
Answer: ESOPs are generally taxed at two distinct stages. First, at exercise, the difference between the share's Fair Market Value (FMV) and exercise price is taxed as a salary perquisite under Section 17(2)(vi) at applicable slab rates. Second, when the shares are eventually sold, any appreciation beyond the FMV is taxed as Capital Gains under Section 45.
Q2: Can a payout received for unexercised options be treated as a salary perquisite?
Answer: According to rulings by the Karnataka High Court (Manjeet Singh Chawla) and Delhi High Court (Sanjay Baweja), Section 17(2)(vi) requires actual allotment or transfer of specified securities/shares. If options are unexercised and no shares are allotted, the statutory precondition for perquisite taxation is not met.
Q3: Does the deduction of TDS under Form 16 automatically make a receipt "Salary"?
Answer: No. The courts have held that an employer’s procedural act of deducting TDS under Section 192 or reporting an amount in Form 16 does not alter the underlying legal character of the income under the Income-tax Act.
Category B: Buybacks, Capital Receipts, and Judicial Precedents
Q4: Why did the ITAT send the Flipkart ex-employee case back to the Commissioner (Appeals)?
Answer: The ITAT found that the first appellate authority dismissed the employee's appeal on procedural grounds without evaluating the legal merits of whether an ESOP buyback payout for unexercised options constitutes salary or capital gains/receipts in light of High Court rulings.
Q5: What is a "Capital Receipt" in the context of stock option payouts?
Answer: A capital receipt is a payment received in connection with a capital asset or the profit-earning apparatus. If a payment is made to compensate an option holder for a loss in value or reduction of contractual rights (rather than as performance reward), courts have classified such one-time payouts as capital receipts.
Q6: How does the "computation failure" rule apply to capital gains on ESOP options?
Answer: Under Supreme Court precedent (B.C. Srinivasa Setty), if the cost of acquisition of an option cannot be determined under Section 48, the charging mechanism for capital gains under Section 45 fails, rendering the capital receipt non-taxable unless specifically covered by statute.
Category C: Tax Strategy and Employee Compliance
Q7: What steps should employees take if their employer deducts salary TDS on an ESOP buyback?
Answer: Employees can evaluate the underlying documentation of the option buyback or compensation plan. If the options were unexercised, they may file their Income Tax Return (ITR) reporting the transaction under capital gains or non-taxable capital receipts, maintaining necessary supporting case law and application under Section 197 or appeal documents where relevant.
Q8: Are buybacks of listed shares treated differently from unlisted startup options?
Answer: Yes. Shares of listed or unlisted companies that have already been exercised and held by employees follow standard capital gains provisions upon buyback under Section 46A. The legal dispute in the recent ITAT and High Court orders specifically concerns unexercised options or options cancelled prior to share allotment.
Income Tax Provision — Statutory Scope & Legal Relevance — Impact on ESOP Payouts
Section 17(2)(vi) — Defines perquisites to include the value of specified securities or sweat equity shares allotted or transferred to an employee. — Triggered only when options are exercised and shares are actually allotted. Perquisite value = Fair Market Value (FMV) on exercise date minus exercise price.
Section 2(14) — Defines a "Capital Asset" as property of any kind held by an assessee. — Vested options grant a valuable contractual right to acquire stock in the future, forming part of a taxpayer's capital apparatus.
Section 45 — Charging section for Capital Gains arising from the transfer of a capital asset. — Applicable when a capital asset is transferred, sold, or relinquished for consideration.
Section 48 — Mode of computation for Capital Gains, requiring deduction of cost of acquisition from full value of consideration. — If the cost of acquisition cannot be computed under the statutory framework, the tax computation mechanism fails.
Section 192 vs. 195/197 — Obligations for withholding tax on salary payments versus certificates for lower or nil deduction. — Merely deducting tax under Section 192 does not conclusively determine the substantive legal nature of the income.