Taxability of One-Time Voluntary Payment Received on Diminution of Value of ESOPs

The taxability of a one-time compensation (“FPS Compensation”) paid by Flipkart Private Limited, Singapore (FPS) to holders of its Employee Stock Options (ESOPs) has been the subject of three judicial decisions in India.

The FPS Compensation was made following the complete separation/divestment of its PhonePe business in 2022, which caused a diminution in the value of FPS’s shares, and consequently, the value of its ESOPs. Importantly, there was no legal or contractual obligation on FPS to pay this compensation to ESOP holders. Even after receiving the FPS Compensation, the ESOP holders retained all ESOPs and their right to receive shares, subject to vesting and exercise.

Legal Controversy

The controversy emerged when ESOP holders were denied a ‘Nil’ withholding tax certificate under Section 197 of the Income-tax Act, 1961 (ITA) for the FPS Compensation. The holders filed writ petitions in their respective jurisdictional High Courts.

The core issue was whether the FPS Compensation should be treated as:

A non-taxable capital receipt,
or taxable as:
- (i) a perquisite under the head ‘Salaries’ (due to its employment link), or
- (ii) under the head ‘Capital Gains’.

Judicial Decisions

Delhi High Court (Sanjay Baweja v. DCIT):
Held that FPS Compensation does not qualify as a perquisite, as no ESOPs were exercised.

Madras High Court (Nishithkumar Mukeshkumar Mehta v. DCIT):
Took a divergent view, holding the payment as a taxable perquisite.

Karnataka High Court (Manjeet Singh Chawla v. DCIT):
Aligned with the Delhi High Court and distinguished the Madras High Court’s view.

Karnataka High Court's Decision

The Karnataka High Court (Kar HC):

Allowed the employee’s writ petition,
Quashed the Income-tax department’s rejection of the Section 197 application,
Directed the issuance of a ‘Nil’ Tax Deduction Certificate.

Key reasoning:

The petitioner had neither exercised the ESOPs nor transferred/sold shares.
Section 17(2)(vi) of the ITA, which governs taxation of ESOPs as perquisites, requires actual exercise and share allotment.
As the mechanism for computation failed, the FPS Compensation cannot be taxed as a perquisite.

The Kar HC also distinguished the Madras High Court’s ruling on both factual and legal grounds.

Conclusion

With three conflicting High Court rulings, the matter is now ripe for Supreme Court adjudication. Until then, the tax treatment of ESOP-related compensation remains unsettled, potentially causing:

Litigation risks,
Uncertainty for both employers and employees, and
Cash flow challenges due to employers’ obligation to withhold taxes on such payments.