ESOP tax treatment uncertain as courts differ on pre-exercise payouts

Divergent court rulings on vested but unexercised ESOPs create uncertainty over whether employee payouts are taxed as salary or capital gains

Tax treatment of employee stock options (ESOPs) is facing fresh uncertainty as courts have taken different views on how money received by employees from vested but unexercised options should be taxed.

 

Employees getting the right to buy the share at a fixed price is referred to as vesting. At that point, they still do not own the share. When they actually buy it and the share is allotted, it is referred to as exercising.

 

The issue is becoming increasingly relevant as companies use buybacks and other liquidity opportunities to allow employees to realise the value of vested options before exercising them, particularly ahead of a public listing.

 

The Bangalore Bench of the Income Tax Appellate Tribunal ruled on July 30 that repurchase of vested but unexercised stock options could constitute a capital asset. The decision came in a case titled Pramod Kumar Jain versus Deputy Commissioner of Income Tax. Since the options were actually repurchased and extinguished, the consideration received by the employee was held taxable as long-term capital gains rather than as a salary perquisite.

 

The ruling adds to a series of differing judicial views on taxation of vested but unexercised employee stock options.

 

On June 2, 2025, the Karnataka High Court held in the Manjeet Singh Chawla versus Deputy Commissioner of Income Tax case that compensation for diminution in the value of vested options, where the options had not been exercised or transferred, was not taxable as a salary perquisite.

 

The court followed the reasoning of the Delhi High Court in an earlier case involving a similar payment.

 

The Delhi High Court had on May 30, 2024, held that a one-time voluntary compensation paid to vested option holders could not be treated as a salary perquisite.

 

However, the Madras High Court took a contrary view on July 31, 2024, in another case, saying that compensation received by an employee in connection with vested employee stock options was a benefit arising from employment and taxable as a salary perquisite, even though the options had not been exercised. The ruling is under appeal before a Division Bench of the Madras High Court.

 

The divergent rulings are creating practical difficulties not only for employees but also for companies, experts said. Employers have to determine how to characterise such payments, whether tax is required to be deducted at source and, if so, the appropriate withholding mechanism.

 

Under the existing framework, ESOPs are generally taxed at two stages.

 

When an employee exercises vested options and acquires shares, the difference between the fair market value of the shares and the exercise price is taxed as a salary perquisite. When the shares are subsequently sold, the resulting gain is taxed as capital gains. However, the law does not specifically spell out the treatment of payments made when vested options are monetised, cancelled or repurchased before exercise, tax experts said.

 

Richa Sawhney, partner at Grant Thornton Bharat, said the uncertainty also extends to the tax withholding obligations of employers. Given the lack of clarity in the current tax position, employers may, as a matter of prudence, choose to withhold tax by treating the payment as salary, she said.