ESOP grant held as recognition for Indian services prior to grant and thereby taxable in India
The decision of the Mumbai Tax Tribunal makes the review of the terms of Employee Stock Option Plans even more crucial when determining the right to tax in cross border situations.
Employee Stock Option (‘ESOP’) is a deferred compensation strategy opted by companies globally to motivate and retain employees. As per the Income-tax Act, 1961 (‘IT Act’), ESOP benefits given to employees, free of cost or at concessional rates, are taxable at the time of allotment/ transfer of shares. Given there is timing difference when the ESOPs are granted and taxed, it creates complexities in case the employees are working cross-border during such tenure.
In this regard, recently, the Mumbai Tax Tribunal (‘Tribunal’) examined the tax implication in the case of an individual who was granted ESOPs while in India but exercised the same while he was outside India (Dubai). A summary of the ruling of the Tribunal and our comments on the impact of this ruling are below:
Facts of the case
The taxpayer is an employee of HDFC Bank Limited, Mumbai, and was deputed to HDFC Bank Representative Office in Dubai on 01 October 2007. He was granted ESOPs on 27 June 2007 which vested equally in two tranches i.e., 27 June 2008 and 27 June 2009. The said vested options were exercised by him during the Fiscal Year (FY) 2012-13 and 2013-14. Upon exercise, HDFC Bank Limited calculated the value and deducted taxes on same. However, at the time of filing return of income for the said FYs, the taxpayer qualified as Non-Resident (‘NR’) and claimed relief under section 90 of the IT Act for taxes deducted by HDFC Bank Limited.
The taxpayer’s return of income for FYs were selected for tax scrutiny. During the tax scrutiny, the Tax Officer (‘TO’) noted that the ESOPs were granted to the taxpayer in the year 2007 while the taxpayer was resident in India. The TO held that the ESOP grant was made inconsideration for the services rendered in India. Thus, the TO disallowed claim of relief under section 90 of the Act.
Aggrieved by the TO’s Order, the taxpayer filed an appeal with the First Appellate Authority [‘Authority’] but the Authority upheld TO’s Order. Aggrieved by the Authority’s Order, the taxpayer filed an appeal with the Tribunal.
The taxpayer contended before the Indian tax authorities that the ESOP income was not taxable in India based on the below:-
Taxpayer qualified as NR in India for the FYs 2012-13 and 2013-14. As per the Act, the income received/deemed to be received, income accrued/deemed to be accrued and income arising/deemed to be arising in India would be subject to tax in India (source taxation rule).
ESOPs are in the nature of salary and the right to receive salary income arose for rendition of services in Dubai (i.e. during vest period). Given that the services were rendered in Dubai during the vesting period, the ESOP income did not accrue or arise in India and therefore was not taxable in India.
Additionally, the taxpayer proclaimed that he qualified as resident of UAE at the time of exercise of ESOP i.e. in FYs 2012-13 and 2013-14. Hence, the taxpayer made an alternate submission relying on Article 15 (Dependent Personal Services) of India-UAE Double Taxation Avoidance Agreement (‘DTAA’) which provides for taxation of “salary, wages and other similar remuneration” in the state of residence unless employment is exercised in the other contracting state. ESOP were covered under the expression “other similar remuneration” and hence, taxable in Dubai i.e. place of exercise of employment.
The taxpayer also placed reliance on several judicial precedents which upheld 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.
On perusing the material on record and hearing contentions of the taxpayer and the TO, the following are the Tribunal’s observations:
- There is no dispute with the fundamental proposition of source taxation rule.
- Reliance was placed on the Apex Court’s judgement wherein the terms “is received”, “accrues” and “arises” was interpreted. It was observed that “accrual” or “arising” of income cannot be equated with “receipt” of an income.
- The Tribunal observed that the ESOP income “accrued” i.e. came into existence in the year 2007 when the taxpayer was in India. The ESOP grant or the “accrual” was for services/employment in India prior to the year 2007. Hence, while the ESOP income was inchoate at the time of grant, it did accrue in India.
- The Tribunal based on the principles of the UN Model Conventions Commentary 2017 held that: ESOP should not be considered to relate to any services rendered after the period of grant that is required as a condition for employee to exercise such ESOP
- ESOP should only be considered to relate to the services rendered before the time of grant as a reward to the services rendered prior to the grant itself
Based on the OECD’s publication, a benefit is accrued when the ESOP options are granted and the said benefit accrues in the jurisdiction in which the qualifying services are rendered.
The judicial precedents quoted by the taxpayer do not directly cover the issue in appeal.
In light of above, the Tribunal held that the ESOPs were granted in the year 2007 in consideration of services rendered by the taxpayer prior to grant. Given the taxpayer has rendered the services in India, the same would be taxable in India irrespective of year of receipt and also the benefit of Article 15 of India-UAE DTAA would, accordingly, not be available.
Indian judicial precedents covering ESOP benefit have held that ESOP benefit is to be taxed in the year of allotment/exercise based on the source taxation rule during the vesting period.
However, this ruling has discussed at length the source taxation rule for ESOP benefit. It brings out new nuances for taxation of ESOP benefit in case of cross-border employment especially the accrual of benefit at the time of grant. Since the ruling is case-specific, it needs to be applied judiciously in other cases.
It is recommended that the ESOP plan and facts of each case is deliberated in detail to understand the taxability of income and appropriate reporting in the tax return.