Recent Tribunal ruling on the taxation of ESOPs (Employee Stock Option Plans) in India

Thu 21 Oct 2021

Multinationals worldwide frequently offer shares under ESOP to their employees as part of their reward and retention strategy. ESOP is a form of remuneration and hence is taxable as such in hands of the employee. In accordance with OECD guidelines, the taxability of ESOP in India depends on where employment is exercised and the period of service for which ESOP has been granted. ESOP taxability has been a subject matter of litigation in India over the past years, however, a recent ruling of the Income tax Appellate Tribunal has helped to clarify the treatment.

In addition to the taxation of the individual in respect of an award under an ESOP, there may be tax liabilities and reporting obligations on the employer.  It is therefore important for the employer to have appropriate record keeping procedures in place in relation to the ESOP, the personal tax position of the relevant employee, and the locations where the employee has worked.

Facts of the case

The taxpayer was an employee of an Indian listed bank and was sent on assignment to UAE. Before moving to UAE, the individual was granted options. The options were specifically and perhaps unusually, granted in respect of services rendered in India prior to the grant date. The options were then vested when the employee was in UAE. The taxpayer exercised his right to acquire shares in the bank at a time when he was a non-resident in India as he was based in UAE. He received shares in the bank and tax was withheld on the value of the award (listed price less purchase price).

The taxpayer, in his Tax Return, claimed a refund of the tax withheld on the ground that the ESOP award was not taxable in India as it related to his services rendered in the UAE during the vesting period. He contended that in the case of a non-resident, India is only entitled to tax Indian sourced income, whereas, in the present case, the source of the ESOP was his services rendered in the UAE. 

As an alternative argument, the taxpayer contended that, based on the employment article of the Double Taxation Avoidance Agreement (DTAA) between India and UAE, no tax liability arises in India since during the vesting period he was rendering services in UAE.

The Tribunal held

1. Shares under ESOP were allotted when the employee was a non-resident in India but the grant of the award had been for services rendered in India.
2. The income may have been received at a later date when the taxpayer was rendering services in UAE, but the income is a result of the services rendered in India.
3. ESOP benefits accrued on account of services rendered in India will be taxable in India, even if the individual is a non-resident in India, in the year when the employee exercises his right and shares are actually allotted. It also observed that, in the opposite situation, if the ESOP benefits accrued on account of rendering services outside India and the shares under ESOP are allotted at a later stage when the employee is resident in India, then the award will not be taxable in India since services were rendered outside India.
4. The treaty position taken by the individual was also denied since the income earned was for services rendered in India and hence taxable in India. In reaching this decision, the tribunal relied on Article 14 of the UN Model Convention which is worded similarly to the employment article of the DTAA between India and UAE. This gives taxing right to the source state i.e. stock options granted in the state where employment is exercised at that time, even if the employee is no longer employed in that state at the time the award is exercised.

Key takeaways

Options granted under ESOP are taxable in the jurisdiction that follows the OECD principles for taxing share awards, where they are earned and not where the taxpayer is located when they exercise the option. To determine the question of where ESOP gains are earned for the purposes of Indian tax, the general practice is to consider where services are rendered during the vesting period. However, this case highlights the fact that different interpretations are possible, for example where the ESOP is granted specifically in recognition of services rendered prior to grant.

Tracking the employment tax obligations of share awards for internationally mobile employees can be complex to administer.  Please get in touch with a member of the Mazars global mobility team for a discussion on efficient management of employment tax responsibilities in relation to globally mobile employees.