Capital gains – Sections 2(14), (42A), (47) and 45 – (i) Capital asset – Stock option is a capital asset – Gains on exercising option – Capital gains; (ii) Salary – Stock option given to consultant – No relationship of employer and employee – Gains on exercising stock option – Assessable as capital gains

Capital gains – Sections 2(14), (42A), (47) and 45 – (i) Capital asset – Stock option is a capital asset – Gains on exercising option – Capital gains; (ii) Salary – Stock option given to consultant – No relationship of employer and employee – Gains on exercising stock option – Assessable as capital gains

The assessee was a software engineer who was employed with a company registered in India from 1995 to 1998. He was deputed to a U.S. company in 1995 as an independent consultant. The assessee served in the US from 1995 to 1998 as an independent consultant and later as an employee of the US company from 2001 to 2004. The assessee thereafter returned to India and was employed in the Indian subsidiary. While on deputation to the US, the assessee was granted stock option by the US company whereunder he was given the right to purchase 30,000 shares at an exercise price of US $0.08 per share. The assessee also had an option of cashless exercise of stock options which was an irrevocable direction to the broker to sell the underlying shares and deliver the proceeds of the sale of the shares after deducting the exercise / option price which was to be delivered to the US company. In the cashless exercise, the underlying shares were not allotted to the assessee and he was only entitled to receive the sale proceeds less the exercise price.

The assessee in the A.Y. 2006-07 exercised his right under the stock option plan by way of cashless exercise and received a net consideration of US $283,606 and offered this as long-term capital gains as the stock options were held for nearly ten years. The A.O. by an order u/s 143(3) split the transaction into two and brought to tax the difference between the market value of the shares on the date of exercise and the exercise price as ‘income from salary’ and the difference between the sale price of shares and market value of shares on the date of exercise of ‘income from short-term capital gains’.

The Tribunal held that the assessee was to be regarded as an employee for the purposes of the plan and the benefits arising therefrom were to be treated as income in the nature of salary in the hands of the assessee.

The Karnataka High Court allowed the appeal filed by the assessee and held as under:

‘i)    The Supreme Court in Dhun Dadabhoy Kapadia and Hari Brothers (P) Ltd. held that the right to subscribe to shares of a company was treated to be a capital asset u/s 2(14). The stock option being a right to purchase the shares underlying the options is a capital asset in the hands of the assessee u/s 2(14) which is also evident from Explanation 1(e) to section 2(42A) which uses the expression “in case of a capital asset being a right to subscribe any financial asset”. The cashless exercise of option therefore is a transfer of capital asset by way of a relinquishment or extinguishment of the right in the capital asset in terms of section 2(47).

ii)    From a perusal of the communication dated 3rd August, 2006 sent by the US company to the assessee, it was evident that the assessee was an independent consultant and not an employee of the US company at the relevant time. Thus, there was no relationship of employer and employee between it and the assessee. The assessee never received the shares in the stock options. At the time of grant of options to the assessee in the year 1996, section 17(2)(iia) was not there in the statute. The difference between the option / exercise price of the stock option and the fair market value of the shares on the date of exercise of the stock option was assessable as capital gains.

iii)   The Revenue in case of several other assessees had accepted the fact that on cashless exercise of option there arises income in the nature of capital gains. However, in the case of the assessee the aforesaid stand was not taken. The Revenue could not be permitted to take a different view.’