Rewarding deserving employees through attractive schemes has always been a priority or focus area for HR function of every organization.  Attractive schemes help motivate high performance employees and help company retain best talent with them for a long tenure.  Amongst other schemes, one can witness companies using various attractive share / stock linked plans as a measure of incentivising and recognising employees.  One such type is SAR which we are discussing in the subsequent paragraphs and ambiguity around taxing such benefit / incentive in the hands of individuals.

SARs concept
SARs is a scheme used by companies to reward or incentivise their management or employees where the company is performing financially well.  SARs are rights given to employees with certain vesting and other specific conditions, wherein employees get benefited if the value of shares of the company increase over a specified period of time. SARs generally doesn't not have a specific settlement date, instead the employees have the flexibility to exercise the SAR as per their individual need and assessment.
SARs are usually structured under following two methods:

* Cash Settled Plan  (also known as Phantom Stock) - An enterprise might grant rights to its employees as part of their rewards package, whereby the employees will become entitled to a future cash payment (rather than shares), based on the increase in the share price of the enterprise from a specified level over a specified period of time. Alternatively, an enterprise might grant to its employees a right to receive a future cash payment by issuing them shares that are redeemable, either mandatorily (e.g., upon cessation of employment) or at the option of the employee.
* Equity Settled Plan - The settlement in an equity settled plan is done by allotting shares to the employees, again based on upward movement in share prices.

The cycle of Stock Appreciation rights covers Granting of option by the company followed by Vesting of the option to the employee. In the last step after the block period, the employee exercises the option and settles the same in either cash or equity form.
Let's consider an example to further understand SAR's: Suppose Mr. X is granted SARs in the form of 1,000 shares when Mr. X's companies share value is Rs. 10 per share. At the time, Mr. X decide to exercise the vested SAR's, Mr. X's companies stock value is Rs. 25 per share. Mr. X will have a gain of Rs. 15,000 (Rs. 25 value at exercise minus the Rs. 10 value at grant, multiplied by the number of SARs exercised). The gain value can be obtained in cash or in form of shares by Mr. X from the employer Company.
Issues with respect to taxability of SARs    
The taxability of SARs in the hands of employees' has been uncertain due to the divergent views. The said issue especially relates to the period prior to 1999 as specific provisions were inserted under the Income Tax Act, 1961 ('the IT Act') in 1999 for taxing the benefits received by the employee under share benefit rewards. However, the provision was omitted vide Finance Act, 2000 and re-inserted in the IT Act vide Finance Act, 2009. Therefore, the said issue may also be relevant for the intervening period as well.
The taxability of the amount received from redemption of SARs has always been under dispute vis-à-vis taxability as perquisite under head salary or taxability as income under the head 'other sources' or taxability as income under head capital gain etc., until specific provisions were introduced vide Finance Act, 1999. The matter was referred to the Special Bench of Mumbai Income Tax Appellate Tribunal ('ITAT') in the case of Sumit Bhattacharya vs ACIT [TS-5001-ITAT-2008(Mumbai)-O], held that the income received on the redemption of SARs is a revenue receipt which is liable to tax as 'income under the head salaries' even if the same were received from the ultimate parent company of the employer. The nature of the payment is primarily deferred wages or bonus payment in cash or otherwise. Against the said ruling, the assessee has filed an appeal before the High Court of Bombay which wherein 5 questions of law were raised. The said appeal was admitted Sumit Bhattacharya vs. ACIT [TS-6256-HC-2008(Bombay)-O] by the High Court, however, in our understanding, the matter has not been disposed off / adjudicated by the High Court yet. If the appeal is now adjudicated by the High Court, one can expect that the matter be decided in line with the recent pronouncement by Supreme Court on the said issue in another case discussed in the next paragraphs.
Interestingly in another case Addl CIT vs Bharat V Patel [TS-5185-SC-2018-O]  recently decided, the apex court overruled the above case of Mumbai tribunal and upheld that while analyzing the taxability of redemption of SARs, it is important to first ascertain that the receipt is taxable in nature or not before being qualified as income. The apex court dismissed the appeal filed by the revenue against the Gujarat High Court judgment CIT vs Bharat V Patel [TS-809-HC-2014(Gujarat)-O]  which covered the redemption of SARs under head 'Capital Gains' and held that no capital gains shall arose as no amount was paid as cost of acquisition by the employee i.e. the capital gains computation mechanism fails.
Further, the apex court held that the redemption of SARs cannot be taxed as 'perquisite' under Section 17(2) of the Income Tax Act, 1961 ('the Act') prior to 1999, as the Act didn't had a specific provision to include SARs within its ambit. It would be worthwhile to discuss the apex court decision which is considered to be law of land, in greater detail to understand the divergent view taken from earlier tribunal judgment.
Facts of the case
The taxpayer, was employed as chairman cum managing director of P&G India Ltd. which is the subsidiary of P&G USA. The P&G USA had issued SARs from 1991 to 1996 and were redeemed by taxpayer in October 1997 and received an amount of Rs. 68.04 million from P&G USA. The taxpayer claimed the same as exempt in the return of income.
The Assessing Officer ('AO') held that the same is taxable as perquisite under section 17(2)(iii) of the Act or will be taxable as business income under section 28(iv) of the Act. Commissioner of Income Tax (Appeals) ['CIT(A)'] upheld the order of AO.
The ITAT held that the stock options are capital assets and the gain arising is liable to capital gain tax. The High Court held that capital gains arises to the taxpayer on redemption of SARs but the same is not taxable since there was no cost of acquisition involved from the side of the taxpayer.
The tax department filed an appeal against the High Court order before the Apex Court.
Decision
The Supreme Court dismissed the appeal of the revenue and held as follows:

* There is distinction between perquisite and capital gain. Perquisite are benefits attached to an employee and are usually non-cash benefits to retain the talented employees in the organization. On the other hand, capital gains means profit from the transfer of a capital asset i.e. property or investment. It is charged to tax in the year of transfer of such capital asset.
* The intention behind inserting the clause (iiia) in section 17(2) of the Act by the Finance Act, 1999 with effect from 01 April 2000 was to tax the benefits transferred by the employer to the employees. However, since the transaction pertains to period prior to amendment, such transaction cannot be brought within its ambit in the absence of express provision of retrospective effect. An individual cannot be made to pay tax in violation of a constitutional right in the absence of a specific provision.
* The Apex Court in its ruling in case of Infosys Technologies, reported in [TS-62-SC-2008-O] settled the position that in case an amendment is not clarificatory, it cannot be retrospective in nature.  Drawing support from the said principles, the Apex Court in the case of ACIT vs. Bharat V. Patel (supra) held that amendment made in the Income tax statute (section 17(2)) vide Finance Act, 1999 could not be said to have retrospective application.
* Circular No. 710 dated 24 July 1995, which provides for 'taxability of the perquisite on shares issued to employees at less than market price' has no applicability in the present case as the taxpayer was allotted SARs which is different from the allotment of shares.
* The present case cannot be covered under section 28(iv) of the Act, since the applicability of the said provision is confined to cases where there is any business or profession related transaction involved. In the taxpayer's case, there is no such transaction.