In India’s vibrant startup landscape, ESOPs have become a key compensation tool, especially in tech-driven, high-growth sectors, offering employees a stake in the company’s future. But what happens when this potential upside is abruptly diminished due to events outside the employee's control? The 2022 Flipkart–PhonePe restructuring is a case in point, where unexercised ESOPs saw a sharp decline in value, prompting a one-time voluntary compensation to affected employees. While well-intentioned, this move sparked complex questions around its tax treatment under Indian law.

Mr. Amit Agarwal (Mergers and Acquisitions Partner, Nangia & Co LLP) and Ms. Damini Dhull (Manager) explore the facts, context, and implications surrounding such compensation, with limited emphasis on judicial precedents and instead focusing on commercial rationale, stakeholder interests, and policy gaps. While emphasizing that clarity in ESOP taxation, particularly in cross-border and restructuring contexts, is essential for ensuring fairness, reducing litigation, and fostering a predictable business environment, the Authors conclude by remarking that “Until then, vigilance, documentation, and proactive advisory remain the best tools for both employers and employees.”

“Navigating the Grey Zone: Tax Treatment of Voluntary ESOP Compensation in India”

In India’s thriving startup ecosystem, Employee Stock Option Plans (ESOPs) have emerged as a cornerstone of the employee compensation, particularly in technology-driven, high-growth sectors and multinational groups. ESOPs offer employees the opportunity to participate in the company's success through future ownership, aligning long-term incentives between employers and employees. These instruments are structured to create significant upside when a company performs well, especially when its valuation increases. They also serve as an effective retention mechanism, motivating employees to stay engaged and committed during the company’s growth stage.

However, what happens when this potential upside is abruptly diminished due to events outside the employee's control? A notable example is the 2022 corporate restructuring involving Flipkart and PhonePe, where the value of unexercised ESOPs dropped substantially, prompting the company to issue a one-time, voluntary compensation to affected employees. This gesture of goodwill, however, opened up a significant and complex debate on its tax treatment under Indian law.

This article explores the facts, context, and implications surrounding such compensation, with limited emphasis on judicial precedents and instead focusing on commercial rationale, stakeholder interests, and policy gaps.

Understanding ESOPs: From Incentive to Value Realization

ESOPs are structured as rights, not obligations, granted by companies to employees to purchase shares at a future date at a pre-agreed price. These rights vest over time and can be exercised upon meeting certain conditions. The life cycle of an ESOP generally involves the following stages:

1. Grant: The option is granted to the employee.

2. Vesting: The employee earns the right to exercise the options over a vesting period.

3. Exercise: The employee purchases shares at the exercise price.

4. Allotment: The company allots the shares to the employee.

5.Sale: The employee sells the shares, triggering potential capital gains.

Under the Indian taxation regime, ESOPs are taxed at two key stages:

• At the time of exercise, where the difference between the fair market value (FMV) and the exercise price is taxed as a perquisite under Section 17(2)(vi).

• Upon sale, where any gain is taxed under the head capital gains.

However, when corporate events like demergers, spin-offs, or strategic realignments occur, the value of unexercised options may fluctuate drastically even before the employees can benefit from them- and that’s where the tax complexities enter. This creates a unique challenge for the tax system, which is built on realization-based taxation principles, not hypothetical or notional events.

Global Perspective and Policy Gaps

Unlike jurisdictions such as the US or UK, where ESOP taxation frameworks are more evolved and better integrated with securities law and corporate actions, India lacks specific provisions dealing with compensatory payments due to notional ESOP value loss. The current legal infrastructure focuses only on exercise and sale events.

As a result, corporate goodwill gestures may inadvertently result in tax burdens that defeat their original purpose. This creates dissonance between commercial reality and fiscal policy, necessitating intervention from the Central Board of Direct Taxes (CBDT) to issue clarifications or introduce tailored rules.

The Flipkart-PhonePe Separation: Background and Compensation

In a significant restructuring exercise in 2022, Flipkart Singapore (FPS), the holding entity for Flipkart India and PhonePe, completed a spin-off that separated PhonePe as an independent entity. While this move was intended to unlock value and create independent growth trajectories for the businesses, it had a depreciative effect on the share value of FPS, impacting the value of ESOPs granted by Flipkart to Indian employees.

Recognizing this loss, Flipkart Singapore made a voluntary, one-time payment to employees, including some who were no longer with the company, as well as certain non-employees like advisors. This payment was:

• Non-contractual: There was no legal obligation to make the payment.

• Non-recurring: It was a one-time compensatory measure.

• Non-transfer-related: The ESOPs were not exercised, sold, or transferred.

Importantly, recipients continued to hold their unexercised ESOPs, which meant that no real transaction had occurred in terms of exercising or liquidating stock options. The payment merely attempted to compensate for unrealized economic value, thereby raising questions on whether it constituted taxable income.

Tax Controversy: Income or Capital Receipt?

The tax classification of this payment quickly became contentious. Employees contended that the payment was a capital receipt, not chargeable under any head of income. On the other hand, the tax authorities appeared inclined to treat the amount as a perquisite, taxable under "income from salary," under Section 17(2)(vi) thereby triggering TDS obligations.

This raised a host of compliance challenges:

• Could the payment be taxed without an actual transfer or benefit being realized?
• Was there a legal basis to consider the compensation as taxable salary or perquisite?
• If it was not income under any head, should TDS have been deducted at all?

Some employees sought Nil TDS certificates under Section 197, anticipating that the payment would not attract tax. However, the inconsistent treatment by tax officers and lack of CBDT guidance meant that many applications were denied, leading to litigation.

Legal Character of Payment- A Brief Analysis

The matter found judicial clarity in the Karnataka High Court’s ruling in Manjeet Singh Chawla v. Deputy Commissioner of Income‑tax [TS-806-HC-2025(KAR)]. Key passages are instructive:

“TDS cannot be directed on a payment that does not constitute income. The one‑time voluntary compensation, being a capital receipt for diminution in the value of stock options, falls outside the charging provisions of the Act.”
— Krishna Kumar J.,  7(i)

This emphasizes that the charging section of the Income-tax Act cannot apply to receipts that do not qualify as 'income' in the first place. The one-time nature of the payment, unconnected with any salary, reinforces its capital nature.

“ESOPs are capital assets within the meaning of s. 2(14); yet, where there is no exercise and therefore no cost of acquisition, the machinery provisions of s. 45 read with s. 48 fail. Consequently, no capital‑gains charge can arise.”
— Krishna Kumar J.,  7(ii)

The Court recognized that while ESOPs may be 'capital assets', no capital gain can be charged without a transfer or a computation mechanism—principles rooted in landmark decisions like B.C. Srinivasa Setty [TS-2-SC-1981].

“Without the mandatory ‘exercise’ trigger in s. 17(2)(vi), no perquisite taxation is possible; Parliament has provided no alternative computation.”
— Krishna Kumar J., 7(v)

This statement reiterates that taxation under Section 17(2)(vi) can only arise upon actual exercise. Since the ESOPs were never exercised, the section cannot apply.

The judgment provides clarity that voluntary compensation for notional loss in ESOP value, without any corresponding benefit or realization, cannot be taxed either as salary or capital gains. The Karnataka HC effectively closed the door on speculative tax treatment by reinforcing that both charge and computation provisions must be satisfied for taxation to succeed.

Other Jurisprudence on Similar Payments

The Indian judiciary has delivered divergent rulings on the tax treatment of one-time ESOP compensation, adding to the uncertainty in this area. The Karnataka High Court in Manjeet Singh Chawla v. DCIT  [TS-806-HC-2025(KAR)] unequivocally held that such compensation is a capital receipt not taxable under the Income-tax Act, primarily because there was no exercise of the ESOPs and no computation mechanism existed to tax the receipt. Similarly, the Delhi High Court in Sanjay Baweja v. DCIT  [TS-377-HC-2024(DEL)] ruled in favor of the assessee, holding that since there was no exercise of options and no benefit actually accrued, the payment could not be brought to tax as a perquisite under Section 17(2)(vi).

The Hon’ble Madras High Court, however, adopted a more substance-oriented interpretation in Nishith Kumar Mehta v. ITO  [TS-582-HC-2024(MAD)]. It held that since ESOPs are granted by virtue of employment, any benefit flowing from them—directly or indirectly—partakes the character of a perquisite. The inclusive definitions of ‘salary’ and ‘perquisite’ are broad enough to cover such a payment. The court reasoned that the absence of a specific computation method for an unexercised option should not defeat the charge of tax, especially when the monetary value of the benefit received is clearly known. It supported this with the principle laid down by the Supreme Court in the Infosys Technologies Ltd. case that "benefit from the ESOP is to be determined for purposes of, and as a prerequisite for, taxation as a ‘perquisite’."

Another important area of divergence concerns the classification of ESOPs as 'capital assets' under Indian tax law. The Madras High Court, in a restrictive reading of the term, held that unexercised ESOPs do not constitute capital assets within the meaning of Section 2(14) of the Income-tax Act. This conclusion led the court to deny the characterization of compensation for ESOP loss as falling under capital gains provisions. In contrast, the Karnataka High Court adopted a broader interpretation, emphasizing that Section 2(14) defines 'capital asset' expansively as 'property of any kind', which includes intangible rights such as ESOPs. However, the Court noted that even if ESOPs qualify as capital assets, the absence of an actual transfer or realization event rendered the capital gains provisions inapplicable in the given circumstances. The key takeaway from this reasoning is that both the characterization of an asset and the occurrence of a taxable event are critical to attract the capital gains tax machinery.

In summary, the Karnataka and Delhi High Courts provide strong support for the view that voluntary compensation for ESOP loss is a capital receipt not chargeable under the Act, while the Madras High Court leans toward a pro-revenue interpretation, relying on the employment linkage and the concept of derived benefit.

The Karnataka HC judgment, aligned with the Delhi HC, provides robust legal grounding that voluntary compensation for ESOP loss is a capital receipt, not taxable under any head of income, and not subject to TDS. It distinguishes the Madras HC’s pro-revenue stance, reinforcing the principle that computation mechanism must exist for a tax levy to succeed.

Broader Implications for Employees and Employers

The complexities arising from such voluntary ESOP compensation extend beyond tax law into the domains of compliance, workforce management, and corporate governance. From an employee's standpoint, receiving a one-time compensatory payment that is taxed—despite being non-liquid and goodwill-based—can create significant cash flow challenges. This becomes particularly burdensome if the funds have already been allocated to personal or financial obligations. Moreover, the absence of a uniform tax treatment across jurisdictions and lack of guidance from the Central Board of Direct Taxes (CBDT) exacerbates uncertainty, making it difficult for employees to accurately assess and plan their tax liabilities. For many, this ambiguity translates into a heightened risk of litigation, as they are forced to contest unjustified tax deductions or penalties.

On the employer’s side, the challenges are equally multifaceted. Companies must navigate a grey zone where deducting tax without clear legal backing risks employee discontent and reputational harm, while failing to withhold could attract regulatory scrutiny and penalties. This uncertainty necessitates a comprehensive review of ESOP plan designs, particularly for multinational corporations operating in India, who must now account for jurisdiction-specific nuances in tax treatment. It also demands closer coordination between HR, legal, and finance departments to ensure that any form of discretionary compensation—voluntary or otherwise—is defensible under Indian tax laws.

In essence, the ripple effects of ambiguous ESOP tax treatment touch upon retention strategies, financial compliance, and the broader employer-employee relationship. These concerns reinforce the urgent need for legislative or administrative clarity.

Looking Ahead: Need for Clarity and Reform

The divergent judicial pronouncements from various High Courts—including Karnataka, Delhi, and Madras—indicate that the issue of taxability of one-time ESOP compensation remains unsettled. While the Karnataka and Delhi High Courts have taken a taxpayer-friendly view by treating such compensation as non-taxable capital receipts, the Madras High Court has interpreted the law differently, classifying the payment as a taxable perquisite. This legal inconsistency underscores the urgent need for either a uniform ruling from the Hon’ble Supreme Court or the issuance of clarificatory guidance from the Central Board of Direct Taxes (CBDT).

In the interim, corporates would be well-advised to rigorously document the rationale behind any discretionary compensation to mitigate exposure. Employers should evaluate their withholding tax obligations in light of these evolving legal positions and, where necessary, pursue advance rulings or certificates under Section 197 of the Income-tax Act to avoid post-facto disputes.

Employees, on their part, must ensure careful record-keeping with respect to their ESOP entitlements, valuations, and any related correspondence or payouts. It is prudent to consult tax advisors before treating such compensation in their tax returns to avoid penal consequences.

Until uniformity is achieved through either legislative clarification or apex judicial pronouncement, both employers and employees must operate with enhanced diligence to navigate the current ambiguities in law.

Final Thoughts

The Flipkart-PhonePe episode serves as a case study on the intersection of tax law, equity compensation, and corporate restructuring. It highlights how well-intentioned corporate actions can result in unintended tax exposure unless the legal and fiscal ecosystem evolves in parallel.

As India grows into a global startup hub, ESOP related tax controversies will only increase. While judicial interpretations will play a role, what’s urgently needed is clarity from the tax administration, especially in borderline cases involving notional losses and voluntary compensation. Clarity in ESOP taxation, particularly in cross-border and restructuring contexts, is essential for ensuring fairness, reducing litigation, and fostering a predictable business environment. Until then, vigilance, documentation, and proactive advisory remain the best tools for both employers and employees.