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Right to exercise an option is a capital asset and gains arising on sale are ‘long term capital gains’ if such right is held for more than three years
In brief
The Delhi Income-tax Appellate Tribunal (“Tribunal”) in the case of Abhiram Seth1 has held that the valuable right to exercise an option is a capital asset and the gains arising on sale would be treated as ‘long-term capital gains’ if the rights in these shares were held for more than three years.
1 Abhiram Seth v. JCIT [TS-586-ITAT-2011(Del)]
Facts
The assessee was an employee of PepsiCo India Holdings (P) Ltd. (“PIHL”) in executive position. PIHL is a part of PepsiCo Inc. He was granted valuable rights in shares of PepsiCo Inc employee stock ownership plan (“ESOP”) stock held with Barry group of Merrill Lynch USA. The rights in these shares were conferred to the assessee on various dates during the period 1995 to 2000. He sold these shares during Assessment Year (“AY”) 2004-05 and claimed the gains as long-term capital gains (“LTCG”) as the rights in these shares were held by him for more than three years. He also claimed deduction under section 54F of the Income Tax Act, 1961 (“the Act”) against these gains by way of investment in residential house.
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2 The income tax return of the assessee was accepted under section 143(1)(a) of the
Act. Thereafter, the assessment was reopened and reassessment proceedings were initiated for assessing income that had escaped assessment. The AO was of the view that the shares were never transferred to the assessee and were actually held by a trust i.e. Barry Group at USA. The assessee only received the differential amount between gross sale consideration and the cost price. Accordingly, the AO treated the gains as short-term capital gains as the shares were allotted to the assessee and sold by him on the same date. The AO held that the date of issue or grant was immaterial.
The Commissioner of Income-tax (Appeals) (the “CIT(A)”) upheld the order of the AO by placing reliance on the decision in the case of Shri Jaswinder Singh Ahuja2 wherein it was emphasised by the Tribunal that for the purposes of determining whether the shares are long-term capital assets or short-term capital asset, the date of acquisition of the shares would be the date on which the option is exercised by the employee. The Tribunal also highlighted in that case that prior to the exercise date, the assessee does not become owner of the shares and is not entitled to any gains/losses arising out of the same.
Aggrieved by the order of CIT(A) , assessee filed an appeal before the Tribunal and contended that:
• The capital asset, i.e. a valuable right to exercise an option to sell stock was a long term capital asset because it was created on the date of acceptance i.e.
1995 and other dates;
• The Barry Group of Merrill Lynch acted merely as a custodian of these shares for and on behalf of Pepsico Inc. and its employees worldwide. The shares were never issued by PepsiCo in the name of the employee but in the name of a
2 ACIT v. Shri Jaswinder Singh Ahuja [ITA no. 185 & 186 DEL/2009]
designated trust and stored in their stock also called ‘capital stock’ for the employees worldwide.
• The employee became the owner of the stock on the day when he signed the agreement and could redeem or encash his rights (part of stock) at any time after a lock-in period of three years.
• The assessee acquired the rights in indistinctive shares at the prevailing market price.
• The ESOP scheme only allowed the deferment of purchase price under which assessee was allowed to pay the purchase price when he opts to sell them.
• The assessee placed reliance on the judgment in the case of Dhurjati Gupta3 where in it was held that it is the date of grant of the stock option that is material for determining the period of holding the asset in question and not the date on which the option was exercised and the stock options were converted into shares.
Tribunal ruling
The Tribunal observed that:-
• The particular number of shares was allotted to the assessee in different years at different prices; only distinctive numbers were not allotted.
• Since there was an apparent fixed consideration of ESOPs shares, the right to allotment of particular quantity of shares accrued to the assessee at relevant time. The benefit of deferment of purchase price cannot lead to an inference that no right accrued to the assessee.
3 ACIT v. Dhurjati Gupta [2009] 127 TTJ 356 (Hyd)
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• Non-allotment of distinctive number of shares by trust cannot be detrimental to the proposition that assessee’s valuable right of claiming shares was held in trust and stood sold by PepsiCo. Accordingly, there was a definite, valuable and transferable right which can be termed as a capital asset in favour of the assessee.
• There will be no taxability if the date of allotment of shares and sale thereof is the same as was held by the assessing officer.
The Tribunal held that the right in shares constitute capital asset and that the gains should be taxed as “long-term capital gains” as the holding period was more than three years.
Conclusion
This decision of the Tribunal pertains to AY 2004-05. The law has subsequently been amended and the extant tax law provides that the taxability of stock options within the ambit of ‘employment income’ at the time of allotment/transfer of specified securities or sweat equity shares by the employer or former employer free of cost or at concessional rate section 17(2)(vi) of the Act. The income is again taxed at the time of sale for the difference between the sales consideration and fair market value (“FMV”) on exercise as ‘capital gains’.
Further, clause (hb) in Explanation 1 to section 2(42A) of the Act4 inserted effective 1 April, 2008 which provides that in case of a capital asset, being any specified security or sweat equity shares, allotted or transferred, directly or indirectly, by the employer free of cost or at concessional rate to his employees (including former employee or employees), the period shall be reckoned from the date of allotment or transfer of such specified security or sweat equity shares.
4 Inserted by Finance Act 2007 w.e.f 01 April, 2008
It is advisable to analyse the possibility to place reliance on this decision under the amended provisions in the light of specific provisions of section 17(2)(vi) of the Act and clause (hb) of Explanation 1 to section 2(42A) of the Act.
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