SC Holds that Income from SARs is Taxed as Capital Gains Only

Stock Appreciation Rights (SARs) are recognised globally as one of the most popular instruments of stock-based compensation. SARs are alternatives adopted for implementing equity-based compensation plans like an employee stock option or employee stock purchase. SARs can be structured as either ‘equity settled’ or ‘cash settled’. As a concept, SARs contemplate passing on of appreciation in the value of a certain number of equity shares to employees.

The Income Tax Act, 1961 (IT Act) did not have any specific provision to tax such income; specific provisions were introduced in 1999 to provide for taxation of benefits provided by an employer to its employees under share benefit rewards. From 1999 onwards, Section 17(2) of the IT Act specifies the payments that come within the ambit of ‘salary’ and ‘perquisites’, and covers benefits available to employees therefrom.

For the period prior to 1999, the issue of taxability of amounts received from various employee benefit programmes, including amounts received from the redemption of SARs, was always under dispute. The special bench of the Mumbai Income Tax Appellate Tribunal (ITAT) in the case of Sumit Bhattacharya[1] held that the amount received on redemption of SARs should be taxable as salary because it was an employment related benefit, in the nature of deferred wages, bonuses or incentives received as a fruit of employment. However, the issue remained inconclusive and litigious. The Supreme Court (SC) appears to have settled this issue in the case of Bharat V. Patel[2], wherein it has been held that the amount received on account of SARs redemption prior to amendment to section 17(2) would not be taxed as salaries.

The SC while analysing the applicability of Section 17(2) on redemption of SARs, reinstated the fundamental principle that a receipt must be made ‘taxable’ before it can be treated as ‘income’. The SC held that the amount received from the redemption of SARs can only be treated as ‘capital gains’ and not as ‘perquisite’ under Section 17(2) prior to 1999, since the IT Act did not then contain a specific provision for taxing share-based rewards.

Analysis of Bharat V. Patel Judgment

Facts

Bharat V. Patel (Assessee) was the chairman and managing director of Procter and Gamble (P&G) India, which was a subsidiary of P&G USA. The Assessee was working as an employee with P&G and was issued SARs without any consideration from 1991 to 1996. Upon redemption of these SARs in 1997, the Assessee received an amount of INR 6,80,40,649 from P&G USA.

The Assessing Officer treated the said amount as ‘perquisite’ and taxed it as ‘income from salaries’. Subsequent appeals were rejected by the Commissioner of Income Tax (Appeals) and the ITAT. However, the High Court allowed the appeal, which was then challenged by the revenue before the SC.

Arguments

The revenue argued that the amount received on redemption of SARs should be taxed as salary since they were perquisites under Section 17(2). They contended that the amount was received by the Assessee as an employee during the subsistence of an employer-employee relationship and, hence, the amount so received must be treated as taxable salaries. The tax authorities relied on the judgment[3] of the ITAT Special Bench wherein it was held that the amount received on redemption of SARs was a revenue receipt liable to tax as ‘income from salaries’, since the nature of the payment is primarily a deferred wage or bonus payment in cash or otherwise.

The Assessee on the other hand contended that the amount received from redemption of SARs can only be treated as ‘capital gains’. He also contended that he did not pay anything to acquire SARs. The Assessee also relied on an earlier SC judgment[4], which held that a benefit received by a person is not taxable as income unless the legislature makes the same taxable.

Decision

The SC while pronouncing the judgment in favour of the Assessee,  –

Distinction between ‘perquisite’ and ‘capital gains’

• These are two distinct terms with different meanings. ‘Perquisites’ are perks or benefits attached to employment, usually of a non-cash nature granted in addition to salary to retain talented employees. On the other hand, ‘capital gains’ means profit from the sale of property, which is charged to tax in the year of ‘transfer’.

Non-applicability of specific provisions inserted in 1999 to tax share-based rewards

• The intention behind amending Section 17(2) of the legislature was to bring the benefits transferred by the employer to the employees by offering stock options within the ambit of tax. Through this amendment, direct or indirect transfer of specified securities from the employer to the employees have been covered with effect from April 1, 2000. Said provisions would not apply to the instant case since the transactions took place before April 1, 2000.
• In the absence of any express statutory provision regarding the applicability of the amendment retrospectively, it cannot be applied for an earlier period.
• It is a well-established rule of interpretation that taxing provisions shall be construed strictly so that no person who is otherwise not liable to pay tax, be made liable to pay tax.

Redemption of SARs not taxable as perquisite

• The Central Board of Direct Taxes had issued a Circular to clarify the doubts about taxation of shares issued to employees. It stated that the issue of shares to employees at a price lesser than that offered to other shareholders would constitute a taxable perquisite. However, the said Circular is of no assistance to the extant case since the Assessee was allotted SARs and not shares.

Redemption of SARs not taxable as business income under Section 28

• The amount received upon the redemption of SARs could not be treated as benefits or perquisites arising from the exercise of a business or profession, since the applicability of the provision is confined to cases where there is any business or profession-related transaction involved. In the instant case, no such transaction was involved.

Conclusion

It is a fundamental principle of law that a receipt under the IT Act must be made taxable before it can be treated as income. Courts cannot construe the law in such a way that brings an individual within the ambit of the IT Act to pay tax who is otherwise not liable to pay. If an individual is subjected to pay tax in the absence of any specific provision taxing the said transaction, it would amount to violation of his Constitutional Right.

The SC in this judgement re-emphasises the well-established rule of interpretation that taxing provisions shall be construed strictly so that no person who is otherwise not liable to pay tax, should be made liable to pay tax. It also reiterates the principle that unless expressly provided, all amendments should be construed prospectively.

The SC ruling lays down the principle that the SARs benefit is covered by the provision that taxes share-based rewards on the basis of allotment or transfer of securities, since SARs usually do not involve allotment of securities. The SC ruling overrules the ITAT decision in the case of Sumit Bhattacharya[5], which on identical facts for the period prior to 2000 had held that SARs were taxable as salary income even if not received directly from employer. This SC decision may be relied upon by taxpayers experiencing similar litigation for the period prior to 2000.

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[1] Sumit Bhattacharya vs. ACIT 112 ITD 1

[2] ACIT vs. Bharat V. Patel (Civil appeal no. 4381 of 2018)

[3] Supra 1

[4] CIT vs. Infosys Technologies Limited 287 ITR 167

[5] Supra 1