Taxing the buy-back of vested but unexercised ESOPs: Salary, capital gains or something else?

Reflections on an evolving jurisprudence, in light of a recent Bangalore Tribunal ruling

The context

Employee stock options have become one of India’s most significant instruments of wealth creation, particularly across the start-up and technology sectors. As option pools mature, companies increasingly offer to buy back vested options from their employees, providing liquidity where the underlying shares are unlisted or an exit is some years away. These buy-backs are commercially welcome. They also raise a question of tax characterisation that is more nuanced than it first appears: when an employee receives money for a vested option that has never been exercised, how should that receipt be taxed?

A recent decision of the Bangalore Bench of the Income Tax Appellate Tribunal, Pramod Kumar Jain v. DCIT (ITA 3034/BANG/2025), offers a thoughtful and well-structured answer to that question. This article walks through the ruling, situates it within the wider and genuinely divergent body of judicial opinion, and reflects on how the law in this area may continue to develop. It is offered as commentary for professionals advising on equity compensation, and takes no position for or against any party to the litigation.

Where a buy-back sits in the ESOP lifecycle

It helps to keep the full life of a stock option in view. Broadly, an option passes through five stages:

1.    Issuance (grant) of the stock option

2.    Vesting of the option

3.    Exercise of the option

4.    Allotment of the underlying shares

5.    Sale of those shares

The tax consequences are settled at either end. On exercise and allotment (stages 3–4), the difference between the fair market value of the shares and the amount paid is generally taxed as a perquisite under section 17(2)(vi) of the Income-tax Act. On the eventual sale of the shares (stage 5), any gain is taxed as capital gains.

A buy-back of a vested option falls in the space between vesting and exercise. The employee never exercises the option and never receives shares; the company simply pays to take the vested option back. Because the perquisite charge is designed to operate at the point of exercise and allotment, this in-between event does not map neatly onto either of the two settled outcomes which is precisely why it invites careful analysis.

The two possible views

Two characterisations are conceivable, and each has a principled basis:

• As salary (a perquisite): because the option was granted by reason of employment, the value later realised from it may be seen as a reward flowing from that employment, taxable under the head Salaries

• As capital gains: a vested option is a right to subscribe to shares, a form of property, and therefore a capital asset, the surrender of which for consideration may be seen as the transfer of a capital asset, taxable under the head Capital Gains

The choice between them turns on a close reading of the statute, and reasonable minds including different High Courts have read it differently. That divergence is a measure of the question’s genuine difficulty, not of any shortcoming in the authorities who have grappled with it.

The Tribunal’s analysis in Pramod Kumar Jain

On the facts, the employee had been granted options by a Singapore group company under an employee stock option plan. The shares were unlisted, and the options could not, in practice, be exercised. During the year, a tranche of vested options was bought back for cash; the employee offered the receipt as long-term capital gains, while the assessing authority treated it as a perquisite. The matter reached the Tribunal.

The Tribunal’s reasoning is careful and worth appreciating on its own terms:

• The perquisite charge is keyed to exercise. Section 17(2)(vi) taxes the value of a specified security allotted or transferred to the employee, and its Explanations compute that value by reference to the fair market value on the date the option is exercised. Reading these together, the Tribunal held that until an option is exercised and a security comes into existence, the specified security that the provision taxes is simply not present

• Where the machinery cannot operate, the charge does not attach. Drawing on the classic principle in CIT v. B.C. Srinivasa Setty [1981] 128 ITR 294 (SC), that the charging and computation provisions form an integrated code, the Tribunal reasoned that if the value cannot be computed (because there is no exercise), the perquisite charge cannot fasten onto the receipt

• A vested option is a capital asset. Relying on Miss Dhun Dadabhoy Kapadia v. CIT [1967] 63 ITR 651 (SC) and the Karnataka High Court in Chittharanjan A. Dasannacharya v. CIT [2020] 429 ITR 570 (Karn.), the Tribunal treated the right to subscribe to shares as property under section 2(14), so that its buy-back is the transfer of a capital asset taxable under section 45

• Withholding and documentation do not settle the head of income. The Tribunal observed that the deduction of tax at source, and the tax note in the offer document, are not conclusive of how a receipt is to be taxed; the head of income is ultimately determined by the statute

Importantly, the Tribunal did not shut the door on perquisite taxation of options generally. It expressly recognised that where an option is exercised and shares are allotted, the perquisite charge applies in the ordinary way. Its conclusion is confined to the specific situation of a pre-exercise buy-back.

An interesting nuance: options are usually non-transferable

Stock options are almost always personal to the employee and cannot be sold or assigned to a third party, typically the only permitted dealings are exercise, lapse, or surrender to the company. This raises a fair question: if an option cannot be transferred to anyone else, can its buy-back really be a transfer for capital-gains purposes?

The answer, on settled principle, is yes. The definition of transfer in section 2(47) is not limited to a sale to a third party: it also covers the relinquishment of an asset and the extinguishment of any rights in it. When a company buys back a vested option, the employee’s rights in that option are extinguished for consideration. The Supreme Court in CIT v. Grace Collis [2001] 248 ITR 323 (SC) confirmed that the extinguishment of rights in a capital asset is a transfer in its own right, independent of any onward transfer to another person. On this view, the non-transferable character of an option does not stand in the way of capital-gains treatment and, in a buy-back, the company is in any event the counterparty acquiring and cancelling the option.

The non-transferable character of an option does not, by itself, take a buy-back outside the concept of “transfer”; the extinguishment of the holder’s rights for consideration is enough.

An open interpretive question worth flagging

One question the jurisprudence will likely need to address is whether the word exercise in section 17(2)(vi) can be read expansively so that giving up (relinquishing) an option for consideration is itself regarded as a form of realising the option’s value, attracting the perquisite charge.

There is a respectable textual argument that it cannot: to exercise an option is to apply for the underlying share, whereas to relinquish it is to give up that very right; and, in any case, without an exercise there is no specified security whose value can be computed. Equally, there is a substance-oriented perspective reflected in the wording “directly or indirectly” in the provision that any benefit ultimately traceable to an employment-linked option may be seen as partaking of the character of a perquisite. Both perspectives are legitimate, and it is this very tension that different courts have weighed differently. Flagging the question is more useful, at this stage, than pretending it is closed.

The wider judicial landscape

The buy-back situation sits alongside a related line of cases concerning a one-time payment made to option holders to compensate for a fall in the value of their options, where the options were retained rather than bought back. On closely comparable facts, different High Courts have reached different conclusions:

• The Delhi High Court in Sanjay Baweja v. DCIT [2025] 474 ITR 376 and the Karnataka High Court in Manjeet Singh Chawla v. DCIT took the view that, absent exercise, such a receipt is not a perquisite

• The Madras High Court in Nishithkumar Mukeshkumar Mehta v. DCIT [2025] 475 ITR 614 took a different view, holding that a benefit flowing from an employment-linked option may be taxed as a perquisite even without exercise.

These are considered decisions of co-ordinate constitutional courts reaching honestly different conclusions on a difficult provision, the kind of divergence that is ultimately be resolved by the Supreme Court. It is worth noting that the Pramod Kumar Jain fact pattern (an actual buy-back that extinguishes the option) is distinct from the compensation-for-diminution cases (where the option is retained), so the Tribunal was able to treat that line of authority as addressing a different situation.

Reflections on the road ahead

A few observations may be made, while recognising that the issue continues to evolve through different judicial forums.

First, the Tribunal’s core proposition that the perquisite charge under section 17(2)(vi) is anchored to the moment of exercise rests on a straightforward reading of the provision’s computation machinery and is supported by long-standing Supreme Court authority. It also aligns with the reasoning of more than one High Court on closely related facts.

Second, the further step of positively taxing the buy-back as capital gains raises its own questions notably the cost of acquisition of an option granted without payment which future decisions may refine. In that sense, the characterisation of the receipt as not being salary rests on firmer ground than the mechanics of computing the capital gain, and practitioners will watch how the latter is worked out.

Until the Supreme Court has the occasion to harmonise the divergent views, a measure of uncertainty will remain, and outcomes may continue to turn on the precise facts whether the option was exercised, retained, or bought back, and the terms on which any payment was made.

Beyond the immediate tax consequences, the decision is significant because it compels a closer examination of the legal character of employee stock options. The ruling reminds us that an ESOP is not merely a compensation tool; at different stages of its life cycle it may also embody proprietary rights capable of independent tax treatment. How the law ultimately reconciles these dual characteristics will shape the taxation of equity compensation for years to come.

What this means for companies and plan design

• Characterisation follows the transaction, not the label. Whether a payment to an option holder is a perquisite or a capital receipt depends on what actually happened at each stage of the option’s life; careful documentation of the transaction and its commercial rationale is valuable

• The stage matters. A payment made before exercise stands on a different footing from one made after exercise and allotment. Plan administrators and advisers benefit from being precise about which stage a given transaction sits in

• Withholding is not the last word. Tax deducted at source, and characterisations in offer documents, are helpful for administration but do not conclusively fix the employee’s tax position, which is governed by the statute

• Watch the space. With the issue awaiting authoritative settlement, employers and option holders alike will be well served by keeping abreast of developments and by taking advice tailored to their specific facts

This article is intended as general professional commentary on an evolving area of law and does not constitute legal or tax advice. It reflects the law as understood at the time of writing and takes no position for or against any party to the proceedings discussed. Readers should seek advice specific to their own facts. Case citations should be verified against the reader’s preferred reporting service.