Can ESOP buyback payouts be taxed as capital gains? ITAT order offers hope for startup employees

Startup employees who receive payouts when their vested but unexercised employee stock options (ESOPs) are bought back before they are exercised could have a stronger case for seeking capital gains tax treatment instead of paying tax under the salary head.

In a recent order, the Bengaluru bench of the Income Tax Appellate Tribunal (ITAT) remanded the case of a former Flipkart employee to the Commissioner of Income Tax (Appeals), directing it to examine the matter on merits in light of the Karnataka High Court’s ruling in Manjeet Singh Chawla vs Deputy Commissioner of TDS.

The dispute relates to nearly ₹39.74 lakh received by the employee from the buyback of vested stock options. While the taxpayer reported the amount as capital gains, the Income Tax Department treated it as salary after noting that the employer had deducted tax at source (TDS) under the salary provisions and reflected the payment in Form 16.

The ITAT did not itself rule on how the payout should be taxed. Instead, it observed that the first appellate authority had dismissed the taxpayer’s appeal on procedural grounds without examining the legal issue. It therefore directed the Commissioner of Income Tax (Appeals) to reconsider the case after taking into account the Karnataka High Court judgment.

When can an ESOP payout be taxed as capital gains instead of salary?

The Karnataka High Court’s June 2025 ruling, which the ITAT has asked the appellate authority to consider, clarified that taxation of ESOPs as a salary perquisite arises only when an employee exercises the stock option and shares are actually allotted.

Until then, vested but unexercised ESOPs merely give the employee a right to acquire shares in the future and do not amount to ownership of shares. The High Court held that compensation received for such unexercised options cannot automatically be taxed as salary merely because the employer deducted TDS or reported the amount in Form 16. The nature of the income has to be determined under the Income Tax Act.

The High Court also noted that ESOP taxation generally happens in two stages. The first is when the employee exercises the option, where the difference between the exercise price and the fair market value is taxed as a salary perquisite. The second is when the allotted shares are eventually sold, where any appreciation is taxed under the capital gains provisions.

What does this order mean for startup employees?

The latest ITAT order is significant for employees of startups and technology companies, where ESOPs are increasingly used as part of compensation and liquidity often comes through acquisitions, mergers, buybacks or secondary transactions rather than public listings.

Although the tribunal has not delivered a final verdict on the tax treatment, its decision to send the matter back for fresh consideration in light of the Karnataka High Court ruling strengthens the legal position of taxpayers in similar disputes. Employees who receive payouts for vested but unexercised ESOPs may be able to argue that such receipts should be assessed under the capital gains provisions instead of salary, depending on the facts of their case.

The outcome is important because the head under which the income is taxed can significantly affect the tax liability. Salary income is taxed at the applicable income tax slab rates, while capital gains are taxed under a separate set of provisions, subject to the nature of the asset and the period of holding.