Taxation of ESOP Liquidity: Buybacks & Beyond

Introduction : Employee Stock Option Plans (ESOPs) are becoming an increasingly important part of the remuneration package in the start-up and technology sectors in India, as they provide employees with compensation that depends on the company's value. Unfortunately, ESOPs are also a very illiquid form of asset unless the employees are able to convert their paper gains into cash through a liquidity event. The primary liquidity options for private companies before their initial public offering (IPO) are buybacks, organised tender offers, and private placements to investors. Each option has unique tax consequences, and the liquidity situation of ESOPs has changed significantly due to various changes in the tax law in the recent past, including the introduction of buyback taxation and its subsequent repeal.

In this blog, we aim to analyse the important provisions of the Income-tax Act, 1961 as they relate to liquidity events such as buybacks, tender offers, and secondary sale; discuss valuation and tax withholding issues; compare buyback, tender offers, and secondary sale; discuss the judicial precedents on the taxability of ESOP compensation; and finally, discuss liquidity planning.

Legal Provisions

According to Section 17(2)(vi) of the Income Tax Act of 1961, the difference between the fair market value (FMV) of specified securities allotted to the employee under ESOP and the amount actually paid for the securities by the employee would be classified as a taxable perquisite under the head ‘Salary’. Rule 3(8) and Rule 3(9) indicate that the FMV would be computed based on the average opening and closing prices of the recognized stock exchange in the case of a listed company on the date of exercise, while in the case of an unlisted company, the FMV is to be calculated based on a certification from a Category I Merchant Banker within a period of 180 days as of the exercise date.

According to Section 192, the employer is required to withhold the TDS on the pre-requisite value arising from the exercise of options since it is chargeable under the head of salary. However, in case of employees working in those startups recognized by DPIIT and qualifying for benefits under Section 80-IAC, the provisions of Section 192(1C) stipulate that TDS by the employer would be delayed for a period of five years from the date of any of the following events, whichever is earlier - date of allotment of shares, date of sale of shares or date of cessation of employment. Furthermore, when selling shares already allotted to employees, the fair market value, already taxed as a perquisite at the time of exercise of options, will be treated as the cost of acquisition of shares for capital gains purposes under Section 49(2AA). The buy back of shares by the company will be subject to Section 68 of the Companies Act, 2013, with amendments over time, alongside applicable provisions of the Income-tax Act.

The taxation regime was earlier defined under section 115QA, wherein the company was liable to pay distribution tax at an effective rate of approximately 23.3%, but the amounts distributed to the shareholders were not charged to tax as per the provisions under section 10(34A) of the Act. However, with effect from 1st October 2024, the Finance (No. 2) Act, 2024 introduced amendments whereby the proceeds of the buy-back were treated as dividend under section 115BBDA. With the earlier law, the money distributed in a buy-back was treated as dividend, and tax was payable as per the rates under the relevant slab. In addition to determining tax, companies would also have to consider the acquisition cost of shares for the purpose of computing long-term capital loss under section 46A.

The Finance Act, 2026 has nullified the amendment from 1st April 2026. Further, the Finance Act, 2026 has introduced a new section 115TA which provides for taxation of promoters owning 10% or more equity shares in an unlisted company. The tender offers and secondary sale of shares by way of buy-back shall be regulated by sections 45 and 48 as amended from time to time. There will not be any tax implications on sale unless the transferee is a non-resident; in that case, the payment will be subject to withholding tax under section 195.

Legal Analysis

1. The two-stage taxation Architecture & the ‘Dry Income’ Problem : As per Indian law, there are two tax implications from ESOP-related gains. First, there is a tax as a perquisite in salary upon exercising the ESOP, which is computed based on fair market value. Thereafter, a second tax is imposed once the ESOP is sold, leading to a case of cash flow mismatch. Exercising the ESOPs in case of a high-growth unlisted business could lead to tax on notional income that is not realised since valuation of such companies is mostly speculative. Although some relief is given in Section 192(1C) allowing some deferment of tax for DPIIT-recognized start-ups, the tax has not been totally evaded.

2. Distinguishing Buyback, Tender Offer & Secondary Sale : In corporate law terminology, a buy-back involves the company repurchasing its own shares and deleting them from their records, subject to certain restrictions on the amount of share capital and free reserves being utilized for the buy-back. The reference to debt-equity ratio means that the buyback does not exceed any limits prescribed by the Governing Authority for the company concerned. A tender offer is an organized action taken by the company or one of its existing partners to invite other shareholders to sell shares (including ESOPs) to the company for a specified price for a specific duration. This is commonly done during a funding round. Secondary sale, however, refers to a private sale of allotments either from the secondary market or by a private investor or platform which does not involve the tender offer process.

   
   

   Whether the buy-back tax would apply depends on whether it was the company which bought back the shares or whether it was some outside party. If it was the company buying back the shares, then the buy-back tax would apply. If it was an outside party, the buy-back of the shares would be considered as a transfer of a capital asset, which does not give rise to company tax. If the company buys back vested options from its employees but which have not yet been exercised, the buy-back amount would be treated as salary income since there was no capital asset at the time of the buy-back.

3. The Buyback Tax Pendulum and the Finance Act, 2026 : Taxation of buybacks in India has changed significantly. Under the previous regime in place until October 2024, the company had to pay distribution tax while shareholders, including departing employees, did not have to pay tax on the amount they received. The new regime, which came into effect on October 1, 2024, has changed the entire burden of taxation to the shareholders by treating the buyback amount as a deemed dividend and has not allowed for any exemption or deduction for the cost of acquisition, which has caused difficulties as tax is applicable on capital gains and certain capital receipts. However, the Finance Act, 2026 has resolved this issue effectively from April 2026 onwards. Buyback proceeds will now be treated as capital gains for capital gains computation. The tax on long-term capital gains on unlisted stocks is fixed at 12.5%. On the other hand, the tax treatment of short-term capital gains will depend on the slab. However, additional tax liability will also arise on large promoter shareholders (including founder employees) who own at least 10% of unlisted stocks, and the effective tax rate will accordingly be 22% on corporate promoters and 30% on other promoters with respect to buyback proceeds.

   
   

   An employee in the case of a company buy-back holding the ESOPs will not have the original payment made as the cost for the purpose of calculating capital gains. The Cost will be the Fair Market Value on the date of exercise, which is taxable as a perquisite under section 49(2AA). If some employees don’t consider this, they may end up claiming more capital gains.

4. Withholding and Timing Considerations : The withholding provisions are triggered at various stages of the ESOP lifecycle. At the time of exercise, the employer deducts the tax at source on the perquisite value under section 192, which is also reflected in the Form 16 and Form 12BA. At the time of buyback, the companies, in most cases, deduct the tax at source on the consideration paid to shareholders. The credit of such tax deducted at source is claimed against the final tax liability on capital gains. However, in the case of tender offers made by a company and secondary sales between residents, no tax is withheld. Still, the transferor is obliged to pay advance tax on gains attributable to these transfers. In the case of non-residents, Section 195 creates a withholding obligation on the payee that may be claimed back in accordance with a tax treaty applicable to the situation. The time of transfer also plays a vital role in determining the extent of benefits in terms of taxes. If the transfer happens after 24 months from the date of exercise, the gains are long-term gains on unlisted shares and attract a concessional rate of 12.5% instead of being taxed at slab rates.

Relevant Case Laws

Sanjay Baweja v. Dy. CIT (2025) 474 ITR 376 (Delhi HC): A former employee of Flipkart applied for a Nil TDS certificate for a one-off voluntary transaction by Flipkart's parent company based in Singapore for compensating ESOP holders whose options had lost value because of the PhonePe demerger. The High Court of Delhi mentioned that as there have been no exercised options or shares issued, the computation provisions of section 17(2)(vi) do not apply, and the/payment cannot be taxed as a perquisite. The payment was treated as a capital receipt related to the employee's profit-earning source.

Manjeet Singh Chawla v. Deputy Commissioner of TDS (2025) 479 ITR 1: On materially identical facts involving the same Flipkart compensation scheme, the Karnataka High Court has taken identical view as the Delhi High Court in holding that the consideration received by the employee for forgoing the difference between the exercise price of the options granted to him and the value of the shares at the time of vesting of the option is a capital receipt not chargeable to tax as perquisite and accordingly directed issue of Nil TDS certificate under Section 197.

Nishithkumar Mukeshkumar Mehta v. DCIT [2025] 475 ITR 614: On the same facts, while the Madras High Court has come to the opposite conclusion that the compensation is taxable as a perquisite under section 17(2)(vi), being connected with the employment of the taxpayer, the position of the taxpayer before the Income-tax Authorities in Delhi and Karnataka remains obfuscated with uncertainty as to the taxability of such one-time ESOP compensation, requiring clarification from the Supreme Court or the Central Board of Direct Taxes.

Practical Implications

While exercising options, many employees must pay attention to liquidity planning since the income tax is charged ahead of the actual cash flow. Hence, it becomes important to create an effective documentation strategy for the certified Fair Market Value (FMV) for each exercise upon purchasing the stocks with options. Moreover, if the employee is a main shareholder owning considerable ESOPs, they must be aware of the high consumer taxes associated with the Finance Act of 2026 that might apply to buyback transactions.

As for the employer’s side, the decision about buyback, tender offer, or secondary sale involves statutory compliance costs. A buyback should follow strict procedures starting from Section 68 of the Companies Act of 2013, and its number is limited due to capital structure regulations; otherwise, the transaction may be challenged. On the other hand, a tender offer or secondary sale would not have restrictions, but appropriate paper work should be prepared to guarantee that such a transaction does not come to be seen as a buyback or additional payment for the same. Moreover, due consideration should be given to the execution of ESOP agreements so that the provisions of the Income-tax Act, 2025, which takes effect on April 1, 2026, are not violated as the new version does alter the numbering of the subsections discussed but has no major changes in connection with their applicability or impact.

Conclusion

The tax implications of ESOP liquidity events in India are at the confluence of employment income taxation, capital gains taxation and corporate law, all of which are currently undergoing extensive developments. The Finance Act, 2026 clarifies capital gains taxation of buybacks (restoring it to where it was prior to retrospective amendments introduced through the Union Budget, 2018), while different High Courts across India have taken divergent views on compensation on account of unexercised options.

Author: Aaradhya Soni in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.

Planning Tips

FMV should be calculated by employees at the time of each exercise as their expense, and, if applicable, they should look into the deferral of Section 192(1C) provisions to alleviate cash flow issues. Further, any sale, tender, or buyback should be conducted just before the 24-month period ends to ensure a lower tax on the unlisted shares. It is also important to advise founders and senior management with significant ESOP liabilities to get independent advice on their classification as promoters before the company’s buyback, while also analysing the tax impacts of buybacks, tenders, or secondary sales individually. Lastly, employers should ensure that their latest merchant banker valuations are at hand, liquidity events should be undertaken with the involvement of corporate law advisors, and tax counsel should be used to determine the compensation character for reporting unexercised/diminished options, as many different judicial decisions exist in this area.

References (Endnotes)

1. Income-tax Act, 1961, s. 17(2)(vi) (India).

2. Income-tax Rules, 1962, r. 3(8) & r. 3(9) (India).

3. Income-tax Act, 1961, s. 192 & s. 192(1C) (India).

4. Income-tax Act, 1961, s. 49(2AA) (India).

5. Income-tax Act, 1961, s. 45, s. 48 & s. 195 (India).

6. Companies Act, 2013, s. 68 (India).

7. Finance (No. 2) Act, 2024, effective 1 October 2024 (India) (deemed dividend treatment of buyback proceeds).

8. Sanjay Baweja v. Dy. CIT, (2025) 474 ITR 376 (Delhi HC).

9. Manjeet Singh Chawla v. Deputy Commissioner of TDS, (2025) 479 ITR 1 (Karnataka HC).

10. Nishithkumar Mukeshkumar Mehta v. DCIT, [2025] 475 ITR 614 (Madras HC).