If you are familiar with the financial world, the â€˜optionsâ€™ is a very commonly traded term. Options are generally financial instruments that will derive their value from the underlying asset. While â€˜optionsâ€™ can be used in terms of various financial assets, it is commonly used in reference to shares of a company. Through â€˜option clausesâ€™, shareholders are provided the opportunity to sell or buy shares at a pre-determined rate. Such clauses will often tie in with the right of first refusal and the right of first offer that is provided to shareholders to protect their shareholding from dilution.
There are two types of share options: put options and call options. Put options will provide a shareholder with the option of selling their shares at a predetermined rate, while call options will allow them to purchase shares at a predetermined rate.
Taxing such transactions may be slightly complicated. No income tax is levied at the time of receiving a share option, as no income has yet been realized. When the shares are finally sold or purchased, then the income may be taxed according to whether it is recognized as a revenue receipt or a capital receipt. Contentions have been raised by tax authorities who argue that this should be recognized as a revenue receipt, while taxpayers have argued that it is a capital receipt since shares are capital assets.
If there is a sale of shareholding, then the tax is charged on capital gains tax under the Income Tax Act. Capital gains tax is charged the there is a profit or gain arising from the transfer of a capital asset by the taxpayer during an assessment year. Capital asset has been defined under section 2(14) of the Income Tax Act, to mean the following: i. Any kind of property held by the taxpayer, whether it is connected to a business or profession and ii. Any securities held by a foreign institutional investor which has been invested in accordance with the SEBI Act, 1992.
Capital assets can be both short term capital assets and long term capital assets, depending on the period for which theyâ€™re held. Short term capital assets are capital assets held for less than 36 months before the date of transfer, while long term capital assets are those held for more than 36 months (or 24 or 12 months depending on the type of asset).
Hence, under the definition shares qualify as capital assets and the income recveived from such transfer of shares is considered a capital receipt which is taxable only under capital gains tax. However, in certain cases the shareholders may provide payments for reserving the share option and this is referred to as option money. Option money may be made periodically by the shareholder to continue to reserve their share options and these payments are usually made in the nature of recurring refundable deposits.
Tax authorities have argued that this option money is in the nature of revenue receipts and should be taxed under income tax as such. Shareholders argue that it is contribution towards an amount that will be offset or refunded at the time of exercising the share option and should be considered a capital receipt. This matter of contention was recently taken up by the Tax Tribunal at Delhi in the case of Dabur Investment Corporation.
The contention surrounding the taxability of income received from the transfer of shares and taxation of share option money was recently dealt with by the Income Tax Appellate Tribunal of Delhi, who held that such income realized are in the nature of capital receipts and should only be taxed under the income head of â€˜capital gainsâ€™.
The tribunal held that the refundable deposits were in the nature of capital receipts and could not be taxed as revenue. The court held that while all incomes are receipts, all receipts cannot be considered incomes.
Income receipts are taxable under the Income Tax Act, but capital receipts are not taxable except for capital gains. The nature and purpose of receipts is determined with reference to the purpose for which payments are made. In this case, the payments for the option money were being made by CUIH to Dabur to retain the right of first offer over the subscription in the event that the foreign investment limits were lifted.
The tribunal ruled that the frequency of receiving payments was immaterial to determining its nature. The option money carried the obligation that the excess amount (above the net sale proceeds at the time of sale) would be refunded by Dabur to CUIH. This was specified in the joint venture agreement and so the payments were made as advances that would be duly refunded. When Dabur transferred the 23% shareholding to CUIH, it had also refunded the excess amount of Rs.4.78 crores out of the option money.
The use of this option money received by Dabur is also not barred by Indian law. The Indian tax law only requires that any income generated from the use of such option money should also be taxed and not lost from revenue. The investment from Dabur to the joint venture company was on capital account and no amount was ever advanced to CUIH. The payments made by CUIH to Dabur were clearly capital payments made to protect their right of first refusal.
The tribunal ruled that the option money received by Dabur could be invested in securities, and would not make any difference in terms of its taxability as a capital receipt.
The ruling by the tribunal is important as it settles the law in regard to taxing the share option monies received by a person to protect the share option rights of another party. The following are the important takeaways from the ruling: