Judgment Review

"CIT v. Infosys
Technology
(2008) 237 ITR
167 (SC)”

Harshita Khinchi, BA.LLB, 21220935

"CIT v. Infosys Technology (2008) 237 ITR 167 (SC)”

Parties Involved:

➢ Appellant: Central Board of Direct Taxes (CBDT)

➢ Respondent: Infosys Technology Ltd.

Jurisdiction: Supreme Court of India

Background: Infosys Technology Ltd., a prominent IT company in India, was

involved in providing software development and IT services. The Central Board of
Direct Taxes (CBDT) initiated proceedings against Infosys regarding its tax returns.

Dispute: The dispute primarily revolved around the classification of certain

revenue earned by Infosys for tax purposes. The main contention was whether
the revenue in question should be classified as "business income" or "income
from other sources."

Facts of the case:

1. Infosys Technologies Ltd., a public limited IT company based in Bangalore,

implemented an ESOP scheme through a Trust known as Technologies Employees
Welfare Trust.

2. The Trust issued 7,50,000 warrants at Re. 1/- each to eligible employees. Each
warrant entitled the holder to apply for and be allotted one equity share of face
value Rs. 10/- each, for a total consideration of Rs. 100/-.

3. The warrants were offered to eligible employees at Re. 1/- each based on their
performance, security, and other criteria. Each warrant had to be retained for a
minimum period of 1 year before the employee could elect to obtain shares
allotted to them by paying the balance of Rs. 99/-. The option could be exercised
anytime after 12 months but before the expiry of 5 years, subject to a lock-in
period.

4. During the lock-in period, the shares remained with the Trust, were non-
transferable, and had no realizable value. If an employee resigned or services
were terminated, the shares were re-transferred to the Trust at Rs. 100 per share.
5. The Assessing Officer (AO) treated the difference between the market value of
the shares and the price paid by employees upon exercising the option as a
perquisite value. Consequently, tax was imposed on this difference, and Infosys
was held liable for not deducting Tax Deducted at Source (TDS) under Section 192
of the Income Tax Act, 1961.

6. The matter was appealed to the Tribunal, which held that the right granted to
employees under the ESOP scheme was not a perquisite under Section 17(2)(iii) of
the Income Tax Act, 1961.

7. The Karnataka High Court upheld the Tribunal's decision, leading to the
Department's appeal to the Supreme Court.

8. The Supreme Court examined whether the benefit received by employees from
exercising stock options constituted a perquisite and whether TDS should have
been deducted by Infosys.

9. The Court observed that there was no provision in the Income Tax Act, 1961,
specifically taxing benefits from ESOPs during the relevant assessment years
(1997-98, 1998-99, and 1999-2000).

10. The Court held that unless a benefit is made taxable under the law, it cannot
be regarded as income. It emphasized that during the relevant assessment years,
the benefit was prospective and contingent upon several conditions, including the
lock-in period.

11. The Court ruled that the Assessing Officer erred in treating the difference
between market value and the price paid by employees as a perquisite value and
in holding Infosys liable for not deducting TDS under Section 192.

12. The Court dismissed the civil appeals with no order as to costs.

Law involved:

The key law involved in the case of Commissioner of Income Tax, Bangalore vs
Infosys Technologies Ltd is Section 17(2)(iii) of the Income Tax Act, 1961. This
section defines "perquisite" for the purposes of taxation under sections 15 and 16
of the Act.

Additionally, the case involves the interpretation of Section 192 of the Income Tax
Act, 1961, which pertains to the deduction of tax at source by an employer from
the income chargeable under the head "Salaries".

The court also considered the principles of taxation under the Income Tax Act,
particularly emphasizing that a benefit or receipt must be made taxable under the
law before it can be regarded as income. The court highlighted the importance of
legislative mandate in determining tax liability and the need for clarity in the law
regarding the taxation of benefits such as those received through Employees
Stock Option Schemes (ESOPs).

Furthermore, the judgment discussed the mechanism introduced under the

Finance Act, 1999, which provided clarification on the valuation of specified
securities for taxation purposes. The court examined whether this mechanism,
introduced through clause (iiia) of Section 17(2), operated retrospectively or only
prospectively from its enactment date.

Overall, the case involved the application and interpretation of relevant

provisions of the Income Tax Act, 1961, to determine the tax treatment of
benefits received by employees through an ESOP scheme implemented by Infosys
Technologies Ltd.

Arguments involved:

The Revenue contended that the value of the benefit accrued to the employees
upon exercising the stock options should be treated as a perquisite under Section
17(2)(iii) of the Income Tax Act, 1961. They argued that the difference between
the market value of the shares and the price paid by the employees for exercising
the option should be considered taxable perquisite value. The Revenue asserted
that tax should have been deducted at source (TDS) by the employer on this
perquisite value under Section 192 of the Act.
Infosys Technologies Ltd argued that the right granted to employees to
participate in the ESOP scheme did not constitute a perquisite under Section
17(2)(iii) of the Act. They contended that until the shares were actually acquired
by the employees after the lock-in period, there was no realizable value to the
shares, and therefore, no taxable perquisite had accrued. Infosys also argued that
the taxation mechanism introduced under the Finance Act, 1999, which clarified
the valuation of specified securities, was prospective and not retrospective.

Both parties presented arguments regarding the interpretation of relevant

provisions of the Income Tax Act, particularly Section 17(2)(iii) regarding the
definition of perquisite and Section 192 regarding the deduction of tax at source
by the employer. Infosys emphasized the absence of specific provisions in the Act
making the benefits received through ESOP taxable as income during the relevant
assessment years.

Infosys highlighted the importance of legislative intent in determining tax liability

and argued that unless a benefit is expressly made taxable under the law, it
cannot be regarded as income. They contended that the taxation of benefits
under the ESOP scheme should be based on clear legislative provisions rather
than retrospective interpretation or application of the law.

Both parties discussed the need for clarity in taxation laws, especially concerning
the treatment of benefits received through ESOPs. Infosys emphasized that until
the enactment of specific provisions in the Act, the taxation of ESOP benefits
remained uncertain, and therefore, they could not be held liable for TDS
deduction on speculative perquisite values.

Judgment:

The judgment in the case of Commissioner of Income Tax, Bangalore vs Infosys

Technologies Ltd, delivered by the Supreme Court, addressed the taxation of
benefits received by employees through Employee Stock Option Plans (ESOPs).

Infosys, a public IT company, established a Trust to implement an ESOP, allotting

warrants to eligible employees. These warrants allowed the holders to apply for
company shares at a nominal price, subject to certain conditions including a lock-
in period. The tax authorities contended that the difference between the market
value of the shares and the price paid by employees upon exercising their options
constituted a taxable perquisite, leading to Infosys being deemed a defaulter for
not deducting tax at source. However, Infosys argued that until the shares were
sold after the lock-in period, there was no realizable income to tax. The Court
delved into the Income Tax Act of 1961, highlighting the absence of a clear
provision for taxing ESOP benefits during the relevant assessment years.

It underscored the principle that unless explicitly stated in the law, a benefit
should not be deemed taxable income. The Court acknowledged that the ESOP
benefits were prospective and contingent on various factors, such as employees
remaining in service and the shares being non-transferable during the lock-in
period. It observed that until the shares were sold, there was no certainty of
income.

The Court also examined a provision inserted in the Income Tax Act in 2000,
clarifying the valuation of specified securities, including ESOPs. However, it noted
that this provision was not retrospective and only applied from its effective date,
emphasizing the need for clarity in taxation laws. Ultimately, the Court ruled in
favor of Infosys, stating that in the absence of clear legislative mandate, potential
benefits from ESOPs could not be considered taxable income.

It emphasized the importance of considering the lock-in period and the

speculative nature of the benefits. The judgment concluded that Infosys should
not be penalized for failing to deduct taxes on benefits that were not definitively
taxable under the prevailing tax laws. This landmark ruling underscored the
necessity for explicit tax provisions and provided clarity on the taxation of ESOP
benefits, offering significant guidance for future tax assessments involving similar
schemes.

Significance of the Judgment:

1. Clarification on Taxation of ESOP Benefits: The judgment provided clarity on the

taxation of benefits derived from Employee Stock Option Plans (ESOPs). It
emphasized that unless explicitly stated in tax laws , potential benefits from
ESOPs should not be considered taxable income.

2. Recognition of Prospective Nature of ESOPs: The Court acknowledged the

prospective and contingent nature of ESOP benefits, highlighting that until shares
were sold after the lock-in period, there was no certainty of income. This
recognition helped in understanding the speculative aspect of ESOPs.

3. Importance of Lock-in Period: The judgment underscored the significance of

considering the lock-in period associated with ESOPs. It highlighted that during
this period, shares were non-transferable, and employees had limited control
over their benefits, impacting their realizable value.

4. Interpretation of Taxation Laws: The ruling emphasized the principle that for a
benefit to be taxable, it must be explicitly included in tax laws. This interpretation
provided guidance for future tax assessments, ensuring that tax liability is
determined based on clear legislative mandates.

5. Evaluation of Legislative Amendments: The Court analyzed a provision inserted

in the Income Tax Act in 2000, clarifying the valuation of specified securities,
including ESOPs. It clarified that such amendments are not retrospective unless
expressly stated, highlighting the importance of legislative intent in tax matters.

6. Prevention of Arbitrary Taxation: By ruling in favor of Infosys, the judgment

prevented arbitrary taxation of ESOP benefits. It ensured that companies are not
penalized for failing to deduct taxes on benefits that were not definitively taxable
under prevailing tax laws, promoting fairness in tax assessments.

7. Guidance for Future Tax Assessments: The judgment provided significant

guidance for future tax assessments involving ESOPs and similar employee benefit
schemes. It set a precedent for evaluating the tax implications of contingent
benefits and emphasized the need for clear tax provisions to avoid ambiguity.

8. Encouragement for Employee Benefit Schemes: The ruling provided assurance

to companies regarding the tax treatment of ESOPs, potentially encouraging them
to implement such employee benefit schemes. It recognized the importance of
incentivizing employee ownership and participation in company growth.

9. Legal Certainty for Corporates: The judgment offered legal certainty to

corporates regarding the taxation of ESOP benefits, allowing them to plan and
structure employee compensation schemes with confidence, knowing the tax
implications involved.

10. Promotion of Equity Culture: By providing clarity on the taxation of ESOP

benefits, the judgment indirectly promoted an equity culture within
organizations, encouraging employee ownership and aligning their interests with
the company's long-term success.

Analysis of Judgment:

The judgment in Commissioner of Income Tax, Bangalore vs Infosys Technologies

Ltd is pivotal in clarifying the tax treatment of Employee Stock Option Plans
(ESOPs) under the Income Tax Act, 1961. One of the key takeaways from this
ruling is the emphasis on the need for explicit legislative provisions to determine
the taxability of ESOP benefits. The court highlighted that unless expressly stated
in the law, potential benefits from ESOPs should not be automatically considered
as taxable income. This aspect brings much-needed clarity to companies and
employees regarding the tax implications of participating in such schemes.

Moreover, the judgment sheds light on the prospective and contingent nature of
ESOP benefits. It underscores the importance of considering factors such as the
lock-in period when assessing the actual value of shares and the uncertainty
surrounding the realization of income for employees until the shares are
eventually sold. By recognizing the speculative nature of these benefits, the
judgment ensures a fair and balanced approach to taxation, preventing undue
penalization of companies for failure to deduct taxes on speculative income that
may or may not materialize.

Another significant aspect of the judgment is its analysis of legislative

amendments related to ESOP taxation. The court observed that the introduction
of Section 17(2)(iiia) by the Finance Act, 1999, provided clarity on how the cost of
acquiring specified securities should be calculated for tax purposes. However, it
made it clear that this clarification was not retrospective in nature and only
applied from the date of its enactment. This aspect of the judgment reinforces the
principle that tax laws should be applied prospectively unless explicitly stated
otherwise, ensuring legal certainty and fairness in tax assessments.

Overall, the judgment has far-reaching implications for both companies and
employees involved in ESOP schemes. It provides clarity on the tax treatment of
ESOP benefits, encourages employee participation in company ownership, and
prevents arbitrary taxation by requiring explicit legislative provisions to tax such
benefits. By fostering transparency, fairness, and legal certainty, the judgment
promotes a conducive environment for employee ownership and incentivizes
companies to implement ESOP schemes as a means of rewarding and retaining
talent.

Conclusion:

The judgment in Commissioner of Income Tax v. Infosys Technologies Ltd

represents a landmark decision in clarifying the tax treatment of Employee Stock
Option Plans (ESOPs) under the Income Tax Act, 1961. This case has far-reaching
implications for both companies and employees engaged in ESOP schemes,
providing clarity, fairness, and legal certainty in the taxation of ESOP benefits.

Firstly, the judgment underscores the need for explicit legislative provisions to
determine the taxability of ESOP benefits. It emphasizes that unless expressly
stated in the law, potential benefits from ESOPs should not automatically be
considered as taxable income. This aspect of the judgment brings much-needed
clarity to companies and employees, preventing uncertainty and ambiguity
regarding the tax implications of participating in such schemes.

Moreover, the judgment recognizes the prospective and contingent nature of

ESOP benefits, highlighting the importance of considering factors such as the lock-
in period when assessing the actual value of shares. By acknowledging the
speculative nature of these benefits, the judgment ensures a fair and balanced
approach to taxation, preventing undue penalization of companies for failure to
deduct taxes on speculative income that may or may not materialize.

Furthermore, the analysis of legislative amendments related to ESOP taxation is

crucial in understanding the evolution of tax laws in this area. The court's
observation regarding the introduction of Section 17(2)(iiia) by the Finance Act,
1999, provides clarity on how the cost of acquiring specified securities should be
calculated for tax purposes. However, the court clarifies that this clarification is
not retrospective in nature and only applies from the date of its enactment. This
aspect of the judgment reinforces the principle that tax laws should be applied
prospectively unless explicitly stated otherwise, ensuring legal certainty and
fairness in tax assessments.

In conclusion, the judgment in Commissioner of Income Tax, Bangalore vs Infosys

Technologies Ltd is significant for its role in providing clarity, fairness, and legal
certainty in the taxation of ESOP benefits. By emphasizing the need for explicit
legislative provisions, recognizing the prospective and contingent nature of ESOP
benefits, and analyzing legislative amendments related to ESOP taxation, the
judgment establishes a framework that promotes transparency and fairness in tax
assessments. Ultimately, the judgment encourages employee participation in
company ownership, incentivizes companies to implement ESOP schemes, and
fosters a conducive environment for talent retention and growth.