Prologue

The shares allotted by the employer under Employee Stock Option Plan (ESOP) are taxable in the hands of the employees as perquisite u/s 17(2)(vi) of the Income-tax Act, 1961 (‘the Act’) under the head salary. Regarding ESOP, the bone of contention between the employer Assessee and the tax department is on the tax deductibility of ESOP expense in the hands of employer Assessee. The employer Assessee claims it as tax deductible business expense stating that it should be allowable to the employer as salary expense. This Article discusses this issue through provisions of the Act and judicial precedents.

1. Arguments which could be placed in favour of Assessee

  • ESOP expense is deductible u/s 37 of the Act

To check satisfaction of the provisions of section 37(1), section 37(1) is reproduced below:

“Any expenditure not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”

ESOP text with business woman using a tablet

From perusal of provisions of section 37(1), it is noticeable that the following four conditions need to be satisfied for any expense to be deductible u/s 37(1) of the Act:

1. Expenditure should not be of the nature described in sections 30 to 36;

2. Expenditure should not be in the nature of capital expenditure;

3. Expenditure should not be in the nature of personal expenses of the assessee;

4. Expenditure should be laid out or expended wholly and exclusively for the purposes of the business or profession.

A satisfaction of aforesaid conditions vis-a-vis “ESOP expense” is tabulated below:

S. No. Conditions prescribed u/s 37(1) of the Act Satisfaction of prescribed conditions vis-a-vis “ESOP expense”
1 Expenditure should not be of the nature described in sections 30 to 36 ESOP expense is not of the nature described in sections 30 to 36
2 Expenditure should not be in the nature of capital expenditure ESOP expense is not in the nature of capital expenditure as it is only a payment of salary in kind rather than in money (cash/bank). Even Bangalore Special Bench in the case of Biocon (infra) inter-alia held that by no stretch of imagination, we can describe it as either a short capital receipt or a capital expenditure.
3 Expenditure should not be in the nature of personal expenses of the assessee ESOP expense is not personal expense of the employer Assessee as it is incurred only for business purpose.
4 Expenditure should be laid out or expended wholly and exclusively for the purposes of the business or profession As the ESOP expense is incurred as an alternative to make direct money payment to the employees for the services rendered by them as employees, therefore it is nothing but salary in kind and thus incurred wholly and exclusively for the purposes of the business of the Assessee.

ESOP is one of the modes of compensating the employees for their services with the intention to retain the dedicated employees to generate more revenues for the entity and thus it qualifies for deduction u/s 37(1) of the Act. The Assessee had an obligation to issue shares at discounted rate on future dates, even if it was not paying anything to its employees. The ESOP granted by the Assessee to its employees was for the purpose of development of its business for earning higher profits.

  • One of the modes of compensating employees

The Assessee could argue that the ESOP scheme was introduced to grant equity based incentives to its employees as one of the modes of compensating employees for their services and thus forms part of employees/salary cost. It could be further submitted that the primary rationale of the Assessee in issuing such options is to earn profits by securing consistent and concentrated efforts of its dedicated employees and to compensate them for the continuity of their services with the Assessee.

  • Double Edge Sword – Both Employer and Employee are taxed

The ESOPs allotted by the employer would also be taxable in the hands of the employees as perquisite u/s 17(2)(vi) under the head salary and even for this reason it should be allowable to the employer as its salary expense. In case deduction of ESOP expense is not allowed to the employer then the same would amount to economic double taxation, firstly in the hands of the employer by way of disallowance and secondly in the hands of the employee under the head salary by way of specific provision u/s 17(2)(vi) of the Act.

  • Not a contingent liability

ESOP expense is in the form of a discount offered on share issue price. For example, if shares are offered at offer price of Rs.100 and exercise price is Rs.30 then Rs.70 will be the discount/expense of the employer. If any ESOPs remain unvested or are not exercised, the expense/discount claimed as deduction is required to be reversed and need to be offered for taxation. Therefore, said expense/discount cannot be held as a contingent liability.

2. Judicial precedents on deductibility of ESOP expense

The issue of deductibility of ESOP expense issue is covered in favour of the Assessee by following judicial precedents of various High court / Tribunals (including Special Bench):

“1. ………………………… since the ITAT followed the previous judgments in CIT v. PVP Ventures Ltd. [2012] 23 taxmann.com 286/211 Taxman 554 (Mad.) the expenditure had to be allowed. ………………………

2. Although the Revenue urges that in terms of Circular No. 9 of 2007, the expenditure ought not to be allowed given that actual expenditure towards acquisition of shares, and not mere allotment of shares by the employer can be considered as a permissible deduction, this Court is of the opinion that such an argument is untenable; that was the rationale of disallowance in this case. What the Revenue urges essentially is that the unless the employer/assessee acquires the shares from a third party, it cannot claim any deduction and that expenditure claimed for allotment or issue of ESOP is merely notional. This Court is of the opinion that such an argument ignores the realities of functioning of commercial entities who would then be asked to purchase shares from market place or third party at prevailing rates instead of allotting them.

3. For above reasons, no question of law arises.”

“11. ………….. On the issue of expenditure of Rs. 66.82 lakhs towards the issue of shares to the employees stock option is concerned, the Tribunal pointed out that the shares were issued to the employees only for the interest of the business of the assessee to induce employees to work in the best interest of the assessee. The allotment of shares was done by the assessee in strict compliance with SEBI regulations, which mandate that the difference between the market prices and the price at which the option is exercised by the employees is to be debited to the profit and loss . . . the Tribunal in its order stated that it was a benefit conferred on the employee. So far as the company is concerned, once the option was given and exercised by the employee, the liability in this behalf got ascertained. This was recognised by the SEBI and the entire employees stock option plan was governed by the guidelines issued by the SEBI. On the facts thus found, the Tribunal held that it was not a case of contingent liability depending on the various factors on which the assessee had no control. The expenditure in this behalf was an ascertained liability, thus the expenditure incurred being on lines of the SEBI Guidelines, there could be no interference in the relief granted by the assessing authority for the expenditure arising on account of the employees’ stock option plan. This expenditure incurred as per the SEBI Guidelines and granted by the Officer could not be considered as erroneous one calling for the exercise of jurisdiction under section 263 of the Act.”

  • Bangalore Special Bench – M/s Biocon Ltd. v. DCIT [2013] 35 taxmann.com 335 (Bangalore – Trib.) (SB)

“9.2.6 It is quite basic that the object of issuing shares can never be lost sight of. Having seen the rationale and modus operandi of the ESOP, it becomes out-and-out clear that when a company undertakes to issue shares to its employees at a discounted premium on a future date, the primary object of this exercise is not to raise share capital but to earn profit by securing the consistent and concentrated efforts of its dedicated employees during the vesting period. Such discount is construed, both by the employees and company, as nothing but a part of package of remuneration. In other words, such discounted premium on shares is a substitute to giving direct incentive in cash for availing the services of the employees. There is no difference in two situations viz., one, when the company issues shares to public at market price and a part of the premium is given to the employees in lieu of their services and two, when the shares are directly issued to employees at a reduced rate. In both the situations, the employees stand compensated for their effort. ………………………. The sole object of issuing shares to employees at a discounted premium is to compensate them for the continuity of their services to the company. By no stretch of imagination, we can describe such discount as either a short capital receipt or a capital expenditure. It is nothing but the employees cost incurred by the company. The substance of this transaction is disbursing compensation to the employees for their services, for which the form of issuing shares at a discounted premium is adopted.

9.2.7. …………………………………………………………… it is pertinent to note that this section does not restrict paying out of expenditure in cash alone. Section 43 contains the definition of certain terms relevant to income from profits of business or profession covering sections 28 to 41. Section 37 obviously falls under Chapter IV-D. Sub-section (2) of section 43 defines “paid” to mean: “actually paid or incurred according to the method of accounting upon the basis of which the profits or gains are computed under the head ‘profits and gains of business or profession’.” When we read the definition of the word “paid” u/s 43(2) in juxtaposition to section 37(1), the position which emerges is that it is not only paying of expenditure but also incurring of the expenditure which entails deduction u/s 37(1) subject to the fulfilment of other conditions. …………………………………………………………………………… by undertaking to issue shares at discounted premium, the company does not pay anything to its employees but incurs obligation of issuing shares at a discounted price on a future date in lieu of their services, which is nothing but an expenditure u/s 37(1) of the Act.

9.3.6 ……………………if some of the options remain unvested or are not exercised, the discount hitherto claimed as deduction is required to be reversed and offered for taxation in such later year. We, therefore, hold that the discount in relation to options vesting during the year cannot be held as a contingent liability.

10.8 Reverting to the questions of ‘when’ and ‘how much’ of deduction for discount on options is to be granted, we hold that the liability to pay the discounted premium is incurred during the vesting period and the amount of such deduction is to be found out as per the terms of the ESOP scheme by considering the period and percentage of vesting during such period. We, therefore, agree with the conclusion drawn by the tribunal in S.S.I. Ltd.’s case (supra) allowing deduction of the discounted premium during the years of vesting on a straight line basis, which coincides with our above reasoning.

12.2 It would be imperative to highlight certain points having bearing on the issue which have come to our notice during the course of hearing. The AO is directed to look, inter alia, into these aspects in quantifying the amount of eligible deduction.

a. The assessee-company was a closely held company in the previous year relevant to the assessment year 2003-2004 and as such there was no question of the listing of its shares and having some market price at the time of grant of options. Ordinarily, the amount of discount on premium which is written off over the vesting period represents the market price of the shares listed on the stock exchange on the date of grant of option as reduced by the price at which option is given to the employees. However, presently there is no availability of any market price of such shares on the date of grant of option as the company came to be listed on a stock exchange in a subsequent year. On a pointed query, the ld. AR furnished the details of such claim by showing that it granted 71,510 options with discount of Rs. 909 per option making total discount at Rs. 6.50 crore. He stated that the face value of shares is at Rs. 10 against which the deduction for discounted premium over the vesting period has been claimed at Rs. 909, meaning thereby that the market price of the share on the date of grant of option was taken at Rs. 919. No material worth the name has been placed on record to indicate as to how a share with face value of Rs. 10 has been valued at Rs. 919 for claiming deduction towards discount at Rs. 909 per share. This aspect of valuation of shares at Rs. 919 per share needs to be examined by the Assessing Officer.

b. We have held above that the deduction of the discounted premium is to be claimed over the vesting period.…………………………………………… The way in which the assessee has claimed deduction runs contrary even to the SEBI Guidelines, which also provide for deduction on straight line basis. The manner of the assessee’s claiming deduction has resulted in needlessly increasing the amount of deduction for the first year at the cost of deduction for the subsequent three years. It needs to be set right by apportioning the total amount of the discounted premium evenly over the vesting period of four years.”

To summarize, Special Bench held that discount on the issue of ESOPs cannot be inter-alia treated as capital expenditure and held that being part of package of remuneration to employees, the obligation incurred for issuing shares to employees at a discounted price at a future date in lieu of their services, is an allowable deduction under section 37(1) of the Act. The Hon’ble Tribunal further held that incurring liabilities towards the discounted premium, which is compensation to employees, is directly linked with the span of services put in by each employee and liability to issue stock options at discount is incurred during the vesting period and the amount of deduction is to be calculated as per the terms of the ESOP scheme, hence the discount was deductible over the vesting period. Further the Special Bench pointed out that the liability for discounts which arose or were incurred during the vesting period required adjustment due to the fact that the actual discount could only be determined at market price when the employees exercise their options. The assessee should make a suitable downward or upward adjustment at that time.

  • SSI Limited v. Deputy Commissioner of Tax [(2004) 85 TTJ 1049]

Tribunal held that the amount written off by the company as prescribed under the SEBI guidelines in its books of accounts in granting its own shares to its employees was an allowable expenditure. The said expenditure was incurred to retain the employees to generate revenue for the companies. The Hon’ble Tribunal held that there can be no denial of the fact that in respect of ESOP, SEBI had issued guidelines and assessee-company had followed these guidelines to the core and the claim of expenditure was in accordance with the guidelines of SEBI and therefore the order of the assessment granting the said claim was not prejudicial and same is to be allowed.

  • Delhi ITAT – M/s Educomp Solutions Limited vs. Addl. CIT (ITA No. 833/Del/2012) followed the order of special bench ruling in case of Biocon (supra).

3. Favourable ruling of Special Bench and High Courts should be followed

A special bench is constituted to give its view when there are divergent views of different tribunals on a specific issue and judicial discipline mandates that the decision of the special bench has to be followed by other benches. The decision of the special bench of the Tribunal must be held to be a binding precedent for division benches otherwise the very purpose of constituting them will get frustrated. In other words, the decision of special bench supersedes the ruling of other tribunal benches unless reversed by High Court. Moreover, underlying issue has already been decided in favour of the taxpayers by Hon’ble Madras and Delhi High Court.

Reliance in this regard could be placed on the ruling of ACIT vs. Amit Naresh Sinha (ITAT Mumbai), ITA No.4154/Mum/2013 (dated 10-09-2014) wherein it was held that –

“From the clarification issued by the Hon’ble High Court, it is clear that until and unless the decision of Marilyn Shipping & Transport (supra) is reversed by the Court, it is binding on all the benches of the Tribunal. We find that Hon’ble Court has held that judicial discipline mandates that the decision of the special bench has to be followed by other benches. As on today, the stay order granted by the Hon’ble Court has been vacated and the order of the special bench is binding on other benches of the Tribunal. Therefore, respectfully following the same, we hold that the FAA was justified in following the order of Marilyn Shipping &Transport (supra). Considering the facts of the case and the clarification issued by the Hon’ble Andhra Pradesh High Court on 24.06.2014 in the case of Janapriya Engineers Syndicate, we decide the effective ground of appeal in favour of the assessee and confirm the order of the FAA.”

4. Foreign parent company issued Global ESOPs Programme

Foreign parent company issued Global ESOPs Programme. Indian subsidiary paid difference of issue price and exercise price to parent company. Tribunal allowed expense u/s 37(1).

Assessee was a wholly owned subsidiary (‘WOS’) of a Denmark entity (‘the parent company’) and was primarily engaged in the marketing and distribution of healthcare products. The parent company issued ESOPs under the name and style of ‘NNAS Global Share Programme 2005’. Its employees were entitled to purchase said shares at a price less than the market price.

As per the ESOP programme, the difference between FMV of shares of parent company on date of issue of shares (e.g. Rs.100) and price at which those shares were issued by the assessee (WOS) to its employees (e.g. Rs.20) was required to be reimbursed (Rs.100 – Rs.20 = Rs.80) by the assessee to its parent company.

The sum so reimbursed (Rs.80) was claimed as an expenditure or employee cost in its books of account. AO rejected the claim of the assessee for deduction of the aforesaid expense on ground that it resulted in the capital building of the parent company.

The Hon’ble Tribunal by relying on (i) Sassoon J. David & Co. (P.) Ltd. v. CIT [1979] 118 ITR 261/1 Taxman 485 (SC) and (ii) Mysore Kirloskar Ltd. v. CIT [1987] 166 ITR 836/30 Taxman 467 (Kar.) held that the expenditure in question was wholly and exclusively used for the purpose of the business of the assessee and motivated its workforce and allowed the deduction u/s 37(1) of the Act.

Novo Nordisk India (P.) Ltd. v. Dy. CIT [2014] 42 taxmann.com 168/63 SOT 242 (Bang.Trib.)

Epilogue

In view of various arguments and favourable judicial precedents cited above, a strong case could be made out by the Assessee employer in its favour to claim deduction of ESOP expense. However, the Assessee should be careful in calculating the deduction of ESOP expense in every year and should keep in mind the guidance provided by appellate authorities in this regard. Further, as the Hon’ble SC has already granted department’s SLP in the case of Lemon Tree (supra), ruling of SC would clear the final clouds on this issue.

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