India: Discount On Employee Stock Option Plan (ESOP) Allowable As Deduction In Computing The Income Under The Head Profits And Gains Of Business

"Employees stock option" means the option given to the whole-time directors, officers or employees of a company, which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a pre-determined price1. In Employee Stock Option Plan (ESOP) employer offers its employees and/or Officers and/or Directors the option to purchase Stocks of the Company on a discounted rate. There is no specific provision in the Income Tax Act, 1961 which provides deduction on the discount given to the employees in ESOP. In order to decide the question that, whether discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head profits and gains of business?, a special bench was constituted at Banglore by the Hon'ble President of the Income Tax Appellate Tribunal(ITAT) on a reference by Division Bench in the case of M/s.Biocon Limited vs The Dy. Commissioner of Income-tax (LTU), Bangalore [ ITA No.368/B/2010 & Ors.(SB), decision pronounced on 18th July, 2013].

The Facts of the case were as follows:

  • M/s. Biocon Limited is engaged in the manufacture of Enzymes and Pharmaceutical ingredients. It formulated ESOP 2000 and a trust was set up under the name and style of "Biocon India Limited Employees Welfare Trust" for giving effect to the ESOP
  • For the assessment year 2003-2004 M/s Biocon Limited floated ESOP 2000 under which it granted option of shares with face value of INR10 at the same rate by claiming that the market price of such shares was INR 919, thereby claiming the total discount per option at INR 909.
  • The difference between the alleged market price and the exercise price, at INR 909 per option totaling INR 6.52 crore was claimed as compensation to the employees to be spread over the vesting period of four years.
  • A deduction of INR 3.38 crore was claimed for the assessment year 2003-2004 on the strength of the SEBI Guidelines.
  • M/s Biocon Limited claimed that the employee stock option compensation expense of INR 3.38 crore was deductible u/s 37(1) of the Act as all the requisite conditions were satisfied.
  • The Assessing Officer (AO) disallowed the said claim on the ground that there was no specific provision entitling the assessee to deduction u/s 37(1) in this regard.
  • The learned CIT(A), vide the impugned order dated 13th November, 2009, upheld the disallowance of ESOP expenditure of INR 3.38 crore, which became the subject matter of the question before the special bench.

The Special Bench, observed that the question before it can be answered in the following three steps, viz.,

  1. Whether any deduction of such discount is allowable?
  2. If yes, then when and how much?
  3. Subsequent adjustment to discount

I. WHETHER ANY DEDUCTION OF SUCH DISCOUNT IS ALLOWABLE?

The revenue contended that the discount under ESOP firstly is not an expenditure in itself, secondly, it is a short capital receipt or at the most a sort of capital expenditures and thirdly it is also a contingent liability.

On the question that whether discount under ESOP is expenditure the bench made the following observations?

  • When section 43(2) of the Act is read in conjunction with section 37(1), the meaning of the term `expenditure' turns out to be the same as is there in the aforequoted part of the definition under section 2(h) of the Expenditure Act, 1957, viz., not only `paying out' but also `incurring'. Coming back to our context, it is seen that 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.

On the question that whether discount under ESOP a short capital receipt the bench made the following observations?

  • During the vesting period that the options granted to the employees vest with them. This period commences with the grant of option and terminates when the options so granted vest in the employees after serving the company for the agreed period. By granting the options, the company gets a sort of assurance from its employee for rendering uninterrupted services during the vesting period and as a quid pro quo it undertakes to compensate the employees with a certain amount given in the shape of discounted premium on the issue of shares.
  • 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. ........It follows that the discount on premium under ESOP is simply one of the modes of compensating the employees for their services and is a part of their remuneration.......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.

On the question that whether discount under ESOP is a Contingent liability the bench made the following observations?

  • A liability definitely incurred by an assessee is deductible notwithstanding the fact that its quantification may take place in a later year. The mere fact that the quantification is not precisely possible at the time of incurring the liability would not make an ascertained liability a contingent.
  • The factum of the employees becoming entitled to exercise options at the end of the vesting period and it is only then that the actual amount of discount would be determined, is akin to the quantification of the precise liability taking place at a future date, thereby not disturbing the otherwise liability which stood incurred at the end of the each year on availing the services.
  • Normally it is provided in the schemes of ESOP that the vested options that lapse due to non-exercise and/ or unvested options that get cancelled due to resignation of the employees or otherwise, would be available for grant at a future date or would be available for being re-granted at a future date. If we consider it at micro level qua each individual employee, it may sound contingent, but if view it at macro level qua the group of employees as a whole, it loses the tag of `contingent' because such lapsing options are up for grabs to the other eligible employees. In any case, 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.

II. As ESOP is a deductibl e expenditure u/s 37(1), the next question is that `when' and for `how much' amount should the deduction be granted?

  • The deduction for an expense is allowable on incurring of liability and the same cannot be disturbed simply because of some difficulty in the proper quantification. A line of distinction needs to be drawn between a situation in which a liability is not incurred and a situation in which the liability is incurred but its quantification is not possible at the material time. Whereas in the first case, there cannot be any question of allowing deduction, in the second case, deduction has to be allowed for a sum determined on some rational basis representing the amount of liability incurred.
  • An employee becomes entitled to the shares at a discounted premium over the vesting period depending upon the length of service provided by him to the company. In all such schemes, it is at the end of the vesting period that option is exercisable albeit the proportionate right to option is acquired by rendering service at the end of each year.
  • A company under the mercantile system can lawfully claim deduction for total discounted premium representing the employees cost over the vesting period at the rate at which there is vesting of options in the employees.
  • Though the company becomes liable to issue shares at the time of the exercise of option, but it is in lieu of the employees compensation liability which it incurred over the vesting period by obtaining their services. From the above it is apparent that the company incurs liability to issue shares at the discounted premium only during the vesting period. The liability is neither incurred at the stage of the grant of options nor when such options are exercised.
  • 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 SSI Ltd.'s case allowing deduction of the discounted premium during the years of vesting on a straight line basis, which coincides with our above reasoning.

III. Whether any subsequent adjustment is warranted at the time of exercise of options, to the deducti ons earlier allowed for the amount of discount?

The Bench bifurcated, the question in two situations.

i. The options remain unvested or lapse at the end of the exercise period.

  • With regards to the first situation the Bench observed that the amount of discount claimed as deduction earlier in respect of unvested/lapsing options, has to be taxed as income on the happening of such events.

ii. The options are exercised by the employees after putting in service during the vesting period.

With regards to the second situation the Bench observed that

  • ESOP discount, which is nothing but the reward for services, is a taxable perquisite to the employee at the time of exercise of option, and its valuation is to be done by considering the fair market value of the shares on the date on which the option is exercised.
  • Since the remuneration to the employees under the ESOP is the amount of discount w.r.t. the market price of shares at the time of exercise of option, the employees cost in the hands of the company should also be w.r.t. the same base.
  • Since actual amount of employees cost can be precisely determined only at the time of the exercise of option by the employees, the provisional amount of discount availed as deduction during the vesting period needs to be adjusted in the light of the actual discount on the basis of the market price of the shares at the time of exercise of options. It can be done by making suitable northwards or southwards adjustment at the time of exercise of option.

On the aspect Taxation vis-à-vis Accountancy principles the Bench made the following observations

  • It has been noticed that broadly there are three stages having effect on the total income of the company in the life cycle of ESOP, viz., i) during the vesting period, ii) at the time of unvesting/lapse of options and iii) finally at the time of exercise of options.
  • What is true for accounting purpose need not necessarily be true for taxation.
  • Taxation principles are enshrined in the legislature. Power to legislate lies with the Parliament. Accounting standards or Guidance Note or Guidelines etc., by whatever name called, issued by any autonomous or even statutory bodies including the Institute of Chartered Accountants of India, or for that matter, the SEBI are meant only to prescribe the way in which the transactions should be recorded in books or reflected in the annual accounts. These guidelines do not have the force of an Act of Parliament. Since the subject matter of tax on income falls in the Union List as per Part XI of the Indian Constitution, it is only the Parliament which can legislate on its scope.
  • Under the head `Profits and gains of business or profession', there are sections granting deductions in respect of specific expenses or allowances. Similarly, there is section 37(1), which grants deduction for expenses not specifically set out in other sections, if the conditions stipulated in the section, are fulfilled. All other items of expenses, which fulfill the requisite conditions, gain deductibility under section 37(1). To put it in simple words, this section is a specific provision for granting deduction in respect of the unspecified or the general categories of expenses. Discount on ESOP is a general expense and hence covered by the specific provision of section 37.
  • Accounting principles have absolutely no role to play in the matter of determination of total income under the Act.............. The essence of the matter is that taxation principles are to be followed. If an accounting principle is in conformity with the mandate of taxing principle and reference is made to such accounting principle while deciding the issue, it does not mean that the accounting principle has been followed. It simply means that the taxation principle has been followed and the accounting principle, which is in line with such taxation principle, has been simply taken note of.
  • That the discount under ESOP is in the nature of employees cost and is hence deductible during the vesting period w.r.t. the market price of shares at the time of grant of options to the employees. The amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvesting/lapsing options at the appropriate time. However, an adjustment to the income is called for at the time of exercise of option by the amount of difference in the amount of discount calculated with reference the market price at the time of grant of option and the market price at the time of exercise of option. No accounting principle can be determinative in the matter of computation of total income under the Act. The question before the special bench is thus answered in affirmative by holding that discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head `Profits and gains of business or profession'.

Conclusion

The Special Bench of ITAT has held that the discount on issue of ESOP will be allowable as deduction in computing the income under the head `Profits and gains of business or profession' as it forms a part of the remuneration given to the employees. The Bench also held that the deduction at the time of grant of options has to be made on the market value of the shares as the exact amount of discount which will be available as deduction can only be ascertained at the time of exercise of options, the difference arrived on discount should be suitably adjustment. Till the time the decision of Special bench is challenged by the Revenue Department or a contradictory judgment is passed by higher judicial forum, the issue on discount on issue of ESOP whether allowable as business expenditure is settled for once.

Footnote

1. Section 2(15A) of the Companies Act, 1956

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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