ESOP – Allowability as an expense in Income-tax Act, 1961
Recently, the Employee Stock Options Plan (ESOP) has been introduced in many corporates as a reward scheme for an employee. ESOPs are used to create a sense of ownership in the company with an intent to retain highly productive and skillful employees. Such plans are options provided to employees to purchase shares of the company at a price lower than the Fair Market Value (FMV) of such shares. The price at which an employee exercises such options is known as the exercise price. The difference between the FMV and the exercise price of such shares is a cost for the employer that is amortized in the books of accounts as per the accounting standards and guidance notes.
Important terms related to ESOP
Grant Date– The date of the agreement between the employer and employee wherein the employer agrees to give the option to own shares to an employee.
Vesting of options- Vest means becoming an entitlement. Under an ESOP, the employee’s right to receive shares vests when the employee fulfills all the vesting conditions. The vesting period is when the conditions are to be satisfied by the employee.
Exercise period- The period after vesting within which the employee should exercise his right to apply for the shares.
Taxation of ESOPs
In the hands of employees: ESOPs are taxed under the head salaries as a perquisite under Section 17(2)(vi) of the Income-tax Act, 1961 (the Act). The taxable amount is the difference between the FMV of the share on the exercise date and the exercise price.
For the employers
Accounting of ESOP costs – ICAI Guidance Note
The ICAI Guidance Note on Accounting for share-based payments(2020) establishes the financial accounting and reporting principles for share-based payments. As per the Guidance Note, the services rendered by an employee during the vesting period are treated as a consideration for the ESOPs and it requires companies to account for the services on a time proportion basis with a credit to equity account.
Litigative issue as per income tax provisions
There has been prolonged litigation regarding the allowability of such costs of services booked on a time proportion basis while computing the “Profits and gains from Business and Profession” of the employer. The Revenue Authorities are of the view that no expenditure has been incurred by the company at the time of grant/during the vesting period of shares under the ESOP scheme, and the expenditure has not crystallized or ascertained till the date on which the employee exercises the option. Hence, it has been the position of the Revenue Authorities that any cost debited to the profit and loss account during the vesting period remains contingent in nature and, hence, cannot be allowed as a deduction.
Another contention of the Revenue Authorities is that the expenditure is capital in nature, as the ultimate objective is related to the issuance of shares, which is not a business activity.
In response to the same, the assessee has contended that the liability is crystallized during the vesting period on the performance of the services by the employee, and it is only the quantification that remains pending.
Also, it is explained that the primary objective of ESOP is not to issue shares; rather, it is to award the employees to boost their productivity, leading to higher profits. Thus, this should be treated as Revenue Expenditure.
The matters have reached high courts across the country, and most of them have, so far, accepted the assessee’s contentions and ruled in favor of the companies. Some of the recent judicial precedents in this regard are discussed below:
Karnataka High Court in the case of CIT v. Biocon Ltd.1
In this case, the ESOPs were granted to employees of the Company at a minimal exercise price. The ESOPs were vested in employees over a period of four years. The employer had claimed a deduction of the discount (Fair value of the shares less exercise price) on ESOPs over the vesting period. The accounting treatment of booking the cost on a time-proportionate basis was in accordance with SEBI Guidelines and the ICAI guidance note. The Karnataka High Court (HC) ruled in the assessee’s favor and held that on the exercise of option, only the quantification of the liability will be finalized. This amount cannot be said to be contingent in nature and shall be treated as ascertained liability. The HC has also held that, as the primary objective was not to raise capital but to earn high profits by securing good employees, it cannot be held as capital in nature. Thus, it shall be allowable as a revenue expenditure under Section 37(1).
It is also pertinent to note that in the case of CIT v PVP Ventures Ltd. (2012)2, the Madras HC held similar facts that the taxpayer had followed the SEBI directions with respect to ESOPs and claimed such costs as a deduction.
The costs booked have been allowed as a deduction, holding them to be an ascertained liability.
Another recent judgment of the Delhi HC in the case of PCIT v New Delhi Television Ltd.3, in which the Court has placed reliance on the judgment of the Supreme Court (SC) in the case of Hon'ble SC in Bharat Earth Movers [2000]4. The Hon’ble SC has held that if a business liability has arisen in an accounting year, then the deduction should be allowed in that year itself, notwithstanding the fact that such liability is incapable of proper quantification at that stage and is dischargeable at a future date. The HC considered that in the given case, liability cannot be disallowed merely because the quantification cannot be done.
Cross charges paid to foreign holding companies
Another practical situation that can be seen is the payment of a cross charge by the Indian company to its foreign Holding Company for the cost of foreign companies’ shares issued as ESOPs to the employees of the Indian company. The employees of the Indian subsidiary are issued ESOPs, allowing them to purchase the shares of the Holding Company. In such cases, the Holding Company recovers the difference between the FMV of the shares and the exercise price from the Indian subsidiary. The Indian companies claim such an amount as an expense, which has again been litigated by the Revenue Authorities.
In the case of Hewlett Packard (India) Software Operation Pvt Ltd vs DCIT (ITAT Banglore)5, the Income Tax Appellate Tribunal (ITAT) has allowed the expenditure under Section 37(1), considering it wholly and exclusively for business. It was held that the amount of cross charges paid is the actual expenditure incurred for the employees and not notional and, thus, allowable.
Current position - ESOP controversy reaches sc
The issue of deductibility of ESOP costs has now reached the SC, which has allowed Revenue’s Special Leave Petition (SLP) against Delhi HC ruling in NDTV (supra) and Karnataka HC Ruling in Biocon (supra). Two grounds to be taken in the final hearing will be:
- ESOP costs are a contingent liability, not crystallized, hence, deduction under Section 37(1) should not be allowed.
- ESOPs are an expense on ‘capital,’ and hence, the deduction should not be granted.
It will be interesting to see what the Hon’ble SC decides in this matter and whether its recent decision in the case of Bharti Hexacom6 regarding capital vs. revenue expenditure turns the balance in favor of Revenue.
1. [2020] 121 taxmann.com 351 (Karnataka)
2. [2012] 23 taxmann.com 286 (Madras)
3. [2018] 99 taxmann.com 401 (Delhi)
4. 245 ITR 428
5. [2023] 149 taxmann.com 280 (Bangalore - Trib.)[03-10-2022]
6. [2023] 155 taxmann.com 322 (SC)