ESOP discount (difference between market price and issue price) is a deductible expenditure at the time of vesting of the option. An adjustment has to be made if the market price is different at the time of exercise of the option
The assessee framed an
Employee Stock Option Plan (ESOP) pursuant to which it granted options to its
employees to subscribe for shares at the face value of Rs. 10. As the market
price of each share was Rs. 919, the assessee claimed that it had given a
discount of Rs. 909 which was allowable as a deduction as 'employee
compensation. Though the options vested equally over four years, the assessee
claimed a larger amount in the first year than was available under the SEBI
guidelines. The AO & CIT(A) rejected the claim on the ground that there was
no "expenditure". On appeal to the Tribunal, the issue was referred
to the Special Bench. HELD by the Special Bench:
(i) The difference (discount)
between the market price of the shares and their issue price is
"expenditure" in the hands of the assessee because it is a substitute
to giving direct incentive in cash for availing the services of the employees.
There is no difference between a case where the company issues shares to the
public at market price and pays a part of the premium to the employees for
their services and another where the shares are directly issued to employees at
a reduced rate. In both situations, the employees stand compensated for their
effort. By undertaking to issue shares at a discount, the company does not pay
anything to its employees but incurs the obligation of issuing shares at a
discounted price at a future date. This is nothing but "expenditure"
u/s 37(1);
(ii) The liability cannot
be regarded as being "contingent" in nature because the rendering of
service for one year is sine qua
non for becoming eligible to avail the benefit under the scheme.
Once the service is rendered for one year, it becomes obligatory on the part of
the company to honor its commitment of allowing the vesting of 25% of the
option. The liability is incurred at the end of the first year though it is
discharged at the end of the fourth year when the options are exercised by the
employees. The fact that some options may lapse due to non-exercise/
resignation etc does not make the entire liability contingent;
(iii) However, the
obligation to issue shares at a discounted premium does not arise at the stage
the options are granted. It arises at the stage that the options are vested in
the employees. The amount deductible has to be determined based on the period
and percentage of vesting under the ESOP scheme;
(iv) There is likely to
be a difference in the quantum of discount at the stage of vesting of the stock
options (when the deduction is allowable) and at the stage of exercise of the
options. The difference has to be adjusted by making suitable northwards or
southwards adjustment at the time of exercise of the option depending on the
market price of the shares then prevailing. The fact that the SEBI Guidelines
do not provide for the adjustment of discount at the time of exercise of
options is irrelevant because accounting principles cannot affect the position
under the Income-tax Act.
(v) On facts, the
assessee's method of claiming a larger deduction in the first year defies
logic. As the options vest equally over a period of four years, the deduction
ought to be claimed in four equal installments on a straight line basis (Ranbaxy Laboratories 124 TTJ 771 (Delhi) reversed, S.S.I. Ltd. v. DCIT
85 TTJ 1049 (Chennai) approved, PVP Ventures 211
Taxman 554 referred. See also Spray Engineering Devices Ltd
53 SOT 70 (Chd)
Facts
• Assessee-company formulated ESOPs and set up
Employees Welfare Trust for that purpose.
• During the assessment year 2003-2004, the
assessee-company floated ESOP 2000 under which it granted option of shares with
face value of Rs.10 at the same rate by claiming that the market price of such
shares was Rs.919, thereby claiming the total discount per option at Rs. 909.
• During the previous year relevant to the
assessment year 2003- 04, the appellant company granted 71,510 options to its
employees.
• The difference between the alleged market
price and the exercise price, at Rs.909 per option totaling Rs.6.52 crore was
claimed as compensation to the employees to be spread over the vesting period
of four years.
• A deduction of Rs3.38 crore was claimed for
the assessment year 2003-2004 on the strength of the SEBI Guidelines.
• Assessee claimed discount under ESOP as
employee compensation cost under section 37(1) of the Act.
• AO disallowed deduction of the same on the
grounds that there was no specific provision in the Act entitling assessee to
deduction under section 37(1).
• CIT(A) upheld AO's orders.
• Aggrieved by denial of deduction for discount
under ESOP, instant appeal is filed by assessee.
Issues before ITAT
• The moot question: Whether the Employee stock
option compensation expense is an allowable deduction in the computation of
income under the head "Profits and gains of business or profession"?
This larger question can be answered in the following three steps, viz.,
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I.
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Whether
any deduction of such discount is allowable?
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II.
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If
yes, then when and how much?
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III.
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Subsequent
adjustment to discount.
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Rival contentions
Revenue
• Discount on ESOPs is short receipt of share
premium which is capital receipt. Since, capital receipt is not taxable, its
short receipt is not deductible.
• Discount on ESOPs is contingent liability as
it crystallizes only when employee fulfils service for 4 years.
• Discount on ESOPs is not an expenditure as
nothing is paid out or away.
Assessee
• Discount is nothing but employees'
compensation cost.
Held
(A) Nature of ESOPs
• Section 2(15A) of the Indian Companies Act,
1956 defines "employee stock option" to mean '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 predetermined
price".
• In an ESOP, the company undertakes to issue
shares to its employees at a future date at a price lower than the current
market price. This is achieved by granting stock options to its employees at
discount.
• The amount of discount represents the
difference between market price of the shares at the time of the grant of
option and the offer price.
• In order to be eligible for acquiring the
shares under the ESOP, the concerned employees are obliged to render services
to the company during the vesting period as given in the scheme.
• On the completion of the vesting period in the
service of the company, such options vest with the employees.
• The options are then exercised by the
employees by making application to the employer for the issue of shares against
the options vested in them.
• The gap between the completion of vesting
period and the time for exercising the options is usually negligible.
• The company, on the exercise of option by the
employees, allots shares to them who can then freely sell such shares in the
open market subject to the terms of the ESOP.
• Thus it can be seen that it is 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.
(B) Whether discount on ESOPs is short
capital receipt?
• If a company issues shares to the public or
the existing shareholders at less than the otherwise prevailing premium due to
market sentiment or otherwise, such short receipt of premium would be a case of
a receipt of a lower amount on capital account.
• It is so because the object of issuing such
shares at a lower price is nowhere directly connected with the earning of
income. It is in such like situation that the contention of the learned
Departmental Representative would properly fit in, thereby debarring the
company from claiming any deduction towards discounted premium.
• It is quite basic that the object of issuing
shares can never be lost sight of.
• 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.
• If under the first situation, the company,
say, on receipt of premium amounting to Rs. 100 from issue of shares to public,
gives Rs. 60 as incentive to its employees, such incentive of Rs. 60 would be
remuneration to employees and hence deductible.
• In the same way, if the company, instead,
issues shares to its employees at a premium of Rs.40, the discounted premium of
Rs.60, being the difference between Rs.100 and Rs.40, is again nothing but a
different mode of awarding remuneration to employees for their continued
services.
• In both the cases, the object is to compensate
employees to the tune of Rs.60.
• 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.
• Thus, the contention of the ld. DR that by
issuing shares to employees at a discounted premium, the company got a lower
capital receipt, is bereft of an force.
• 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.
(C) Whether discount on ESOPs is an
expenditure
• 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"
under section 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 under section 37(1) subject to the
fulfillment of other conditions.
• The word 'expenditure' has not been defined in
the Act.
• However, sec. 2(h) of the Expenditure Act,
1957 defines 'expenditure' as : 'Any sum of money or money's worth spent or
disbursed or for the spending or disbursing of which a liability has been
incurred by an assessee……'.
• 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'.
• 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 under section 37(1) of the
Act.
(D) Whether discount of ESOPs is contingent
liability
• 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.
• 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.
• The discount in relation to options vesting
during the year cannot be held as a contingent liability.
(E) ESOP is fringe benefit and
consideration for employment
• Section 115WB(1)(d) defines discounted premium
to employees on ESOP as consideration for employment and fringe benefit.
• Natural corollary is that discount on ESOP is
(i) an expenditure (ii) an ascertained and not contingent liability (iii)not a
short capital receipt.
(F) When and how much-quantum of
deduction in respect of discount on ESOPs.
• 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.
• Deduction of the discounted premium to be
allowed during the years of vesting on a straight line basis.
• This view accords with ITAT's ruling in SSI
Ltd and accounting treatment as per SEBI's Guidelines on ESOPs.
(G) Subsequent adjustment to cost
• 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.
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