Vexed issue of allowability/quantification/timing of expenditure on ESOPs

A troublesome issue for companies
is the deductibility of ESOPs expenditure under the Income-tax Act, 1961. ESOPs
(employees stock options/shares) are often given at a discount at their fair value.
A share having a fair value of Rs. 100 is given, say, at Rs. 80. This is one
extreme of a simple example. In practice, ESOPs are even more complicated with
different features such as of vesting, exercise, quantum, pricing, etc. However,
the fundamental question is whether the discount is deductible as an
expenditure. Two related important questions are (i) if the amount is
deductible, when is such amount deductible? (ii) how is such amount determined?
The taxability of such discount
in the hands of the employee/allottee, though a separate issue, needs just one mention.
Though the method has varied, income from ESOPs has been subject to tax by a specific provision since several years.
A recent decision of the ITAT
has highlighted again that just one of the uncertainties surrounding deductibility
of this expenditure and the consistently unreasonable stand of the Department. In
Nova Nordisk India (P.) Ltd. vs DCIT
[2014] 42 168 (Bangalore – Trib.), a question arose of a typical
cross border issue. It is common that the employees of an Indian subsidiary are
granted shares of the overseas parent company at a discount. In this case, the
parent company adopted a slightly different approach. To simplify the facts a
little, the parent subsidiary issued the shares through the Indian subsidiary.
The Indian subsidiary issued the shares to its employees at a discount. The
full price was, however, paid to the parent company by the subsidiary. The
discount was borne by the Indian subsidiary and claimed as expenditure. This
deduction was disputed by the department on various grounds including the basic
issue deductibility of expenditure on ESOPs. An important issue raised was that
it was really a capital expenditure of the parent but was claimed in the hands
of the subsidiary. The Tribunal, however, allowed the expenditure, following an
earlier case.
However, this only reminds us
that very fundamental issues still remain over the deductibility of ESOPs
expenditure. Some of these are:-
  1. Whether
    ESOPs expenditure is deductible at all? Is it disallowable because it is
    foregoing of share premium and thus a capital expenditure? Is it
    disallowable because it is not really an expenditure but foregoing of an
  2. When is
    such expenditure allowable? At the time of grant of ESOPs? At the time of
    vesting? At the time of exercise? Is it to be allocated over a period? Is
    the amount to be adjusted for change in market price at time of exercise?
  3. How is
    the amount of such expenditure to be determined? How does one take into
    account and value certain and uncertain parameters involved? Which method
    of valuation should be followed?
  4. Should
    one apply the principles of accounting prescribed by ICAI and/or the SEBI Guidelines?
    Do we at the very least take them for guidance/reference?

In practice, considering the
wide variety of ESOPs structures in practice, the issues that arise are many
The Income-tax Act, 1961 has no
specific provision for deductibility of such expenditure. The predictable
kneejerk approach of the department is to disallow the expenditure fully and further
take an extreme stand on each issue. To begin the expenditure is sought to be
disallowed. The timing of allowability is sought to be delayed. The amount of
deduction is sought to be minimised. And so on. And, as also expected, the
assessee’s stance is equally predictable. To claim the amount as deduction, at
the highest amount and at the earliest stage.
There have been recent
precedents but a review of the same shows that there is no unanimity not just on
the issue of principle of allowability but on other issues also.
A recent decision of the
Bangalore ITAT in
[2013] 35 335 (Bangalore – Trib.) (SB) is noteworthy because
several fundamental issues have been raised and discussed at length. It also
refers to other precedents which are worth reviewing including the decision of
the Chennai High Court in
CIT v. PVP Ventures Ltd. [2012] 211
Taxman 554/23 286 (Mad.).
The decision of the Supreme Court in CIT v. Infosys Technologies Ltd. [2008] 297
ITR 167/116 Taxman 204 (SC), though on certain limited issue of taxability in
hands of
employee under certain facts, is also noteworthy. However, a decision of
the Tribunal – even a Special Bench – may not get India wide acceptance.
Further, even this decision does not give comprehensive guidelines on basic
issues of how and when the deductibility should be allowed. Indeed, it
considers the SEBI Guidelines and the ICAI Guidelines as not necessarily
authoritative. Thus, other courts/tribunals will have to deal with individual
situations and issues.
What is acutely needed is a
specific and comprehensive provision in the Income-tax Act, 1961 to deal with
the issue of deductibility, timing and quantification of the expenditure on
The SEBI Guidelines on ESOPs are
fairly emphatic that the discount on issue of ESOPs should be written off in
the accounts. A minimum though simplistic method is also provided for
determining the amount and timing of such write off including reversal under
certain circumstances. However, option is also given to the company to follow
the slightly more complicated but more refined methods such as Black Scholes
formula. However, the Guidelines essentially apply to listed companies.
The ICAI Guidelines are far more
comprehensive and they provide guidance not just on basic issues of timing and
quantification but also provide guidance in form of basic principles for
application in individual situations.
It is strange that, though the
approach taken is correct on basic principles, even the appellate authorities
have not given authoritative status to the SEBI Guidelines and/or the ICAI
Guidelines. At the very minimum, these could have been accepted as binding
unless the department could clearly prove that specific circumstances of the
assessee’s case require a different treatment.
Even if specific provisions are
made in law, concern also arises on how well they will be framed. In case of tax
treatment of income from ESOPs, it
has been seen that the specific provisions have been far from comprehensive and
clear. There has been uncertainty and litigation on several issues. It would be
unrealistic to expect that even if specific provisions are made in law, they
would be fair and comprehensive. But an initial start is overdue.

Considering the above, it
can be expected that the issue of ESOPs expenditure will continue be the
subject matter of disputes on a variety of issues.

About the author

CA Jayant Thakur

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