Income Tax Provisions on ESOP Expenditure

Employee Stock Option Plan (ESOP) is a scheme where a company issues its share to its employees at price lower than its market price with a condition that employees should be in employment or fulfill conditions attached to the scheme.

Accounting of ESOP ( as per old GAAP):

The Guidance note of the Institute of Chartered Accountants of India (ICAI) has laid down accounting principles and practices of ESOP. The guidance note has given two accounting methods for ESOP;

A. Fair Value Accounting:

In fair value accounting, the option which is given to the employees is valued based upon the option pricing model (Black and Scholes Model). In which the fair value of the option is charged to P/L over a period of the option (knows as the Vesting period).

B. Intrinsic Value Accounting:

Intrinsic value is the amount by which quoted market price of underlying share exceed the ESOP price (known as the exercise price) commonly known as a discount (i.e Market price – issue price) and this discount is charged to P/L over the vesting period of ESOP.

Tax effect of ESOP under intrinsic value accounting:

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”.

Applying section 37, to the ESOP expenditure following is the issue which has been raised by tax officers;

  • ESOP is not an expense as the company is choosing to either receive a securities premium of a lower amount or no securities premium when compared to that of which it would have received during a normal course of the share issue. Hence there is no expenditure that the company is incurring or laying out.
  • The ESOP expense even if treated as expenditure is a capital expenditure since securities premium being a capital item.
  • ESOP expense represented a contingent liability since there is no certainty of options getting vested in the employees and/or employees exercising the options.
  • If it is allowed as a deduction then what will be the timing and quantum of deduction.

The above question has been raised before various tax authorities and there is a difference of opinion by the authorities. Therefore, to come upon a single solution an ITAT Special Bench Bangalore (SB) in Biocon Industries case has been formed and the decision of special bench has been supported by various High Courts such as Madras High Court and Delhi High Court.

A. ESOP discount can be considered as expenditure?

The SB relies upon the Supreme Court judgment Indian Molasses in which an expenditure is defined as something that is ‘paid out or away’ has taken a recourse and reliance on section 43(2) relevant for section 37 which reads the word ‘paid’ used by the Apex court as:

Further, the SB has also put additional reliance on section 2(h) of Expenditure Act 1957 (since no definition of expenditure is given under Income Tax Act) which describes 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”

Hence, the SB has from the above definitions has made clear that the word paid includes incurred by an assessee (The Company), though no actual payout or layout has occurred and in turn, the word expenditure includes not only any sum paid but also any sum incurred, which is the present case since though no cash outflow is expected from an ESOP arrangement the company has incurred/committed an obligation to issue shares at a discount which according to the SB is nothing but incurring the expenditure.

B. ESOP expenditure is a capital expenditure or revenue expenditure?

In the case where the share is issued under ESOP, the primary objective is not to raise share capital but to earn profit by securing the uninterrupted, Consistent, and concentrated efforts of its employees, and the sole object of issuing share at a discounted premium is to compensate employees for their services to the company.

Therefore, ESOP discount cannot be considered as a capital expenditure it is revenue expenditure.

C. ESOP is Contingent Liability or Ascertained Liability?

To determine whether ESOP expenses is a contingent liability, the tribunal referred to the general term of the scheme and held that once an employee rendered service in the first year of the relevant scheme, it becomes obligatory on the part of the company to honor the commitment of allowing the vesting part of the option in that particular year. Hence, the liability stood and was incurred at the end of each year of service by the employee, even though the actual quantification of expenses will be finalized only when ESOP is actually issued to the employees in a later year.

D. Timing and Quantum of deduction:

As per the Companies Act, 2013 every company has to follow a mercantile system of accounting, the SB has stated that the company has to follow a mercantile system of accounting and all income and expenses will be booked based upon the accrual concept of accounting. Once a company record an expenditure it is no longer remains contingent. The liability of ESOP will be accounted for based upon the ESOP scheme and the amount of deduction will be claimed on a straight-line basis over the vesting period. However, the actual amount of expenses will be finalized only when ESOP is exercised by employees. In that context, SB has stated that the actual amount will be adjusted upward or downward based upon the actual amount. This is known as “True-up adjustment”

 The tax authority was not happy (aggrieved) by the decision of SB ITAT, they prefer an appeal to the High Court of Karnataka against the decision of SB. The Karnataka High Court gave the decision in favor of the company and held that ESOP expenditure is allowed as a deduction on November 11, 2020. However, the High court has not given any decision on “True-up adjustment” as it was not the subject matter of the appeal.

*Note: As the High court has not given any decision on True-up adjustment, one can always argue that it is prior period expenses and it should be disallowed.