ITAT clarifies deductibility of discount on ESOP

Recently, the Bangalore Special Bench of the Income Tax Appellate Tribunal (ITAT), in the case of M/s Biocon Ltd v DCIT, has held that discount on employee stock option plans (ESOPs) is an allowable expenditure. In the past, various judicial precedents have delivered conflicting views on this subject.

Typically, ESOPs are a mechanism used by companies to provide incentives to their employees. Generally, companies issue options to purchase stock below the market price in order to motivate and strengthen employees’ trust in the company and increase their interest in the growth of the company. Based on commercial needs, a company devises an ESOP to align the goals of the company with those of its employees.

The ESOPs devised by companies can involve setting up an employee trust, phantom equity schemes, stock appreciation rights, etc.

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Taxability of ESOPs

Stock options allotted on and after 1 April 2009 are to be taxed as perquisite in the hands of the employees at the time of exercise. The difference between the fair market value of shares received and the amount paid is treated as income in the hands of the employees. The employer is required to withhold taxes on such perquisite under section 192 of the Income Tax Act, 1961, in the year in which the option is exercised. Subsequent appreciation to the value of the shares received on exercise is in the capital stream and any gain on ultimate sale of shares is taxable as a capital gain.

Companies have been facing various issues in terms of analysing the taxability and calculating the tax in the hands of employees and the quantum of deduction in relation to the expenditure incurred on ESOPs, etc.

Three-step analysis

The Bangalore ITAT’s recent ruling in relation to deduction of discount on ESOPs as expenditure while computing taxable profits of the company issuing ESOPs addresses the question of deductibility of discount on ESOPs in three steps as follows:

First, a deduction of discount on ESOP is an allowable expenditure if: (a) the substance of issuing employee stock options is disbursing compensation to employees for their services, for which the form of issuing stocks at a discounted premium is adopted; and (b) the obligation of issuing stocks at a discounted price on a future date in return for services is an expenditure incurred wholly and exclusively for the purpose of business so as to be eligible under section 37(1) of the act.

Second, on the quantum and timing of the deduction, an ESOP discount can be claimed as a deduction over the vesting period at the rate at which there is vesting of options in the hands of the employees.

Third, on whether there can be any subsequent adjustment to the amount of discount, if required, no deduction of discount can be claimed on unvested or lapsed options as there is no employee cost to that extent so an adjustment to that extent would be required to be made.

Considering the above, the ITAT held that while computing the income under the head “profits and gains from business or profession”, an assessee can claim the discount on the ESOPs granted to its employees as a deductible expenditure under section 37(1) of the act.

Key clarifications

Thus, the above ruling has clarified the following major issues: (a) discount on ESOPs is a deductible expenditure since it is in the nature of employee cost; (b) such discount on options under ESOPs is an ascertained liability and not a contingent liability; (c) such discount is deductible over the vesting period on a straight line basis, if the vesting is on a uniform basis; (d) if the vesting is not uniform, then subsequent adjustment to the amount of discount claimed earlier would need to be made at the time of exercise of options; (e) an adjustment to the income is called for at the time of exercise of an option, amounting to the difference between the amount of discount calculated with reference to the market price at the time of grant of the option and the market price at the time of exercise of the option.

Conclusion

Although the judicial precedent discussed above has clarified the long-standing issue of whether the discount on ESOPs is an allowable expenditure, computing the eligibility and quantum of deduction during the course of the period of implementing an ESOP will always be a challenge. It is therefore important not only to envisage the possibilities, but to document the scheme such that it not only meets the commercial intent of the company but also provides for how the eventualities would be dealt with as all of that would become the basis for claiming deduction.

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Economic Laws Practice is a full-service law firm with headquarters in Mumbai and offices in New Delhi, Pune, Ahmedabad, Bangalore and Chennai. Pranay Bhatia is a tax partner at the firm and Hardik Choksi is an associate.