Tax treatment of employees stock Option (ESOP)

Whether discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head profits and gains in business

A special bench of Income Tax Appellate Tribunal, Bangalore in the matter of M/s Bicon Limited VsDy Commissioner of Income Tax (LTU), Bangalorewas constituted to adjudicate the following question of law: “Whether discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head profits and gains in business?” To answer this question, it is necessary to understand the import of the word “employee’s stock option” (hereinafter referred to as ESOP). Section 2(15A) of the Indian Companies Act gives the definition of ESOP. In an ESOP, the given company undertakes to issue shares to its employees at a future date at a price lower than the current market price, which is achieved by granting stock options to its employees at discount. An employee in order to be eligible for acquiring the shares under the ESOP, are obliged to render services to the employer/company during the vesting period as given in the scheme. The employee becomes entitled to seek such option on completion of the vesting period. Upon the receipt of the application by the employee for the issue of the shares, the company allots the shares. The employee is free to sell the said allotted shares in the market, subject to the terms of ESOP. By granting the stock options, the company gets a sort of assurance from its employees for rendering un-interrupted 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 the discounted premium on the issue of shares. On behalf of the government it was argued that discount on shares allotted to the employees is an under recovery of share premium/capital, hence it falls in the category of short capital receipt. ITAT held that since the rationale and primary object of bringing scheme of ESOP 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 a discount is construed both by the employees and company as a part of remuneration, thus by no stretch of imagination it can be described as either short capital receipt or a capital expenditure. It was also argued on behalf of the government that discount on ESOP is not an expenditure under Section 37 of the Income Tax Act; for the reason that there is no “paying out or away”. The ITAT relying on the judgement of the Supreme Court held that no doubt the expression “expenditure” within the meaning of Section 37 means what is “paid out or away”, howevernoted that section does not restrict paying out the expenditure in cash alone. “Paid” would mean actually paid or incurred according to method of accounting. By undertaking to issue shares at discounted premium though the company does not pay anything to its employees but incurs obligation of issuing shares at a discounted price on a future date, which is expenditure under Section 37(1) of the Act. The final findings of the special bench can be summarised in following points :• Discount represents the difference between market price of the shares at the time of grant of option and the offer price. • Discount under ESOP is an employee cost, deductible during the vesting period with regard to the market price of shares at the time of grant of options to the employees .• The primary objective of issuing shares to employees at a discounted premium is to compensate them for the continuity of their services to the company, which is nothing but the employees cost incurred by the company . • Obligation to issue shares at a discounted price on a future date in lieu of their services by company is expenditure under Section 37(1) of the Income Tax Act .• Company incurs obligation to issue discounted shares at the time of exercise of option during the vesting period . • Deduction is permissible in respect of an ascertained liability and not a contingent liability. Discount in relation to options vesting during the year is not a contingent liability. • Discount is an allowable deduction under the ESOP.The bench further held that Accounting principles have no role in determining total income under the Act. It is the taxation principles which are to be followed and in the event of conflict, the taxation principle shall prevail. SEBI Guidelines prescribe accounting treatment only in respect of the period of vesting of options and situation arising out of unvested options or lapsing of vested options. The amount of discount claimed as deduction during the vesting period is to be reversed in relation to the unvesting/lapsing options at the appropriate time. The author of this Article is Anupam Srivastava who can be reached at