Special Bench rules ESOP discount is deductible on vesting of options

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1 19 July mber 2012 EY Tax Alert Special Bench rules ESOP discount is deductible on vesting of options Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor. This Tax Alert summarizes a recent ruling of the Special Bench (SB) of the Bangalore Income Tax Appellate Tribunal (Tribunal) in the case of Biocon Ltd [1]. (Taxpayer) on the issue of allowability of Employee Stock Option Plan (ESOP) discount, being the difference between the market value of the shares and the value at which the employees are granted option to acquire shares of the employer (ESOP discount). The SB upheld the following propositions on deductibility of ESOP discount: 1. On principle, ESOP discount is deductible business expenditure since it represents consideration/compensation for services rendered by employees. It cannot be equated with short receipt of share premium. Furthermore, it is an ascertained liability since the employer incurs obligation to compensate the employees over the vesting period, notwithstanding the fact that the exact amount of discount is quantified only at the time of exercising the options. 2. ESOP discount deduction is allowable on provisional basis on each vesting date. The exact quantum of ESOP discount is, however, determined on the date of exercise of options i.e., the difference between market value on date of exercise and exercise price represents the cost which is actually incurred by the employer. Hence, deduction provisionally allowed in earlier periods based on vesting of options should be adjusted upwards or downwards based on market value as on date of exercise. This adjustment is over and above adjustments that are necessitated on account of lapsing or forfeiture of options. [1] ITA Nos. 368, 369, 370, 371, 1206, 248/Bang/2010

2 Background and facts In an ESOP, the employer company undertakes to issue shares to its employees, at a future date, at a price usually lower than the current market price. In order to be eligible to acquire such shares, the employees are obliged to render services and/or achieve specified benchmarks during the vesting period. The employees acquire the right to exercise the options on completion of the vesting period. Upon vesting, the employee can exercise the options within a specified period. Therefore, the three relevant events during an ESOP lifecycle are: (a) Grant of options (b) Vesting of options (c) Exercise of options. In India, ESOPs granted by listed companies [2] are governed by SEBI [3] (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999 (SEBI Guidelines). As per SEBI guidelines, ESOP discount as on date of grant is required to be treated as another form of employee compensation by amortizing the discount over the vesting period of the options. Such accounting treatment is mandatory for listed companies. The ICAI [4] has also issued a Guidance Note on Accounting for Employee Sharebased Payments which recommends similar accounting treatment for other companies. The Taxpayer s ESOP scheme provided for vesting of options equally over four years (i.e., 25% in each year) at the end of completion of service in each year. The Taxpayer debited pro-rata [5] ESOP discount to Profit & Loss (P&L) statement as employee compensation expenses. It claimed deduction thereof for tax purposes. [2] Whose shares are traded on recognized stock exchanges [3] Securities and Exchange Board of India, the regulator of securities trading in India [4] The Institute of Chartered Accountants of India, the apex The Tax Authority disallowed the claim on the following grounds: There are no specific provisions under the Indian Tax Laws (ITL) permitting such deduction. ESOP discount is not an expenditure, in the sense of spending or paying out i.e., something going out of the coffers of the Taxpayer. It was merely in the nature of short receipt of premium on shares, which is a capital receipt or, alternatively, it was a capital expenditure. Alternatively, ESOP discount represents a contingent liability since there is no certainty of options getting vested in the employees and/or employees actually exercising the options. The First Appellate Authority upheld the Tax Authority s order. Aggrieved, the Taxpayer appealed before the Tribunal. The Chennai bench of the Tribunal, in the case of SSI Ltd. v. DCIT [6], ruled that ESOP discount is a deductible expenditure on the basis of SEBI Guidelines. Per contra, the Delhi and Mumbai benches of the Tribunal, in the cases of Ranbaxy Laboratories Ltd. v. ADIT [7] and VIP Industries Ltd. v. DCIT [8], held that ESOP discount is not a deductible expenditure. In view of conflicting decisions between different benches of the Tribunal, an SB was constituted to adjudicate the issue on deductibility of ESOP discount. accounting body in India [5] Pro-rata ESOP discount was calculated as follows : 25% vesting in Year 1 100% 25% vesting in Year 2 50% 25% vesting in Year % 25% vesting in Year 4 25% [6] [85 TTJ 1049 (Chennai)] [7] [26 DTR 420(Del)(Trib)] See EY Tax Alert dated 1 September 2009 [8] [2010-TIOL-654-ITAT-MUM]

3 Issues before the SB The issue referred to the SB was whether ESOP discount is allowable as deduction in computing business income which, according to the SB, could be answered by adjudicating upon the following three issues: 1. Whether any deduction for ESOP discount is allowable in computation of business income. 2. If yes, what is the quantum and timing of such deduction. 3. Whether any adjustment is necessary in subsequent years. It is also not correct to suggest that ESOP discount does not represent an expenditure. Expenditure need not necessarily be incurred in cash. Incurrence of an obligation is also expenditure. By undertaking an obligation to issue shares at a discounted premium at a future date, the Taxpayer incurs an obligation towards remunerating the employees for their services, which is nothing but expenditure. Fringe Benefit Tax (FBT) provisions which existed in the past between tax years to and, in terms of which, an employer was made liable to pay FBT on ESOPs, also regarded ESOPs as consideration for employment. SB s ruling On deductibility of ESOP discount The SB, based on the following reasoning, ruled that ESOP discount is a deductible expenditure and not a contingent or notional expenditure. The primary object of ESOPs is to earn profit by securing consistent and concentrated efforts of dedicated employees during the vesting period and is one of the modes of compensating the employees for their services. It is a part of their remuneration packages and an alternative to direct incentive in cash. It is not correct to equate ESOP discount to short receipt of premium on issue of shares. ESOP shares are not issued with the object of raising capital. Rather, they are intended to remunerate the employees for their services. ESOP discount is a substitute to giving direct incentive in cash for their services. There is no difference between both the situations viz., one, when the company issues shares to the 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. ESOP discount does not represent a contingent or notional liability till the date of exercise of options. The Taxpayer incurred liability towards employees on the date of vesting of options post rendering of services by the employees. The fact that the exact quantum of discount enjoyed by the employees gets determined subsequently on the date of exercise does not dilute the incurrence of the obligation. Year of deductibility of ESOP cost The SB ruled that ESOP discount is deductible during the vesting period based on the following reasoning: Mere grant of option neither entitles the employee to exercise ESOPs nor allows the Taxpayer to claim deduction for ESOP cost. The Taxpayer incurs liability to issue shares at a discounted premium only on vesting of options. Hence, if options vest uniformly over a period, ESOP discount is deductible during such period on straight line basis. Therefore, the quantum of deductible ESOP discount should be determined as per terms of ESOP scheme by considering the period and percentage of vesting during such period. The event of exercise merely represents realization of income which was earned during vesting period.

4 Necessity of subsequent adjustment on lapsing/forfeiture of options The SB held that it is necessary to make adjustment in subsequent years to ESOP discount allowed as deduction in earlier years in the event of lapsing or forfeiture of options due to non-fulfilment of vesting conditions and/or non-exercise of vested options by employees. The SB acknowledged that even SEBI Guidelines mandate appropriate adjustment for such events. Necessity of subsequent adjustment on exercise of options the cases of Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT [9] and Godhra Electricity Co. Ltd. v. CIT [10] for this proposition. As per the SB, no accounting principle can be determinative in the matter of computation of total income under the ITL. The SB also distinguished the Madras High Court (HC) ruling in the case of PVP Ventures Ltd [11]. which allowed deduction on the basis of SEBI guidelines. The SB held that, in the PVP Ventures ruling, the HC was concerned with the year in which options vested in the employees and not the year in which options were exercised by the employees. The SB held that, in addition to subsequent adjustments for lapsing or forfeiture of options, adjustment is also necessary for options which are exercised by the employees based on the following reasoning: As per salary taxation provisions, the difference between market price as on date of exercise and exercise price is taxed as perquisite in the hands of the employees. The same difference should logically represent corresponding cost for the employer. This is for the reason that cost for the company and remuneration in the hands of the employees in respect of the same item cannot be different. The employer is granted deduction for ESOP discount over the period of vesting with respect to market price as on date of grant. Such deduction is a provisional deduction which is required to be finally adjusted at the time of exercise of options. The adjustment can be upward or downward adjustment based on movement of market price on date of exercise as compared to date of grant. Accordingly, such adjustment can result in additional deduction or charge back of income for the Taxpayer. Although accounting treatment prescribed by SEBI guidelines does not require such adjustment, it is a wellsettled fact that accounting principles do not determine tax liability. Reliance was placed on the Supreme Court rulings in [9] [227 ITR 172 (SC)] [10] [225 ITR 746 (SC)] [11] This decision upheld the Chennai Tribunal ruling in SSI Ltd. s case (supra). For more information, see EY Tax Alert dated 23 July 2012

5 Comments Deductibility of ESOP discount is a highly controversial issue in the absence of specific provisions governing tax treatment of such discount. The present SB ruling has unequivocally accepted that ESOP discount is deductible over vesting period. This will be welcomed by taxpayers. However, the SB appears to have admitted deduction only in the year of vesting. This may give rise to a timing difference if companies follow one of the permissible alternatives under SEBI Guidelines in terms of which ESOP discount is amortized in straight line method over vesting period. To illustrate, if 100 options vest over four years equally in each year (i.e., 25 options in each year), debit to P&L in terms of permissible alternative under SEBI Guidelines in Year 1 towards ESOP discount will comprise whole of discount pertaining to 25 options vesting in Year 1 as also proportionate deduction in respect of other options vesting over three years. As against that, the SB seems to have granted deduction of ESOP discount in Year 1 in respect of only 25 options vesting in Year 1. If the ratio of the SB ruling is followed, taxpayers following the above referred method of straight line amortization as per SEBI Guidelines may need to consider the impact of such potential timing difference in computation of taxable income during the ESOP lifecycle. The SB s conclusion on subsequent adjustment in the year of exercise may also give rise to difference between ESOP discount accounted in books and that allowable for tax purposes. Furthermore, the SB s view that accounting principles cannot be determinative in computation of taxable income may also appear to be in conflict with the well-settled legal position that accounting principles are generally determinative in computation of taxable income unless superseded by specific tax provisions. A SB is generally constituted when there are conflicting decisions of Tribunals or the matter pending for adjudication is of considerable importance. It is also a well-settled convention to consider the SB's decision as binding on the division benches of the Tribunals.

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