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  42 taxmann.com 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:-
- 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 income?
- 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?
- 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?
- 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 more.
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  35 taxmann.com 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.  211 Taxman 554/23 taxmann.com 286 (Mad.). The decision of the Supreme Court in CIT v. Infosys Technologies Ltd.  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 ESOPs.
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.