Is esop is an allowable expense?

What is an ESOP?

In today’s world employers have become increasingly motivated to make the employees a part of their wealth creation process. A scheme of Employee Stock Option (‘ESOP’) is one such process where employers reward employees by making them partners/ rightful owners in wealth which they have build together by issuing shares in the entity at a discounted price which otherwise is available at higher price in the market due to various reasons such as market expecting to reap the reserves sitting in the books of accounts, goodwill generated by the Company in the market, expected discounted cash flow forecasts of the Company etc .

ESOP is a plan wherein an option is provided by the employer to employee to opt for issue of shares in the company at the end of vesting period on satisfying specific conditions set in by employer at an agreed pre-determined discounted price against a commitment from the employee of provision of uninterrupted services to the company.
The major benefits out of such ESOP scheme are (i) Employers do not have immediate payout obligation while they continue to lure the employees and receive their uninterrupted services. (ii) Employees feel a sense of ownership and their efforts can directly be remunerated in an employee oriented industry (iii) Employees may get a sense of getting retained with the company for atleast a near future time period (iv) Employees get a very good opportunity to become partners in wealth creation in a twofold manner wherein on one side they are issued shares at a discounted price when compared to market price or sometimes even at free of cost and on the other side they become eligible for all the future shareholder payouts whether be it dividends or buyback/ redemption of capital.
Accounting treatment of ESOP:
As per the Guidance Note issued by Institute of Chartered Accounts of India (‘ICAI’) and SEBI the main objective to issue an ESOP share or say sweat equity share is to remunerate the employee for, his past services, for making available intellectual property rights to the employer.
However, due to the issue of ESOP the rights of the existing shareholders get diluted and therefore there is a need to compensate such dilution by creating an artificial reserve. The only resource available with any company is the corporate profits. Hence the ICAI and SEBI have suggests to create such reserve from the current profits earned by the company. The methodology to be adopted as suggested by ICAI and SEBI to compute the quantum of reserve is the difference between market value as computed under SEBI rules on the date of grant and the price at which the shares are issued to the employees in order to compensate the payout obligation which might arise on ESOP shares either at buyback or at liquidation.
Jargons of an ESOP plan:
An employer who wishes to issue ESOP proposes a plan to the employees on a certain date i.e. grant date with certain conditions attached to it which inter-alia includes a minimum period of employment with the company i.e. vesting period. There is a certain time period within which the employee after the ESOP getting vest gets an opportunity to exercise the option i.e. Exercise period. The value at which the shares are issued to employees is technically called exercise price. Some companies also keep a lock in period for the exercised ESOP within which an employee cannot sell those shares in the market.
Legal Issues in claiming Tax Deduction (‘TD’)
There is no specific section under which ESOP expenditure is allowable under the Income Tax Act 1961 (‘Act’). The only provision where a company can claim the expenditure is section 37 of the Act. Hence, it is pertinent to test the conditions mentioned in section 37 in order to conclude whether the expenditure is allowable?
Section 37 of the Act allows an assessee to claim expenditure if it fulfills the following conditions:

It should be an expenditure,
It should not be dealt in section 30 to 36,
It should not be a capital expenditure, and
It should be incurred or laid out wholly and exclusively for the purpose of business.

Now let us analyse all the above tests in detail:
As discussed above, the expense which is debited to profit and loss account (‘P&L’) is the difference between the market value of share as computed under the guidelines of SEBI and the value at which the share are issued to employees.
The revenue has always contested to disallow the ESOP expenditure debited to P&L account based on the following arguments;

The company is choosing to either receive 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 share issue. Hence there is no expenditure that the company is incurring or laying out.
The issue of shares is also not crystallized till the date on which the employee exercises the option and hence any expenditure debited during the vesting period remains contingent in nature.
The ESOP expense even if treated as expenditure is a capital expenditure since securities premium being a capital item.

The views of various judicial courts on the above issue differ widely. Whereas the Delhi ITAT in the case of ACIT Vs Ranbaxy Laboratories ITA No 2613 & 3871 has held that the ESOP expense debited to P&L is notional in nature since the assessee has neither laid out or expended any amount while choosing to receive no/ lesser securities premium. The alternative argument that this ITAT has supported is since the receipt of securities premium is not chargeable to tax being a capital receipt any short collection of securities premium should also be considered as capital outlay and cannot be allowed as expenditure.
The Delhi ITAT in the case of Ranbaxy (Supra) has relied on the following court rulings which have held that shares issued against assets/ Technical know-how contributed by shareholders cannot be claimed as revenue expenditure:

Eimco K.C.P Ltd Vs CIT 159 CTR 137 (Supreme Court)
CIT Vs Reinz Talbros Pvt Ltd 252 ITR 637 (Delhi HC).

Further , there are different views within the Supreme Court rulings as to what constitutes an expenditure since there are rulings on one side of Indian Mollasses Co Pvt Ltd Vs CIT 37 ITR 66, CIT Vs Nainital Bank Ltd 62 ITR 638 which denotes expenditure in the normal course as ‘spending’, ‘paying out or away’ of money. However, there are other rulings of Supreme Court in the case of Madras Industrial Investment Corp Ltd 225 ITR 802 (SC) where it has held that ‘expenditure is not confined to what is paid out but also includes any liability which has accrued or incurred which might have to be paid in future’.
The above views of Delhi ITAT in the case of Ranbaxy (supra) were also upheld subsequently by the following judicial courts:

Hyderabad ITAT in the case of Medha Servo Drivers Limited ITA No 1114/Hyd/2008.
Mumbai Tribunal in the cases of:

DCIT Vs Blow Plast Limited ITA No 512/Mum/2009.
Mahindra & Mahindra Vs DCIT ITA No 8597/Mum/2010.
M/s VIP Industries Vs DCIT ITA No 7242/Mum/2008.

However, there were following judicial courts which did not buy the above line of argument and ruled that since the SEBI has promulgated such debit to P&L and since the ESOP are issued with an expectation to receive uninterrupted services from employees and further this expenditure is treated as part of remuneration by employer and employee, this expenditure should be allowed as deduction U/s 37 of the Act:

CIT Vs M/s PVP Ventures Limited TC (A) No 1023 of 2005 (Madras HC).
S.I Ltd Vs DCIT 85 TTJ 1049 (Chandigarh ITAT)
ACIT Vs Spray Engineering Devices Limited ITA No 701 of 2009 (Chandigarh ITAT).

Though there is a High court judgement available on this issue, the ruling of PVP Ventures (supra) is not a speaking order and does not justify the conclusion it has given in the favour of PVP Ventures. Hence, this led to a confused state of environment with regard to claim of ESOP expenditure under the Act.
It is under this circumstances that a special bench was constituted by Bangalore ITAT (‘SB’) in the case of M/s Biacon Ltd Vs DCIT ITA No 368/369/370/371/1206/Bang/2010 which was then intervened by M/s Advinus Therapeatics Limited, M/s Bharti Airtel Limited, M/s NDTV media Ltd, and M/s New Delhi Television Limited.
It is also important to note that Biacon Ltd had apart from the above arguments taken by various assessees in the above rulings had taken an additional argument that when there is nothing in the taxing statue regarding a claim then the guidance should be taken from the accountancy principles. This claim was also supported by two Apex Court ruling:

Challapalli Sugars Limited Vs CIT 98 ITR 167.
CIT Vs Industrial Development Corporation 225 ITR 703.

However, the revenue authorities contested the supremacy of accounting principles by citing the following rulings of Apex court:

Tuticorin Alkali Chemicals & Fertilizers Ltd Vs CIT 227 ITR 172 (SC).
Godhra Electricity Co Ltd Vs CIT 225 ITR 746 (SC).

The SB has divided the question of allowability of ESOP expenditure into three parts:

Whether deduction of any such discount is allowable?
If yes, then when and how much?
Subsequent adjustments to the discount if any?

The SB has given a detailed reasoned judgement on all the above questions. The first argument of the revenue that since the receipt of share premium is considered as capital item, any short receipt of such securities premium should also be considered as capital outflow was overruled by relying on the recent amendment to section 56 of the Act wherein monies received over and above the face value and in excess of fair market value of the shares during its issue is considered as income for the purpose of the Act, thereby negating the comparison of receipt of share premium and lower recovery of share premium. The SB also has by this argument overruled the plea of Revenue authorities that accounting principles which treat share premium as a capital receipt are not supreme when it comes to taxing statue.
Further, on the question whether an ESOP layout can be considered as an expenditure the SB has in order to substantiate and correct the interpretation of the ruling given by Apex court, relied by the revenue authorities, in the case of Indian Molasses (Supra) 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:
“Actually paid or incurred according to the method accounting upon the basis of which profits and gains are computed”
Further the SB has also put additional reliance on section 2(h) of Expenditure Act 1957 (since no definition of expenditure is given under the 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, 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 discount which according to the SB is nothing but incurring expenditure.
Further, to support the above argument it has also relied on the ruling of Apex Court in the case of CIT Vs Woodward Governor India (P) Ltd 312 ITR 254 (SC) by citing that:
“it is worth noting that the Hon’ble Supreme Court in the case of CIT v. Woodward Governor India (P) Limited [(2009) 312 ITR 254 (SC)] has gone to the extent of covering “loss” in certain 17 circumstances within the purview of “expenditure” as used in section in 37(1). In that case, the assessee incurred additional liability due to exchange rate fluctuation on a revenue account. The Assessing Officer did not allow deduction u/s 37. When the matter finally reached the Hon’ble Supreme Court, their Lordships noticed that the word “expenditure” has not been defined in the Act. They held that “the word “expenditure” is, therefore, required to be understood in the context in which it is used. Section 37 enjoins that any expenditure not being expenditure of the nature described in sections 30 to 36 laid out or expended wholly and exclusively for the purposes of the business should be allowed in computing the income chargeable under the head “profits and gains of business or profession”. In sections 30 to 36 the expression “expenditure incurred”, as well as allowance and depreciation, has also been used. For example depreciation and allowances are dealt with in section 32; therefore, the parliament has used expression “any expenditure” in section 37 to cover both. Therefore, the expression “expenditure” as used in section 37 made in the circumstances of a particular case, covers an amount which is really a “loss” even though the said amount has not gone out from the pocket of the assessee’. From the above enunciation of law by the Hon’ble Summit Court, there remains no doubt whatsoever that the term `expenditure’ in certain circumstances can also encompass `loss’ even though no amount is actually paid out”
Further, there is an alternative argument that one can make in the above context, though not taken in the above ruling, that debiting the ESOP expense leads to creation of artificial reserve which goes and sits in the reserves in the balance sheet, be it either securities premium account or any specific reserve created for ESOP. Hence at the time of liquidation or buyback there is a liability to payout the shareholders from not only the amounts lying in share capital account and general free reserves but also from the above mentioned reserves. Hence, these amounts which are debited to P&L, which are located in reserves during buyback/ liquidation, are ultimately liable to be paid to shareholders which also means that company has not only incurred the ESOP expense but also is be liable to pay such amounts to employees who have become shareholders during the process of ESOP plans or has to be paid to persons who have become shareholders by buying those ESOP shares from employees.
Further, it is pertinent to note that the company has not received any money against the portion of reserves created for ESOP which it will pay during the process of buyback/ liquidation. Instead the company has received services from employees, the payment for which in the form of payouts during the buyback/ liquidation is going to the employees AKA shareholders.
Further, the SB has also upheld the arguments ruled by S.S.I Ltd (Supra) and Spray Engineering (Supra) that the main objective of issuing ESOP is not to raise the share capital but to expect an uninterrupted service from the employee which will be used in revenue generation and hence it cannot be equated with issue of share capital against acquisition of asset so as to fall into the brackets of capital items.
The SB has also pondered on the issue of whether the ESOP expenditure is of contingent in nature. The major reasons of revenue authorities treating such expense as contingent in nature was because In the case of ESOP the question whether share will be ultimately issued is not clear since it contains restrictions and various other eligibility criteria on employees in order to make them eligible for ESOP, the clouds on which get clear only on exercise of ESOP options by employees.
However, the SB has ruled that since the companies follow mercantile system of accounting in which any income or expense is booked in the books based on the accrual concept. Accordingly in the present context once the employer has committed the issue of shares at the end of the vesting period, the expenditure no longer remains contingent and the company has to issue shares at the vesting period. However, the SB has also ruled that based on the actual number of options exercised at the end of the vesting period the company needs to make a downward adjustment to the discount on ESOP which are lapsed and such discount should be offered it to tax.
To add strength to the above argument the SB has taken recourse to the following two Apex Court rulings wherein it is held that a liability definitely incurred by an assessee is deductable notwithstanding the fact that its quantification may take place in a later year. The mere fact that the quantification is not precisely possible at the time of incurring the liability would not make an ascertained liability a contingent one:

Bharat Earth Movers Ltd. v. CIT (245 ITR 428) (SC)
Rotork Controls India (P) Vs CIT [(2009) 314 ITR 62 (SC)]

The SB has also invited attention to erstwhile Fringe Benefit rules wherein the same ESOP cost was treated as expenditure liable for Fringe Benefit Tax (‘FBT’). The SB has also ruled that once the legislature has treated the very same ESOP as expenditure while taxing it under FBT, it is not open on the part of legislature to argue that the ESOP layout is not expenditure now once the FBT legislature is written off. This has on the one hand negated the argument upheld by Ranbaxy (supra) and on the other has once again reiterated the supremacy of taxing statue over the accounting principles.
Further, adding to the concept of accrual system of accounting, it has gone ahead and said that the companies are eligible to claim the ESOP expenditure during the vesting period depending upon the conditions prescribed under that ESOP plan.
The next question that the SB has put suo-motto is as to what happens when there is a difference between market price of shares as on the date of grant of the option and the price of the share as on the date of exercise of options?
The SB has further taken the argument of Tuticorin Alkali (Supra) and Godhra Electricity (Supra) and ruled that accountancy principles cannot govern the amount of income that should be offered to tax in cases where no specific provisions are available. Since the employees become the legal owners/rightful owners of the shares only on the date on which they exercise the option the SB has ruled that the discount on ESOP must be computed based on the market price of the share as on the date of exercise of options. Alternatively it can be said that the actual expense/ loss born by the company in an ESOP arrangement is the difference between the market price of the shares as on the date of exercise of options and value that is received from the employees against such ESOP.
The difference if any arising from the quantum of discount computed based on the market value of shares as on the date of grant should be appropriately adjusted to taxable income in the year of excursive and should be offered to tax/ claimed as expenditure. In this manner though the SB has allowed the ESOP deduction throughout the vesting period, it has called for a revision of computation of discount on ESOP as on the date of exercise and adjust it appropriately while computing tax liability.

Conclusion
Though the judgement of SB seems to clear the clouds on the variety of decisions given by various tribunals and a decision given by Madras High Court on PVP Ventures (Supra) the dust is not yet settled because the case of Ranbaxy (Supra) is pending before the Hon’ble Delhi High Court and one can expect that this dispute may travel through the corridors of Supreme Court.