ESOP share discount held deductible employee cost, to be amortized evenly over vesting period, with reversals for lapsed options

ITAT Bangalore (SB) held that discount on shares issued under an ESOP constitutes employee cost and is allowable as a deduction in computing business income. The Tribunal ruled that the liability for ESOP discount accrues over the vesting period, as the employee renders service and progressively earns the right to exercise options. Deduction must therefore be spread on a straight-line basis over the vesting period, with reversal for unvested/lapsed options and adjustment at exercise based on the difference between market price at grant and at exercise. In the assessee's case, front-loading the deduction in the first year was disallowed and the total discount was directed to be evenly apportioned across the four-year vesting period.

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Issues Involved:
1. Whether discount on the issue of Employee Stock Options (ESOP) is allowable as a deduction in computing income under the head "Profits and gains of business or profession."
2. The timing and amount of such deduction.
3. Subsequent adjustments to the discount.

Issue-Wise Detailed Analysis:

I. Whether any deduction of such discount is allowable:

A. Is discount under ESOP a short capital receiptRs.

The assessee argued that the discount under ESOP is an employee cost, and thus deductible. The Revenue contended that no deduction is permissible as the discount represents a short capital receipt or a contingent liability. The Tribunal rejected the Revenue's argument, stating that the discount on ESOP is not a capital receipt but an employee cost. The Tribunal emphasized that the substance of the transaction is compensating employees for their services, making it a deductible expense under Section 37(1) of the Income Tax Act.

B. Is discount a contingent liabilityRs.

The Tribunal examined whether the liability arising from ESOP is contingent. It referred to the Supreme Court's decisions in Bharat Earth Movers v. CIT and Rotork Controls India (P) Ltd. v. CIT, which established that a definite business liability arising in an accounting year is deductible even if it is to be quantified and discharged at a future date. The Tribunal concluded that the liability for the discount under ESOP is not contingent but an ascertained liability, making it deductible.

C. Fringe benefit:

The Tribunal noted that the discount on ESOP is considered a fringe benefit under Chapter XII-H of the Income Tax Act, which further supports its classification as an employee cost. Therefore, the discount on ESOP is an allowable deduction.

II. Timing and Amount of Deduction:

The Tribunal clarified that under the mercantile system of accounting, an expense becomes deductible when the liability to pay arises, not necessarily when it is discharged. The liability for the discount on ESOP arises during the vesting period, not at the grant or exercise of the options. The Tribunal held that the deduction should be spread over the vesting period, matching the period during which employees render services.

III. Subsequent Adjustment to Discount:

The Tribunal addressed the need for adjustments at the time of exercise of options. It explained that the actual amount of employee cost can only be determined at the time of exercise of options. If the market price at the time of exercise differs from the market price at the time of grant, adjustments must be made. The Tribunal provided examples illustrating how such adjustments should be made to reflect the actual employee cost.

Taxation vis-`a-vis Accountancy Principles:

The Tribunal emphasized that taxation principles take precedence over accounting principles. While SEBI Guidelines may guide accounting treatment, they do not override the Income Tax Act's provisions. The Tribunal noted that the SEBI Guidelines align with the taxation principle of spreading the discount over the vesting period but do not address adjustments at the time of exercise. Therefore, the Tribunal concluded that adjustments must be made based on the actual market price at the time of exercise.

Relevant Factors in Assessee's Case:

The Tribunal remitted the matter to the Assessing Officer (AO) for verification of the correct amount of deduction. It highlighted specific aspects for the AO to examine, including the valuation of shares, the timing of the grant of options, and the reversal of deductions for unvested or lapsed options.

Conclusion:

The Tribunal concluded that the discount on ESOP is an allowable deduction under Section 37(1) of the Income Tax Act. The deduction should be spread over the vesting period, and adjustments must be made at the time of exercise based on the actual market price. The matter was remitted to the AO for verification and quantification of the eligible deduction.

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