2013 (8) TMI 629 - AT - Income Tax

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 ... Whether discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head profits and gains of business? - Vesting period and quantum of entitlement of shares – Held that:- The period from grant of option to the vesting of option is the `vesting period' - It is during such period that an employee is supposed to render service to the company so as to earn an entitlement to the shares at a discounted premium. The vesting period may vary from a case to case. If the vesting period is, say, four years with equal vesting at the end of each year, then it is at the end of the vesting period or during the exercise period, which in turn immediately succeeds the vesting period, that the employee becomes entitled to exercise 100 options or qualify for receipt of 100 shares at discount - Though the shares are allotted at the end of the vesting period, but it is during such vesting period that the entitlement is earned. It means that 25 options vest with the employee at the end of each year on his rendering service for the respective year. If during the interregnum, he leaves the service, say after one year, he will still remain entitled to exercise option for 25 shares at the discounted premium at the time of exercise of option. In that case, the benefit which would have accrued to him at the end of the second, third and fourth years would stand forfeited. Thus it becomes abundantly clear that an employee becomes entitled to the shares at a discounted premium over the vesting period depending upon the length of service provided by him to the company. In all such schemes, it is at the end of the vesting period that option is exercisable albeit the proportionate right to option is acquired by rendering service at the end of each year. Quantification of ESOP discount – Subsequent adjustment at the time of exercise of options – Held that:- Company incurs a definite liability during the vesting period, but its proper quantification is not possible at that stage as the actual amount of employees cost to the company, can be finally determined at the time of the exercise of option or when the options remain unvested or lapse at the end of the exercise period. It is at this later stage that the provisional amount of discount on ESOP, initially quantified on the basis of market price at the time of grant of options, needs to be suitably adjusted with the actual amount of discount. ESOP discount – Held that:- Discount under ESOP is in the nature of employees cost and is hence deductible during the vesting period w.r.t. the market price of shares at the time of grant of options to the employees - The amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvesting/lapsing options at the appropriate time. However, an adjustment to the income is called for at the time of exercise of option by the amount of difference in the amount of discount calculated with reference the market price at the time of grant of option and the market price at the time of exercise of option. No accounting principle can be determinative in the matter of computation of total income under the Act. The question before the special bench is thus answered in affirmative by holding that discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head `Profits and gains of business or profession'. Deduction for discount – Discount amounting to ₹ 3.38 crore for the A.Y. 2003-04 - On being called upon to furnish bifurcation of such claim, the assessee filed a chart showing its detail comprising of four amounts. First amount of ₹ 1.62 crore has been shown as the first tranche of 25% option. Second amount of ₹ 81.25 lakh as the second tranche of 25% option; third amount of ₹ 54.16 lakh as the third tranche of 25% option and the last amount of ₹ 40.62 lakh as the fourth tranche of 25% option – Held that:- Last three amounts can’t qualify for deduction at the end of the first year itself - Assessee claimed deduction for the proportionate part of discount for the second, third and fourth year at the end of the first year itself because 25% of options vested in the employees at the end of the first to fourth year each. This defies all logics and rationalities - When the options vest equally over a period of four years, it is but natural that the company would incur equal liability for the discounted premium @ 25% of total discount on receipt of services of the employees at the end of each year. The way in which the assessee has claimed deduction runs contrary even to the SEBI Guidelines, which also provide for deduction on straight line basis. The manner of the assessee's claiming deduction has resulted in needlessly increasing the amount of deduction for the first year at the cost of deduction for the subsequent three years. It needs to be set right by apportioning the total amount of the discounted premium evenly over the vesting period of four years. 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.