2016 (4) TMI 905 - AT - Income Tax

Appellate Tribunal reverses disallowance under Income Tax Act, recognizes ESOP expenses as deductible business costs.

The Appellate Tribunal allowed the appellant's appeal, overturning the disallowance under section 14A of the Income Tax Act and rejecting the addition of ... Disallowance of expenditure attributable to exempt income under section 14A read with Rule 8D - Nexus requirement between expenditure and exempt income for making a disallowance - Relevance of funding source (investment out of own funds) in applying section 14A/Rule 8D - Allowability of ESOP cost as business expenditure under section 37(1) - Timing of deduction for ESOP expenses-vesting/exercise as determinative of liabilityDisallowance of expenditure attributable to exempt income under section 14A read with Rule 8D - Nexus requirement between expenditure and exempt income for making a disallowance - Relevance of funding source (investment out of own funds) in applying section 14A/Rule 8D - Whether the Assessing Officer could invoke section 14A read with Rule 8D to make a disallowance without recording satisfaction, obtaining and considering the assessee's explanation and establishing that any expenditure was incurred to earn exempt (dividend) income. - HELD THAT: - The AO applied Rule 8D and made a mechanical disallowance without indicating what expenditure, if any, had been incurred to earn the dividend income or recording requisite satisfaction prior to invoking section 14A read with Rule 8D. The Tribunal held that invocation of the provisions requires the AO to record satisfaction and to elicit and consider the assessee's explanation; absent any expenditure incurred to earn exempt income, section 14A/Rule 8D cannot be applied. The Bench disagreed with the FAA's view that the fact of investment out of own funds was irrelevant. The Tribunal relied on the principle stated by the Hon'ble Delhi High Court in Om Prakash Khaitan that a nexus between the expenditure claimed and the exempt income is essential before any disallowance can be made, and concluded that the disallowance made by AO (and upheld by FAA referring to Godrej & Boyce Ltd. ) could not stand where no expenditure to earn exempt income was shown or examined by the AO.Order of the authorities disallowing expenditure under section 14A read with Rule 8D is reversed and Ground No.1 is allowed in favour of the assessee.Allowability of ESOP cost as business expenditure under section 37(1) - Timing of deduction for ESOP expenses-vesting/exercise as determinative of liability - Distinction between payment of Fringe Benefit Tax and allowability of ESOP cost - Whether the amount debited by the assessee on account of stock awarded under ESOP (paid to parent company) is allowable as business expenditure in the relevant year despite FBT having been paid only on the portion vested during that year. - HELD THAT: - The Tribunal found that the assessee had purchased stock/options from its parent and had paid the parent company; part of the ESOP value had been assessed for FBT in the year but the assessee had accounted the entire cost in its books. The Bench accepted the principle that once stock options are granted to and exercised by employees, the liability is ascertained and the cost is allowable in the year in which options are granted/exercised. Relying on the decision in Novo Nordisk India Pvt. Ltd. (as applied in the facts), the Tribunal held that where shares of the parent are offered to employees of the assessee, the difference between FMV and issue price constitutes an allowable business expenditure under section 37(1). The distinction between the incidence/timing of FBT and the allowability of the ESOP expenditure was recognised and, following the precedent, the addition made by the AO was deleted.Ground No.2 is allowed and the addition made by the AO in respect of ESOP cost is deleted; the ESOP cost is held allowable.Final Conclusion: The appeal is allowed: the disallowance under section 14A read with Rule 8D is set aside for want of recorded satisfaction and nexus, and the addition in respect of ESOP cost is deleted with the ESOP expenditure held allowable in the year options vested/exercised. Issues:1. Disallowance u/s. 14A of the Act2. Addition of expenditure under ESOP (Employee Stock Option Scheme)Analysis:Issue 1: Disallowance u/s. 14A of the ActThe appellant, a company engaged in executive search and consulting, challenged the disallowance of &8377; 2.74 lakhs under section 14A of the Income Tax Act. The Assessing Officer (AO) invoked Rule 8D of the Income Tax Rules, 1962, to make the disallowance based on the dividend income claimed by the appellant. The First Appellate Authority (FAA) upheld the AO's decision, citing the judgment of Godrej & Boyce Ltd. The Appellate Tribunal found that the AO did not specify the actual expenditure incurred for earning tax-free income and emphasized the need for a nexus between expenditure and income not forming part of total income. Relying on the case of Om Prakash Khaitan, the Tribunal reversed the FAA's order, stating that the AO must establish a connection between expenditure and non-taxable income. Ground No.1 was decided in favor of the appellant.Issue 2: Addition of expenditure under ESOPThe AO added &8377; 56.40 lakhs to the appellant's income, alleging that the full amount debited under ESOP was not paid as Fringe Benefit Tax (FBT). The appellant argued that ESOP expenses and FBT payment were distinct concepts, and the FBT liability arises upon ESOP vesting in employees. The Tribunal noted that the appellant had paid FBT on a portion of the ESOP amount and treated the ESOP expenditure as compensation cost. Relying on precedents like Biocon Ltd. and Novo Nordisk India Pvt. Ltd., the Tribunal held that once stock options are exercised, the liability is ascertained, and the cost is allowable in the same year. Following the decision in Novo Nordisk India Pvt. Ltd., the Tribunal decided Ground No.2 in favor of the appellant.In conclusion, the appeal filed by the appellant was allowed by the Appellate Tribunal, emphasizing the importance of establishing a direct link between expenditure and income for disallowance under section 14A and recognizing ESOP expenses as deductible business costs.