2020 (11) TMI 779 - HC - Income Tax

ESOP share-issue discount treated as employee pay u/s37(1), deductible over vesting period; tax authority appeal dismissed

Whether ESOP discount is deductible under s.37(1) was the dominant issue. The HC held that 'expenditure' includes loss; issuing shares at a discount, with ... Deduction under Section 37(1) of the Income-tax Act - Employees Stock Option Plan (ESOP) discount as remuneration - Ascertainment of business liability under mercantile system of accounting - Vesting creating enforceable right - Allocation of ESOP expense over the vesting period - Non-applicability of TDS decision in determining employer's deductionDeduction under Section 37(1) of the Income-tax Act - Employees Stock Option Plan (ESOP) discount as remuneration - Ascertainment of business liability under mercantile system of accounting - Vesting creating enforceable right - Allocation of ESOP expense over the vesting period - Whether the difference between market price and grant/offer price of shares under ESOP (the 'discount') is allowable as a deduction under Section 37(1) for Assessment Year 2004-05 - HELD THAT: - The Court examined whether the ESOP discount constituted an expenditure 'laid out or expended' within the meaning of Section 37(1). Noting that Section 37(1) does not require a cash payout and that 'expenditure' includes a loss, the Court accepted the tribunal's finding that the employer incurs an ascertainable business liability when options vest. The scheme in question provided for vesting at 25% per year over four years so that at the end of the first year employees acquire a definite right to the vested portion; consequently the employer is bound to allow vesting and has incurred a liability even though quantification or payment may occur later. The Court relied on the principle that, under the mercantile system of accounting, a business liability which has arisen in the accounting year is deductible though the final discharge may be in a later year. The Court further held that the discount is compensatory - a form of remuneration to secure employees' continuity of service - and is not a mere contingent, hypothetical or capital diminution. The allocation of the discount over the vesting period, consistent with the accounting treatment and SEBI guidelines, was held to be appropriate. The Court rejected reliance on the decision dealing with TDS (Infosys) as not determinative of the employer's right to deduction, and observed that subsequent practice by the revenue in later assessment years (from 2009-10) supported consistency in treatment. [Paras 7, 9, 10, 11, 12]The ESOP discount (difference between market price and grant price) is an ascertained business expenditure and, subject to fulfillment of conditions and appropriate allocation over the vesting period, is allowable as a deduction under Section 37(1) for AY 2004-05.Final Conclusion: Substantial questions of law framed were answered against the revenue and in favour of the assessee; the appeal is dismissed. Issues Involved:1. Deductibility of ESOP discounts under Section 37 of the Income Tax Act, 1961.2. Classification of the difference between market price and offer price of shares as remuneration.3. Contingent nature of ESOP-related expenditure and its eligibility for deduction.Detailed Analysis:Issue 1: Deductibility of ESOP Discounts under Section 37 of the Income Tax Act, 1961The primary issue was whether the discount on the issue of Employee Stock Option Plans (ESOP) is an allowable deduction in computing business income under Section 37 of the Income Tax Act, 1961. The tribunal held that the difference between the market price and the face value at which shares are allotted is part of remuneration to employees for their continuity of service and is allowable as an expenditure under Section 37. The High Court agreed, noting that Section 37(1) permits deduction for expenditure laid out or expended and does not require a cash payout. The court emphasized that the issuance of shares at a discount, where the assessee absorbs the difference between the issue price and the market value, constitutes an incurred expenditure for the purposes of Section 37(1). This expenditure is aimed at securing consistent employee services, not wasting capital, thus qualifying as a deductible business expense.Issue 2: Classification of the Difference Between Market Price and Offer Price of Shares as RemunerationThe tribunal concluded that the difference between the market price of shares at the time of granting the option and the offer price amounts to a discount, which should be treated as remuneration to employees. The High Court upheld this view, explaining that the ESOPs vest over a period (in this case, four years), and employees gain a definite right to a portion of the shares each year. This vesting creates a business liability that is permissible as a deduction, even if the liability is quantified and discharged in the future. The court cited Supreme Court decisions in Bharat Earth Movers and Rotork Controls India, affirming that such discounts are not contingent liabilities but ascertained ones.Issue 3: Contingent Nature of ESOP-Related Expenditure and Its Eligibility for DeductionThe revenue argued that the ESOP expenses were neither incurred nor accrued during the relevant assessment year and were contingent, not crystallized liabilities. The High Court rejected this argument, stating that the ESOP expenditure is an ascertained liability, not contingent. The court noted that the deduction of ESOP discounts over the vesting period aligns with accounting practices under SEBI guidelines. The court also dismissed the revenue's reliance on the Infosys Technologies case, clarifying that it dealt with non-deduction of tax at source and not the allowability of expenses in the employer's hands. The court concluded that the assessee's practice of debiting ESOP discounts as expenditure in its books was appropriate under the mercantile system of accounting.Conclusion:The High Court dismissed the revenue's appeal, affirming the tribunal's decision that the ESOP-related expenses are allowable deductions under Section 37 of the Income Tax Act. The court emphasized that the ESOP discounts represent a definite business liability and are not contingent, thereby supporting the assessee's claim for deduction. The court also highlighted the consistency in the assessee's accounting practices and the acceptance of similar deductions in subsequent assessment years.