27 November 2020
EY Tax Alert
Karnataka HC upholds Special
Bench ruling allowing ESOP
discount as a deductible
expenditure
Tax Alerts cover significant Executive summary
tax news, developments and
changes in legislation that This Tax Alert summarizes a ruling of the Karnataka High Court (HC), dated 11
November 2020, in the case of Biocon Ltd1 (Taxpayer) on the issue of allowability of
affect Indian businesses. They Employee Stock Option Plan (ESOP) discount, being the difference between the market
act as technical summaries to value of shares and the value at which employees are granted option to acquire shares
of the employer (ESOP discount). The HC upheld the ruling of Special Bench (SB)2 of
keep you on top of the latest tax the Bangalore Income Tax Appellate Tribunal (Tribunal) that ESOP discount is a
issues. For more information, deductible expenditure and not a contingent or notional expenditure.
please contact your EY advisor. The HC held that ESOP discount represents consideration for services rendered by
employees and hence, is a deductible business expenditure. It cannot be equated with
short receipt of share premium. Rather, it is intended to earn profits by securing
employees’ consistent services. Furthermore, it is an ascertained liability since the
employer incurs an obligation to compensate employees over the vesting period,
notwithstanding the fact that the exact amount of discount is quantified only at the
time of exercising the options.
While so concluding, the HC concurred with similar rulings of the Madras HC in the case
of PVP Ventures Ltd.3, and the Delhi HC in the case of Lemon Tree Hotels Ltd4.
[1] [TS-608-HC-2020(Kar)]
[2] (2013) 35 taxmann.com 335] - Refer our alert titled “Special Bench rules ESOP discount is
deductible on vesting of options” dated 19 July 2013
[3] [(2012) 23 Taxmann.com 286 (Mad)]
[4] [(2019) 104 Taxmann.com 26 (Del)]
► The Taxpayer debited pro rata ESOP discount
to profit and loss (P&L) statement as employee
Background compensation expenses and claimed it as
business deduction for tax purposes.
► Generally, in a conventional ESOP scheme ► The tax authority disallowed the claim on the
(Scheme), the employer company undertakes to ground that the Taxpayer did not incur any
issue shares to its employees at a future date, at a expenditure and ESOP discount represented a
price usually lower than the current market price. contingent liability since there is no certainty of
options getting vested in the employees and/or
► In order to be eligible to acquire such shares, the employees exercising the options.
employees are obliged to render services and/or
achieve specified benchmarks during the vesting ► The first appellate authority upheld the tax
period. The employees acquire the right to exercise authority’s order. Aggrieved, the Taxpayer
the options on completion of the vesting period. appealed before the Tribunal.
Upon vesting, the employee can exercise the
options within a specified period. Therefore, the ► The division bench of the Tribunal referred the
three relevant events during an ESOP lifecycle are: case to the SB in view of conflicting decisions
(a.) Grant of options. (b.) Vesting of options. (c.) between different benches of the Tribunal. The
Exercise of options. SB ruled that ESOP discount is a deductible
expenditure and not a contingent or notional
► In India, ESOPs granted by listed companies5 are expenditure. Furthermore, ESOP discount is
governed by guidelines or regulations laid down by part of an employee’s remuneration which is
the Securities and Exchange Board of India (SEBI), paid to the employees in order to compensate
being the regulator for trading of securities. As per for their continuity of services to the company
the erstwhile SEBI guidelines issued in 1999, ESOP and, hence, ESOP discount is allowable as an
discount, as on the date of grant, is required to be expenditure.
treated as another form of employee compensation
by amortizing the discount over the vesting period ► The SB also held that ESOP discount deduction
of the options. As per the extant SEBI regulations, is allowable on a provisional basis on each
the company must follow the requirements of the vesting date. The exact quantum of ESOP
guidance note issued by the Institute of Chartered discount is, however, determined on the date of
Accountants of India (ICAI)6 exercise of options i.e., the difference between
the market value on the date of exercise and
the exercise price represents the cost which is
► As per the provisions of the Indian Tax Laws (ITL), actually incurred by the employer. Hence,
any expenditure which is not covered under any deduction provisionally allowed in earlier
specific sections of the PGBP7 head, but is laid out periods based on vesting of options should be
or expended wholly and exclusively for the purposes adjusted upwards or downwards based on the
of the business or profession and which is not in the market value on the date of exercise (true up
nature of capital expenditure or personal in nature, adjustment). Such true up adjustment is over
is allowed as deduction while computing the income and above adjustments that are necessitated
from business or profession (business deduction). on account of lapsing or forfeiture of options.
► Aggrieved by the SB ruling, the tax authority
Facts filed an appeal before the HC.
► The Taxpayer, a company engaged in the business
of manufacture of enzymes and pharmaceutical ► The HC admitted the appeal on the following
ingredients, floated a Scheme and transferred its issues:
shares at face value to a separate trust constituted
for administering the Scheme. a. Whether ESOP discount is allowable as
deduction in computing business income.
► The employees of the Taxpayer could exercise the
option to buy the shares within the time prescribed b. Whether the SB was right in holding that
under the Scheme. The Scheme provided for the difference between the market price
vesting of options equally over four years (i.e., 25% of shares at the time of grant of option
in each year) at the end of completion of service in and the offer price amounts to discount
each year. to be treated as remuneration for their
continuity of service.
c. Whether the SB erred on facts in not
examining the Scheme, from which it is
5
Whose shares are traded on recognized stock exchanges clear that the employees will not get any
6
Regulator of accounting profession in India
right in the shares till completion of the
7
Profits and gains of business or profession
prescribed period and, hence, the CIT11, where the SC permitted deduction for
expenditure claimed is contingent. leave encashment and warranty liability based
on scientific estimation.
► To clarify, the HC did not consider the issue of
whether the SB was correct in permitting true up ► For business deduction, it is sufficient that
adjustment on exercise of options. expenditure is incurred and, hence, grant of
ESOPs at a discount would also be an
expenditure incurred for the purposes of
business deduction. It is only a form of
compensation paid to employees and not a
Tax Authority’s contentions short capital receipt of premium.
► ESOP expenditure was neither incurred nor ► The amortization of ESOP discount over grant
accrued during the relevant tax year 2003-04 to the vesting period is in accordance with the
and, hence, it cannot be claimed as business accounting treatment prescribed in the SEBI
deduction. ESOP discount is a contingent, and guidelines. It is well-settled that business
not a crystallized, liability which was deduction is allowable on commercial
enforceable during tax year 2003-04. Since the principles of accounting12.
Taxpayer follows the mercantile method of
accounting, the expenditure is not allowable ► ESOP discount has been allowed as deduction
during the tax year under reference. by other HCs in the cases of PVP Ventures
Ltd., Lemon Tree Hotels Ltd. (supra). The tax
► ESOP expenditure is not real. It is hypothetical, authority had also accepted the Taxpayer’s
notional and imaginary. Shares were not handed claim and allowed ESOP discount deduction
over to the concerned employees and it is up to from tax year 2008-09 onwards. Hence, it
employees to, whether or not, exercise the cannot be permitted to alter its stand.
ESOPs at any time. Under the mercantile
method of accounting, unless legal liability is
incurred, the expenditure is not allowable as
accrued. HC’s ruling
► As the control of shares for the period of the The HC affirmed the SB ruling that ESOP discount is
Scheme remained with the Taxpayer, the a deductible expenditure and not a contingent or
Taxpayer had neither assumed any liability nor notional expenditure. The reasoning adopted by the
had incurred the same. Furthermore, no amount HC is briefly as follows:
was actually paid in order to be allowed as
expenditure incurred for business purpose. ► ESOP discount allowable as business
deduction
► The tax authority relied on several rulings of the
Supreme Court (SC) in support of the a. For the purposes of business deduction,
propositions that contingent liability is not expenditure need not necessarily be incurred
allowable as deduction8 and that no benefit in cash and actual pay-out is not a
arises at the stage of grant or vesting of prerequisite to claim the deduction.
options9. Incurrence of an obligation is also an
expenditure allowable as business deduction.
Taxpayer’s contentions b. Furthermore, as held by the SC in the case of
CIT v. Woodward Governor (India) Pvt.
Ltd.13, expenditure also includes a “loss”.
► ESOP discount is not a contingent liability, but Hence, issuance of shares at a discount,
an ascertained one. Since the Scheme provides where the taxpayer absorbs the difference
for 25% vesting every year over four years, the between the market value of shares and the
employees acquire definite right of 25% every discounted issue price, constitutes an
year with corresponding obligation to the expenditure allowable as business deduction.
Taxpayer.
c. By undertaking an obligation to issue shares
► In this regard, reliance was placed on the SC at a discounted premium at a future date,
rulings in the cases of Bharat Earth Movers v. the Taxpayer incurred an obligation towards
CIT10 and Rotork Controls India Pvt. Ltd. v. remunerating the employees for their
services, which is nothing but expenditure.
8
Morvi Industries Ltd v. CIT [(1971) 82 ITR 835 (SC)];
11
Keshav Mills Ltd v. CIT [(153) 23 ITR 230 (SC)]; Gajapathy [(2009) 180 taxman 422 (SC)]
Naidu v. CIT [(1964) 53 ITR 114 (SC)] 12
UP State Industrial Development Corporation v. CIT
9
Infosys Technologies Ltd v. CIT [(2008) 166 taxman 204 [(1997) 92 taxman 45 (SC)] and Challapalli Sugars Ltd v.
(SC)] CIT [(1975) 88 ITR 167 (SC)]
10 13
[(2000) 112 Taxman 61 (SC)] [(2009) 179 taxman 326 (SC)]
a. The HC concurred with the rulings of other
d. It is not correct to equate ESOP discount to HCs relied on by the Taxpayer in the cases of
short receipt of premium on issue of shares. PVP Ventures Ltd. and Lemon Tree Hotels
ESOP shares are not issued with the object Ltd. (supra), wherein the HCs allowed
of raising capital. Rather, they are intended deduction of ESOP cost.
to earn profits by securing consistent
services of the employees. ► Consistency with the position adopted in
subsequent tax years
► ESOP discount is not a contingent liability but an a. It is pertinent to mention that the tax
ascertained liability authority has allowed ESOP discount
deduction in subsequent years from tax
a. The Taxpayer’s Scheme provided for vesting year 2008-09 onwards. In view of the law
of options equally over four years (i.e., 25% laid down by the SC in the case of
in each year). Hence, the employees have a Radhasoami Satsang v. CIT14, the tax
definite right to 25% of the shares and the authority cannot be permitted to take a
Taxpayer is bound to allow the vesting of different stand in the tax year in question
25% of the options. i.e., 2003-04.
b. Since the business liability has arisen, which
the Taxpayer is obliged to honor, the ESOP
discount is allowable as an expenditure, Comments
irrespective of the fact that the exact
quantum of discount enjoyed by the Deductibility of ESOP discount is a controversial issue
employees gets determined subsequently on in the absence of specific provisions governing tax
the date of exercise. treatment of such discount.
c. ESOP discount does not represent a The present ruling follows the trend of favorable
contingent liability, but an ascertained rulings by other HCs (Madras and Delhi) in allowing
liability. The SC rulings in the cases of Bharat ESOP discount as business deduction based on
Earth Movers (supra) and Rotork Controls accounting treatment followed as per SEBI guidelines.
(supra) support this proposition. However, its significance lies in upholding the ruling of
SB which resolved the conflict of views between
different benches of the tribunal on the issue of
d. The Taxpayer had claimed deduction of allowability of ESOP discount in favor of the taxpayer.
ESOP discount over the vesting period in
accordance with the accounting in the books It is significant to note that, in the present ruling, the
of accounts which are prepared in HC did not adjudicate upon the allowability of “true up
accordance with the SEBI guidelines. adjustment” (i.e., difference between market value of
shares on the date of exercise and market value on the
► SC rulings relied on by the tax authority are date of grant). However, the SB had allowed the true
distinguishable up adjustment as a permissible deduction, even though
it was not recorded in books of account as per
a. In Infosys Technologies (supra), the SC was accounting principles. Hence, the issue of allowability
concerned about the consequences for of “true up adjustment” remains to be tested by HCs
failure to withhold taxes on the perquisite and the SC.
value, being the difference between the
market value and the total amount paid by
employees upon exercise of options. Hence,
it did not assist to decide the issue of
allowability of expenses in the hands of the
taxpayer. Furthermore, the decision pertains
to tax years 1996-97 to 1998-99 when the
ITL did not contain any specific provisions to
tax ESOP benefits.
b. The other decisions relied by the tax
authority, in fact, support the Taxpayer,
since the Taxpayer had incurred definite
legal liability. Following the mercantile
system of accounting, ESOP discount had
been rightly debited as expenditure in the
books of account.
► Concurrence with other HC rulings on
allowability of ESOP discount
14
[(1992) 193 ITR 321 (SC)]
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