Discount on ESOP – The contentious issue!

1. Employee Stock Option Plan / Scheme

1.1 An employee stock option Plan (hereinafter referred to as 'ESOP') is a stock option granted to specified employees of a company. ESOPs carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price. Section 2(15A) of the Indian Companies

Act, 1956 defines "Employee Stock Option" to mean 'the option given to the whole-time Directors, Officers or employees of a company, which gives such Directors, Officers or employees, the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a predetermined price'.

1.2 The idea behind stock options is to align incentives between the employees and shareholders of a company. Shareholders want to see the stock appreciate, so rewarding employees when the stock goes up ensures, in theory that everyone is striving for the same goals.

1.3 In an ESOP, the company undertakes to issue shares to its employees at a future date either free or at a price lower than the current market price. This is achieved by granting stock options to its employees at discount. The amount of discount represents the difference between market price of the shares at the time of the grant of option and the offer price.

1.4 In order to be eligible for acquiring the shares under the ESOP, the concerned employees are obliged to render services to the company during the vesting period as given in the scheme. On the completion of the vesting period in the service of the company, such options vest with the employees. The options are then exercised by the employees by making application to the employer for the issue of shares against the options vested in them.

1.5 The gap between the completion of vesting period and the time for exercising the options is usually negligible. The company, on the exercise of option by the employees, allots shares to them who can then freely sell such shares in the open market subject to the terms of the ESOP.

1.6 It is during the vesting period that the options granted to the employees vest with them. This period commences with the grant of option and terminates when the options so granted vesting in the employees after serving the company for the agreed period.

1.7 On the biggest advantage for the Companies granting option is that by granting the options, the company gets assurance from its employee for rendering uninterrupted services during the vesting period and as a quid pro quo it undertakes to compensate the employees with a certain amount given in the shape of discounted premium on the issue of shares.

1.8 Such ESOPs are very customary in the knowledge based and other service sector companies where the major dependence is on the skilled staff.

2. Treatment of Discount on issue of shares offered in ESOP

2.1 Certain recent judicial precedence suggests that the tax fraternity is grappling with the controversy on the tax treatment of the discount on the shares issued to the employees under ESOP.

2.2 The companies that issue shares under ESOP have been claiming such discount is a loss to the company and therefore should be allowed as deduction while computing the income under the head 'Profits and gains from Business and Profession'. Such deduction for discount is, however, not claimed at one stroke but is amortized over the vesting period. On the other hand, the revenue has been contending that the said discount can never be allowed as deduction.

2.3 The revenue's claim is based on the following contentions:

♦ The discount offered under ESOP is not in the nature of expenditure
♦ Such discount is not in the normal course of routine business carried on by the Company.
♦ Such discount merely represents short receipt of premium on issue of shares. If the receipt of premium is not taxable, the short receipt of such premium should also not be allowed as deduction.
♦ At the most, such discount could be considered as ashort capital receipt or a sort of capital expenditure
Therefore, the discount on issue of shares under ESOP should not be allowable

2.4 Conversely, the Companies issuing ESOP provide the following reasoning for claiming the deduction for discount:

♦ The primary object of ESOP is not to raise share capital but to earn profit by securing the consistent and concentrated efforts of its dedicated employees during the vesting period. Therefore, such discount should be construed as nothing but a part of package of remuneration. Such discounted premium on shares is a substitute to giving direct incentive in cash for availing the services of the employees.
♦ If Company would have issued shares to public at market price and would have paid part of such premium to the employees as incentives, the same would have been allowed as deduction. Issue of shares at discount to employees is a similar transaction and therefore discount is nothing but the employee cost.
3. Judicial Precedence

3.1 One of the earliest decisive verdict on the issue of allowability of discount on shares issued under ESOP was a special bench decision of Bangalore Tribunal in case of Biocon Ltd. v. Dy. CIT [2013] 35 taxmann.com 335/[2014] 144 ITR 21 (Bnag. - Trib.). In this case, the special bench had decided the matter in favour of the company issuing shares under ESOP stating that the discount is an allowable deduction under section 37(1) during years of vesting on basis of percentage of vesting during such period, subject to adjustment at time of exercise of option

3.2 The above Special Bench's decision has been followed by several other tribunals in the following decisions:

♦ Apollo Health Street v Dy. CIT [2014] 45 taxmann.com 507/151 ITD 246 (Hyd. Trib.)
♦ Bharti Airtel Ltd. v Addl CIT [2014] 43 taxmann.com 50/64 SOT 50 (URO) (Del. Trib)
♦ Dr. Reddy's Laboratories Ltd. v Addl. CIT (No. 1) [2014] 51 taxmann.com 136/66 SOT 159 (Hyd. Trib)
♦ HDFC Bank Ltd. v Dy. CIT [2015] 61 taxmann.com 361 (Mum. - Trib)
3.3 The prominent decision holding that the discount on issue of shares under ESOP is to be disallowed and therefore favoring the revenue is that of Delhi Tribunal in the case of Asstt. CIT v. Ranbaxy Laboratories Ltd. [2012] 20 taxmann.com 334

3.4 It is pertinent to note that we do not seem to have any high court decisions on this issue.

4. Conclusion / Need for Clarification

4.1 In order to avoid unnecessary litigation, it is prudent for the Finance Minister to clarify its stand on the tax treatment of Discount on issue of shares under ESOP.

4.2 The industry expects a clarification in line with the Special Bench's decision stating that the discount on ESOP scheme should be amortized over the vesting period.

4.3 Such clarification, if brought in the Finance Bill, 2016will not only put this contentious issue to rest but also bring cheer to the Knowledge-based companies and other companies mostly in service sector that either have or are planning to come up with ESOPs.