TAX TREATMENT OF ESOP DISCOUNT – BIOCON CASE

Income Tax Appellate Tribunal in a recent order (Dy. Commissioner of Income-tax (LTU), Bangalore Vs M/s. Biocon Limited) (“Case”) held that “discounts under the ESOP are an employee cost and should be allowed as a deduction over the vesting period, in the hands of the issuing company.” The above order of ITAT will clear certain ambiguities surrounding the accounting treatment of “discount” provided by the Companies.

In an ESOP, the shares are issued to the employees at a future date (after vesting period) at price lower than fair market value (FMV) of the share.

Hence ESOP discount, is nothing but the reward for services, is a taxable perquisite to the employee at the time of exercise of option, and its valuation is to be done by considering the fair market value of the shares on the date on which the option is exercised.

Please read the Order here.  It is about 50 pages only and must admit it is one of the really well drafted order and you’ll enjoy reading it as much as we did.

Brief Facts of the Case:  

  • Assessee Company (Biocon) had set up ESOP Plan for its employees, where exercise price of options granted was Rs. 10 against the FMV of Rs. 919, thereby giving an upside per option at Rs. 909.
  • Assessee granted certain options to its employees at the above exercise price and total of 6.52 crore was claimed as compensation (difference between Exercise and FMV) to the employees to be spread over the vesting period of four years.
    • Assessee claimed discount under ESOP as employee compensation cost under section 37(1) of the Income tax Act, and claimed a deduction of 3.38 crore in conformity with SEBI Guidelines
    • Assessing Officer disallowed deduction of the same, on the ground that there being no provision to claim deduction under said section.

Issues Involved

Whether the ESOP compensation is an allowable deduction in the computation of income under the head “Profits and gains of business or profession”? Three questions emanating from the statement are as follows:

a)    Whether any deduction of such discount is allowable?

b)    If yes, then when and how much?

c)    Subsequent adjustment to discount

Held:

One of the contentions of the Department was that since there has been no cash outflow from the books of the Assessee, there is no question of expense incurred, hence no deduction can be allowed, as the company has issued options (which will become shares at time of exercise) at a discounted rate to incentivize their employees.

However, it was held that u/s 37(1), which states “Any expenditure laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.

And, reliance was made on certain Supreme Court cases, which held the expression “expenditure” as used in section 37covers an amount which is really a “loss” even though the said amount has not gone out from the pocket of the assessee.

Hence, even though the Assesee, didn’t make any cash outflow at the time of exercise of options, however it suffered a notional loss, while issuing shares at a discounted rate to its employees. Hence such an expense/expenditure is allowed as a deduction as they are employee cost to the company/assessee.

Contingent Liability:

Tribunal also held that such an event is not a contingent liability: “If we consider it at micro level qua each individual employee, it may sound contingent, but if view it at macro level qua the group of employees as a whole, it loses the tag of `contingent’ because any lapsing options (because of termination of the employee during vesting period) are up for grabs to the other eligible employees. In any case, if some of the options remain unvested or are not exercised, the discount hitherto claimed as deduction is required to be reversed and offered for taxation in such later year. We, therefore, hold that the discount in relation to options vesting during the year cannot be held as a contingent liability”

When and How Much Discount:

It was further debated, on when is the deduction to be allowed and to what extent such deduction is allowed. It was held that no liability on the Company arises at the time of grant of options or at the time of exercise or thereafter.

The actual liability arises during the vesting period and hence held that “the liability to pay the discounted premium is incurred during the vesting period and the amount of such deduction is to be found out as per the terms of the ESOP scheme by considering the period and percentage of vesting during such period”.

Reliance was made on one Re. SSI Limited, case law where deduction was allowed of the discounted premium during the years of vesting on a straight line basis.

Subsequent adjustment to cost

A very important point that emanates from this case is regarding to the variation of FMV of the share at time of exercise.

Now, since the expenditure is allowed as a deduction during vesting period, and as expenditure is difference between the exercise price and FMV, there might be a situation, where the FMV calculated by the company for granting options differs from the actual FMV at the time of exercise.

The accounting of such variations were also dicussed and it was held that

  • “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”. Like in case the options lapsed or are unvested the deduction claimed on such options shall be reversed back in the books of the Company.
  • 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.”

In case there is increase in the FMV at the time of exercise to what Company has claimed deduction for, the Company is still eligible to claim the difference in the valuation in relevant assessment years.

Similarly, if the FMV drops from the valuation at which company has made reliance on, than the Company shall be obligated to reverse the over expensed amount.

Conclusion:

This order of ITAT will help in substantially reducing the ambiguities around the accounting treatment of the discount/expenditure incurred by the Company. Hence it was summed up as follows:

“That the discount under ESOP is in the nature of employees cost and is hence deductible during the vesting period. 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’.”

Disclaimer:  This is not a legal opinion and should not be construed as one. Please speak with your attorney for any advice.

Dheeraj Khanna, Senior Associate, specializes in structuring businesses and IP.

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