The Hindu Business Line : Sweating it out on ESOPs

THE provisions relating to determining perquisites in case of employee stock options (ESOPs) and the effectiveness of Board circulars came up before the Bangalore Bench of the Income-Tax Appellate Tribunal (ITAT) in the Infosys Technologies Ltd (ITL) vs Deputy Commissioner of Income Tax (2003 130 Taxman 129) case.

The facts of the case were that ITL had formulated an ESOP scheme for its employees. A trust was set up by ITL which was allotted 7,50,000 warrants of Re 1 each, entitling the holder to apply for and be allotted one equity share of the face value of Rs 10. For this, the employee had to fork out a nominal amount of Rs 100.

The trust was to hold the securities and to transfer them to the employees as per the terms and conditions of the ESOP. ITL had deducted tax at source on the payments to the employees but did not deduct tax treating the ESOPs as a perquisite. The assessing officer (AO) passed an order under Section 201 holding the assessee as in default. The Commissioner (Appeals) did not see any reason to disagree with the AO.

The ITAT, in a well-reasoned judgement, rejected the stance of both the AO and the Commissioner (Appeals). To validate their stand, the ITAT put forward the following counter arguments:

At the outset, it was stated that for the assessment years under consideration, there was no provision in law which made such benefit taxable as income.

The terms income, salary and perquisites are defined in an inclusive manner by Sections 2(24), 15 and 17(2) respectively. However, the definition is not all-embracing.

The word income should be regarded as purposeful in its import. Hence, it would not encompass every receipt or every benefit. In the case under hearing, there was no contemplation of unencumbered allotment of shares.

The shares could not be obtained by the employees till the lock-in period was over and the other terms and conditions were fulfilled. Hence, the benefit was both notional and contingent — such prospective or potential benefit could not be brought under the realm of the term income.

The Finance Act, 1999 introduced some provisions regarding taxing of ESOPs. However, they were quickly deleted by the Finance Act, 2000 when fresh provisions were introduced. The Department sought to apply these provisions from a retrospective date and for the assessment years under litigation. This argument too was vetoed by the ITAT saying that the orders were not retrospective.

The ESOP, in its concept, normally has a uniform philosophy. However, the procedures followed by companies to implement ESOP may not be uniform. As a result, this would bring in a lot of subjectiveness in taxing ESOPs by different AOs. There has to be certainty and uniformity in valuing and taxing a perquisite. In the absence of a mechanism for computation of the value of perquisite laid down by law, the charge itself would fail.

It is a cardinal principle of taxation that what has to be taxed is real income and not any hypothetical, notional or imaginary income. The benefits should not be subjected to a number of conditionalties or obligations. In the case under review, the physical custody of the shares was not with the employees. It was with the trust.

The possessory right, the sine qua non of ownership, was not available with the employees. They may be entitled to enjoy dividends, bonuses shares, and so on, but these were again dependent on the financials of the company.

The employees could not demand the same as a matter of right. In case the employee resigned during the lock-in period, his entitlement to the shares would expire.

A debate also ensued as to the value of the benefit to be taxed. As per the norms of taxation, the `fair-market value' had to be adopted. However, in the ESOP scheme as formulated, the fair-market value of the shares at some future date could not be visualised. Hence, all the employee would get in the interregnum would be Rs 100 which has to be considered as the value.

To substantiate their stand, the Department relied on Circular No 710 for legislative intent. They once again put forth the argument to apply this retrospectively.

While conceding that the circular did provide information as to how to value a perquisite, the ITAT ruled that it could not be applied from a previous date. Board circulars cannot create any law or lay down any law. All they can do is to properly administer the law and, hence, the circular dated later was not binding on the assessee.

ITL argued that during the period under review, taxation of ESOPs were under a cloud of doubt. The government-appointed committee had suggested that ESOPs were to be taxed only at the time of sale, the CBDT circulars issued that that period were silent about the taxation of ESOPs, the clarification sought from the CBDT was not forthcoming and also there was no specific provision in the Act taxing ESOPs.

The ITAT held that under Section 192, an employer is required to deduct tax at source on the estimated income of the employee. An estimation would involve guesswork. Precision is neither demanded nor expected.

What is needed is a fair, honest and bona fide estimation. ITL had made valiant attempts to clear the doubt regarding taxation of ESOPs to no avail. They could not be held guilty for no fault of theirs.

However, based on the order of the Commissioner (Appeals), ITL proceeded to deduct tax at source from the employees. Latching on to this, the Department held that ITL was no longer an aggrieved person and, hence, they did not have a right of further appeal. The ITAT rejected this stand, too, holding that there were no such specific provisions in Section 246A.

This Tribunal's decision has brought much insight into the definition of income, taxation and valuation of perquisites as also the validity of Board circulars.

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