The Hindu Business Line : Fringe benefit to employer from FBT on ESOP

The FBT (Fringe Benefit Tax) on ESOP (Employee Stock Option Scheme) and its legal recovery from the employee is now law. The employer has emerged the least affected, and for right reasons. But can the employer also hope to walk away with more benefit?

To answer this question, let us focus on the employer. Can he now claim ESOP as tax-deductible expenditure and, if so, what steps should precede for such a claim to pass through?

There is nothing in law that prohibits or prevents a company from claiming ESOP as tax-deductible expenditure. Charging ESOP as expenditure in the books of the company is well accepted, and in fact required as per SEBI guidelines and the ICAI guidance note.

Nobel Laureate Prof Robert Merton has this to say in an article in the March 2003 issue of Harvard Business Review: "For the last time: stock options are an expense." If the case for expensing ESOP in the books of accounts is so emphatic, why is it that it is not so when it comes to tax treatment?

If ESOP is treated as a fringe benefit (rather than as perquisite) meaning it is an expenditure incurred by the employer for the employee, and the tax thereon (FBT) is legally permitted to be passed on to the employee, then there should be nothing which should come in the way of treating ESOP as tax deductible expense in the books of the employer. But life is not so simple.

Take, for example, CBDT's FAQ (as it existed in 2006). A reading of FAQs 8 and 35 together leads to the inference that:

a) ESOP, if it is to be taxed as FBT, will have to be allowed as a deduction under Section 37(1) and not disallowed under Sections 40 and 40-A of the I-T Act; and

b) What comes in the way is valuation of the ESOP for tax purposes.

What will make ESOP a tax-deductible expenditure?

A standalone and conjoint reading of some of the tribunal and court judgments covering some of these aspects leads to the following, for ESOP to be able to be charged off as tax deductible expense:

The expenditure is quantifiable or at least quantified by statute, as in the case of cost of goodwill, which is deemed to be nil for calculating capital gains.

The expenditure is accounted in the books, according to the practice the company has been generally following ( Section 145 of the I-T Act).

The onus of proving necessary facts is on the assessee and if the assessee fails to establish the facts necessary for supporting his claim for deduction under Section 37(1), the claim is not admissible (CIT vs Calcutta Agency Ltd — 1951 19 ITR 191 SC).

Is ESOP a notional expenditure?

This controversy arises because of not appreciating the basic idea of an option. Normally, a company does not write market-traded options, while for ESOP it writes options. Except for a few restrictions on employee option, the nature of the option does not change.

Quantification of ESOP expenditure has been a contentious issue. Drawing from Prof Robert Merton's statement in the US Senate Committee on Stock Option Accounting Reforms Act, at least two issues emerge clearly:

a) Compensatory stock options are a real cost to the company: "... the form in which the compensation is paid by the firm should not decide whether it is expensed or not... ." He states further, "... even if no cash changes hands, issuing stock options to employees incurs a scarifies of cash... "

b) "The cost to the firm of compensatory option can be estimated."

Financial institutions throughout the world, India included, value and execute transactions involving all kinds of options and derivative securities in large volumes. These are valued using different models, and these valuations are in fact tacitly accepted by the tax administration.

If these are notional then any outcome derived from it cannot be real and, hence, subjected to tax.

Prof Merton further states that owing to the special nature of compensatory options, they have little/negligible impact on valuation of a relatively short period option.

This expert view demolishes the contention that ESOP expense is notional to the employer.

Enter CBDT

In this context, when the CBDT issues guidelines to value ESOP on the vesting date, it is also basing its valuation on the market price on the date, which is real.

Also, can the valuation of benefit conferred on the employee for FBT calculation be different from the cost of the benefit suffered by the employer for his own taxation? By allowing such a difference to emerge, the tax department will be creating not only a tax but also an accounting fiction.

The second issue relates to accounting. It is again an accepted principle that for claiming expenditure the company will have to actually charge off the expense in its books.

SEBI guidelines applicable to listed companies and the ICAI guidance note recommend expensing and provide detailed accounting steps. The focus of SEBI is reporting to shareholders at the earliest, while the ICAI goes more by possible accounting convention. The ICAI is yet to issue its accounting standard and there is room for churning of views on the subject. Both the views are not from the perspective of impact of taxation on the company and, for that matter, it is not their agenda.

Without stirring the Hornet's nest, the corporate sector would need to take a call at this stage, and adopt it as its accounting practice for ESOP. The aggressive nature or otherwise of the stance will be a function of the specific circumstances.

This will be a non-trivial step, needed for establishing claim for deduction. The responsibility to providing support and proving the claim still vests with the assessee.

Where does this eventually leave the employer? By carefully planning and leading the sequence of steps, employers can make FBT on ESOP a true fringe benefit to them.

What is in it for the tax department? If the mirror image of FBT collected is to be allowed as deduction from taxable income of the corporate, then what is in it for the tax department? Will they have to settle for this position?

Maybe yes, if the legislation tends to be ad hoc and piecemeal as in the case of taxation of ESOP.

(The author is a Chennai-based management consultant and can be reached at pbramanujam@yahoo.com.)

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