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Employee Stock Option Plan (ESOP) is one of the most popular ways in which companies motivate employees to perform better and retain them. In a typical ESOP, employees are granted options to purchase shares in the company at a substantial discount to the market price. The scheme runs over a period of time called vesting period. The employees become entitled to receive the shares after fulfilling conditions in the scheme.
For accounting, the discount on ESOPs (difference between the market price of shares and the amount recovered from employees) is usually spread out over the vesting period. A proportionate discount is charged to the profit-and-loss account each year as employee compensation. The issue of whether the discount on ESOP can be allowed as a business expense is contentious, with judiciaries ruling both for and against it.
In one case, it was held that issue of shares at a discount represented short receipt of premium on shares. As premium was not taxable as income, the short receipt of premium was not a loss to the company. Furthermore, as the issue of shares does not involve outgo of funds, it has been held that there is no expense for the company and, consequently, the discount was not allowable business expenditure. In another case, however, it was held that the difference between the market price and the price at which the shares were issued to employees, debited to profit-and-loss account, was allowable business expenditure and an ascertained liability.
A recent ruling in the case of Biocon Ltd, by a Special Bench of the Income Tax Appellate Tribunal in Bangalore, tried to settle the issue. The ITAT ruled that the discount on shares issued under ESOP (and accounted for according to SEBI guidelines) is an allowable expenditure and not a short receipt of premium. The ITAT observed that the discount on ESOP shares was part of employee remuneration and only a substitute for direct cash incentive. As ‘expenditure’ includes a loss, and if there is no money outgo, the discount on ESOP shares was allowable business expenditure.
The ITAT observed that under the company’s ESOP scheme, at the end of each year it was obligatory for the company to allow vesting of 25 per cent of options. Hence, the company incurred the liability of allowing proportionate discount at the end of each year of the vesting period. The actual liability, however, crystallised at the end of the fourth year when the options were exercised by the employees. The company’s liability was not contingent liability as it stood incurred at the end of each year when employees rendered services and became entitled to receive proportionate options. The ITAT also observed that deduction with respect to the discount would be allowed over the vesting period, on the basis of the period and percentage of vesting. Further, at the end of the vesting period the discount would be adjusted in the light of the market price of the shares at the time of exercising the options. This would result in a higher deduction (when market price was higher) and vice-versa.
Thus, the tribunal has approved that the discount on ESOP shares can be allowed as business expense. This would be helpful to companies that have accounted for the discount according to SEBI guidelines and claimed deduction in their litigation with tax authorities. However, for companies for which SEBI guidelines do not apply, the decision would have limited applicability.
The authors are chartered accountants