Facts:
The assessee-company floated an ESOP scheme, under which it granted option of shares with face value of Rs. 10 at the same rate by claiming that the market price of such shares was Rs. 919, thereby claiming the total discount per option at Rs. 909. The difference between the alleged market price and the exercise price, at Rs. 909 per option was claimed as compensation to the employees to be spread over the vesting period of four years on the strength of the SEBI Guidelines and accounting principles. The assessee claimed that the employee stock option compensation expense was deductible u/s. 37(1).
The revenue did not accept the assessee’s contention of the supremacy of the accounting principles and SEBI Guidelines for the purposes of computation of total income on ground that it was a short capital receipt and a contingent liability. The revenue also canvassed a view that expenditure denotes “paying out or away” and unless the money goes out from the assessee, there can be no expenditure so as to qualify for deduction u/s. 37.
A Special Bench was constituted by the Division bench to decide whether discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head profits and gains of business.
Held:
The Special Bench analysed this issue by sub-dividing it into three questions , viz.,
I. Whether any deduction of such discount is allowable?
When a company undertakes to issue shares to its employees at a discount on a future date, the primary object of this exercise 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. Such discount is simply one of the modes of compensating the employees for their services and is a part of their remuneration. Thus, the contention of the revenue that by issuing shares to employees at a discount, the company got a lower capital receipt, is bereft of any force.
From the stand point of the company, the options under ESOP vest with the employees at the rate of 25 % only on putting in service for one year by the employees. Once the service is rendered for one year, it becomes obligatory on the part of the company to honour its commitment of allowing the vesting of 25 % of the option. The mere fact that the quantification is not precisely possible at the time of incurring the liability would not make an ascertained liability a contingent. It is, therefore, held that the discount in relation to options vesting during the year cannot be regarded as a contingent liability.
When the definition of the word “paid” u/s. 43(2) is read in juxtaposition to section 37(1), the position which emerges is that it is not only paying of expenditure, but also incurring of the expenditure which entails deduction u/s. 37(1) subject to the fulfillment of other conditions. Thus discount on shares under the ESOP is an allowable deduction.
II. If deductible, then when and how much?
Mere granting of option does neither entitle the employee to exercise such option nor allow the company to claim deduction for the discounted premium. It is during the vesting period that the company incurs obligation to issue discounted shares at the time of exercise of option. Thus the event of granting options does not cast any liability on the company. On the other end is the date of exercising the options. Though the employees become entitled to exercise the option at such stage but the fact is that it is simply a result of vesting of options with them over the vesting period on the rendition of services to the company. In the same manner, though the company becomes liable to issue shares at the time of the exercise of option, but it is in lieu of the liability which it incurred over the vesting period by obtaining their services. Thus, the liability is neither incurred at the stage of the grant of options nor when such options are exercised.
The company incurs liability to issue shares at the discount only 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.
III. Subsequent adjustment to discount
The company incurs a definite liability during the vesting period, but its proper quantification is not possible at that stage as the actual amount of employees cost to the company, can be finally determined at the time of the exercise of option or when the options remain unvested or lapse at the end of the exercise period. It is at this later stage that the provisional amount of discount on ESOP, initially quantified on the basis of market price at the time of grant of options, needs to be suitably adjusted with the actual amount of discount.
As regards the adjustment of discount when the options remain unvested or lapse at the end of the exercise period, it is but natural that there is no employee cost to that extent and hence there can be no deduction of discount qua such part of unvested or lapsing options. But, as the amount was claimed as deduction by the company, such discount needs to be reversed and taken as income.
In the second situation in which the options are exercised by the employees after putting in service during the vesting period, the actual amount of remuneration to the employees would be only the amount of actual discount at the time of exercise of option. After certain changes to the relevant provisions in this regard , the position which now stands is that the discount on ESOP is taxable as perquisite u/s. 17(2)(vi). The position has been clarified beyond doubt by the legislature that the ESOP discount, which 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. Thus, it is palpable that since the remuneration to the employees under the ESOP is the amount of discount with respect to the market price of shares at the time of exercise of option, the employees cost in the hands of the company should also be with respect to the same base.
The amount of discount at the stage of granting of options with respect to the market price of shares at the time of grant of options is always a tentative employee cost because of the impossibility in correctly visualising the likely market price of shares at the time of exercise of option by the employees, which, in turn, would reflect the correct employees cost. Since the definite liability is incurred during the vesting period, it has to be quantified on some logical basis. It is this market price at the time of the grant of options which is considered for working out the amount of discount during the vesting period. But, since actual amount of employee cost can be precisely determined only at the time of the exercise of option by the employees, the provisional amount of discount availed as deduction during the vesting period needs to be adjusted in the light of the actual discount on the basis of the market price of the shares at the time of exercise of options.
