PART C(4) — Deductibility of ESOP
discountu/s.28 of the Act
If for any reason ESOP discount cannot be claimed u/s.37, it would alternatively be allowable u/s.28 of the Act.
Business loss is different from expenditure
Disbursement or expenses of a trader is something ‘which goes out of his pocket’. A loss is something different. That is not a thing which he expends or disburses. That is a thing which comes upon him ‘ab-extra’ from outside.
There is a distinction between the business expenditure and business loss. Finlay J said
in the case of Allen v. Farquharson Bros., 17 TC 59, 64 observed
“…expenditure or disbursement means something or other which the trader pays out; I think some sort of volition is indicated. He chooses to pay out some disbursement; it is an expense; it is something which comes out of his pocket. A loss is something different. That is not a thing which he expends or disburses. That is a thing which so to speak, comes upon him ab-extra”
Certain judicial principles have held that section 37 does not envisage losses. The Supreme Court in the case of CIT v. Piara Singh, (1980) 124 ITR 40 (SC) held —
“The confiscation of the currency notes is a loss occasioned in pursuing the business; it is a loss in much the same was as if the currency notes had been stolen or dropped on the way while carrying on the business.”
In the case of Dr. T. A. Quereshi v. CIT, (2006) 287 ITR 547 (SC), the Supreme Court relied on the aforesaid judgment and held —
“The Explanation to section 37 has really noth-ing to do with the present case as it is not a case of a business expenditure, but of business loss. Business losses are allowable on ordinary commercial principles in computing profits. Once it is found that the heroin seized formed part of the stock-in-trade of the assessee, it follows that the seizure and confiscation of such stock-in-trade has to be allowed as a business loss.”
If ESOP discount is not held to be expenditure, its deductibility will have to be examined u/s.28 of the Act.
Business loss allowable u/s.28
Sections 30 to 37 are not exhaustive of the type of permissible deductions. Non deductibility u/s.30 to 37 does
not mar the claim for business loss as a deduction. These are to be allowed in section 28 itself.
“The list of allowances enumerated in sections 30 to 43D is not exhaustive. An item of loss incidental to the carrying on of a business may be deducted while computing the profits and gains of that business, even if it does not fall within any of the specified sections”.
The above observations have been quoted with approval in CIT v. Chitnivas, AIR 1932 PC 178; Ram-chander Shivnarayan v. CIT, (1978) 111 ITR 263, 267 (SC); Motipur Sugar Factory Ltd. v. CIT, (1955) 28 ITR 128 (Pat.); Tata Iron & Steel Co. Ltd. v. ITO, (1975) 101 ITR 292, 303 (Bom.).
As mentioned earlier, the charge u/s.28 is on ‘profits’. This term has to be understood in a commercial sense. Expenditure incurred or loss suffered in the course of business or which is incidental to the carrying of business would be allowed as a deduction even in the absence of any statutory provision granting such deduction.
The concept of ‘profit’ in section 28 and the provisions of sections 30 to 43D correspond to section 10(1) and section 10(2) respectively of the Indian Income Tax Act, 1922. The interrelation of these sections was explained by the Supreme Court in Badridas Daga v. CIT, (1958) 34 ITR 10 (SC), in the following words:
“It is to be noted that while section 10(1) imposes a charge on the profits and gains of a trade, it does not provide how those how profits are to be computed. Section 10(2) enumerates various items which are admissible as deductions, but it is settled that they are not exhaustive of all allowances which could be made in ascertaining profits taxable u/s.10(1). The result is that when a claim is made for a deduction for which there is no specific provision in section 10(2) whether it is admissible or not will depend on whether having regard to accepted commercial practice and trading principles, it can be said to arise out of the carrying on of the business and to be incidental to it. If that is established, then the deduction must be allowed provided of course there is no prohibition against it, express or implied in the Act.”
Accordingly, a loss suffered in the course of business and incidental to the carrying of business is allowable as a deduction even in the absence of any specific provision conferring the said deduction.
Conditions for claim of loss u/s.28
In order to claim a loss u/s.28, such loss should fulfill the following conditions:
- It should be a real loss, not notional or fictitious
- It should have actually arisen and been incurred, not contingent upon a future event
- It must be incidental to business and arise out of an operation therefrom and not on capital account
A. ESOP discount is real loss and not notional or fictitious
Under the general principles of tax laws, artificial and/ or fictitious transactions are disregarded. In order to be deductible, the loss must be a real loss and not merely notional or anticipatory.
In an ESOP, the loss is the sum that the company could have derived, if it had issued the shares at the premium prevailing in the market. It is the quantum of money forgone, as a result of the employer choosing not to issue shares at market value.
A fair measure of assessing trading profits in such circumstances is to take the potential market value at one end and the actual proceeds at the other. The difference between the two would be the loss since loss is not notional or fictional.
Section 145(1) is enacted for the purpose of determining profits under the head ‘Profits and gains of business or profession’. In the present case, section 28 is relevant and hence, section 145(1) is attracted. Under the principles of mercantile system of accounting on which section 145 is founded, ‘prudence’ is an extricable part. Under this principle, the expenditure is debited when a legal liability has been incurred. Any ‘delay in actual disbursement’ or ‘non occurrence of disbursement’ does not mar the liability so created. In other words, expenses ought to be recognised in the year of incurrence of liability irrespective of the time of actual disbursement.
The recognition of the said loss is supported by the corresponding benefit enjoyed by an employee.
The enjoyment of a benefit by an employee and the corresponding suffering of a pecuniary detriment by the employer are two sides of the same coin. Being inter-related, the nature of benefit should influence the characterisation of the sufferance by the other.
ESOP is nothing but a bonus or an incentive paid in the form of company stocks. From an employee perspective, it is an election made by him by opting to have the bonus/incentive received in the form of shares. Alternatively, the employee may opt for actual payment of salary and subsequently, pay it back to the company as subscription to share capital. If such a mode is adopted the salary payment would be deductible. The receipt of subscription monies thereafter would be on capital account. The character of the subsequent transaction would not impact the allowability of the earlier payment. This conclusion should not alter merely because the two-stage transaction is accomplished through a unified act. One may rely on the principles underlined in Circular No. 731 [(1996) 217 ITR (St.) 5], dated December 20, 1995, in relation to claim u/s.80-O of the Act.
Circular No. 731, dated 20-12-1995 reads as follows:
“1. Under the provisions of section 80-O of the Income-tax Act, 1961, an Indian company or a non-corporate assessee, who is resident in India, is entitled to a deduction of fifty per cent. of the income received by way of royalty, commission, fees, etc., from a foreign Government or foreign enterprise for the use outside India of any patent, invention, model, design, secret formula or process, etc., or in consideration of technical or professional services rendered by the resident. The deduction is available if such income is received in India in convertible foreign exchange or having been converted into convertible foreign exchange outside India, is brought in by or on behalf of the Indian company or aforementioned assessee in accordance with the relevant provisions of the Foreign Exchange Regulation Act, 1973, for the time being in force.
2. Reinsurance brokers, operating in India on behalf of principals abroad, are required to collect the re-insurance premia from ceding insurance companies in India and remit the same to their principals. In such cases, brokerage can be paid either by allowing the brokers to deduct their brokerage out of the gross premia collected from Indian insurance companies and remit the net premia overseas or they could simply remit the gross premia and get back their brokerage in the form of remittance through banking channels.
3. The Reserve Bank of India have expressed the view that since the principle underlying both the transactions is the same, there is no difference between the two modes of brokerage payment. In fact, the former method is administratively more convenient and the reinsurance brokers had been following this method till 1987 when they switched over to the second method to avail of deduction u/s.80-O of the Act.
4. The matter has been examined. The condition for deduction u/s.80-O is that the receipt should be in convertible foreign exchange. When the commission is remitted abroad, it should be in a currency that is regarded as convertible foreign exchange according to FERA. The Board are of the view that in such cases the receipt of brokerage by a reinsurance agent in India from the gross premia before remittance to his foreign principals will also be entitled to the deduction u/s.80-O of the Act.”
(Emphasis supplied by us)
The Apex Court relied on the aforesaid circular, in the case of J. B. Boda and Company Private Limited v. CBDT, (1996) 223 ITR 271 (SC); and held —
“It seems to us that a ‘two-way traffic’ is unneces-sary. To insist on a formal remittance to the foreign reinsurers first and thereafter to receive the commission from the foreign reinsurer will be an empty formality and a meaningless ritual, on the facts of this case.”
Applying this principle in the present case, insisting for actual payment of salary to employees and taking it back as subscription to capital is unnecessary. The purpose is short circuited by issue of ESOP shares instead of initial salary payment and deployment of salary by the employees to buy stocks.
Hypothetically, it could be assumed that employees are paid remuneration with an attached compulsion/ condition to appropriate such payments mandatorily towards Company’s shares. In such cases, whether the deductibility of salary payments could be questioned? — The answer obviously is no. Disallowing ESOP discount on the ground that there is no actual payment of salary, but only profit forgone may not be a correct proposition of law.
B. Whether ESOP expenses have actually arisen/ incurred, not contingent upon future events?
A loss is allowable in the year in which it is incurred. In a commercial sense, trading loss is said not to have resulted so long as reasonable chances of obtaining restitution is possible. Losses can be claimed in the year in which they occur if there are no chances of recovery/restitution.
If one follows the mercantile system, the loss becomes deductible at the point when it occurs. Lord Russell in the case of CIT v. Chitnavis, 6 ITC 453, 457 (PC) stated
“You may not, when setting out to ascertain the profits and gains of one year, deduct a loss which had, in fact, been incurred before the commencement of that year. If you did you would not arrive at the true profits and gains for the year. For the purposes of computing yearly profits and gains, each year is a self contained period of time in regard to which profits earned or losses sustained before its commencement are irrelevant.”
The accounting treatment of a contingent loss is determined by the expected outcome of the contingency. If it is likely that a contingency will result in a loss to the enterprise, then it is prudent to provide for that loss in the financial statements.
The term ‘contingent’ has not been defined in the Act. Section 31 of the Indian Contract Act, 1872 defines ‘contingent contract’ as
A ‘contingent contract’ is a contract to do or not to do something, if some event, collateral to such contract, does or does not happen.
A contract which is dependent on ‘happening’ or ‘not happening’ of an event is a contingent contract. In an ESOP, the loss contemplated is the discount on issue of shares. The quantum of loss would depend on the number of employees accepting the offer. This however does not render the loss ‘contingent’. In other words, the aggregate obligation to discharge discount to all the employ-ees in a year cannot be regarded as contingent merely because some employees may forfeit their rights. Accordingly, ESOP discount is not a contingent loss.
Support can be drawn from Owen v. Southern Railway of Peru Ltd., (1956) 36 TC 602 (HL) which dealt with a liability arising on account of gratuity benefit. It was held —
“where you are dealing with a number of obligations that arise from trading, although it may be true to say of each separate one that it may never mature, it is the sum of the obligations that matters to the trader, and experience may show that, while each remains uncertain, the aggregate can be fixed with some precision.”
ESOP discount is thus an ascertained loss. ESOP discount is actuarially calculated. The Black-Scholes model or the Binomial model is generally used in quantifying the discount. The method of ascertaining the loss is scientific. It is not adhoc or arbitrary.
C. Whether ESOP discount is incidental to business and not on capital account
It is only a trading loss that is allowable and not capital loss. The loss should be one that springs directly from carrying on of the business or is incidental to it. From section 28 it is discernible that the words ‘income’ or ‘profits and gains’ should be understood as including losses also. In other words, loss is negative profit. Thus, trading loss of a business is deductible in computing the profits earned by the business. The loss for being deductible must be incurred in carrying out business or must be incidental to the operation of business. The determination of whether it is incidental to business is a question of fact.
For the reasons already detailed, ESOP discount should be treated as a revenue account. Business income is to be computed based on the general commercial principles. In the application of these commercial principles, reckoning a loss is an integral part.
In summary, ESOP discount is a loss incidental to business which is incurred by the company. This loss is incurred on account of forgoing the right to issue shares at a higher value. The company abdicates such right in favour of employees as a part of employee recognition and compensation strategy. It is an act which is consistent and justified by the business interest of the employer. Accordingly, a claim of ESOP discount should be allowable u/s.28 of the Act, if it is, for any reason, not allowable u/s.37.
PART C(5) — Year of deductibility
After ascertaining that the ESOP discount is a deductible expense, the year of deductibility needs to be determined. As per section 145, provision should be made for all known liabilities and losses, even though the amount cannot be determined with certainty. Section 145(1) regulates the method of accounting for computing incomes under the ‘Business income’ and ‘Income from other sources’ head. It provides:
“(1) Income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’ shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.”
Assessees therefore have a choice in selecting the system of accounting to be followed in maintenance of the books of account. However, u/s.209 of the Companies Act, 1956, companies are bound to maintain their accounts on the accrual or mercantile basis only. If companies fail to follow the accrual system of accounting, it will be deemed that no proper books have been maintained by them.
Under the mercantile or accrual system of accounting, income and expenditure are recorded at the time of their accrual or incurrence. For instance, income accrued during the year is recorded whether it is received during the year or during a year preceding or following the relevant year. Similarly, expenditure is recorded if it becomes due during the previous year, irrespective of the fact whether it is paid during the previous year or not. The profit calculated under the mercantile system is profit actually earned during the previous year, though not necessarily realised in cash.
There can be no computation of profits and gains until the expenditure necessary for earning the receipts is deducted therefrom. Profits or gains have to be understood in a commercial sense. Whether the liability was discharged at some future date, would not be an impediment in the claim as a deduction. The difficulty in the estimation of expenditure would not convert the accrued liability into a conditional one. This was upheld by the Apex Court in the case of Calcutta Co. Limited v. CIT, (1959) 37 ITR 1 (SC).
The use of the words ‘laid out or expended’ in section 37 along with the word ‘expenditure’ indicates that the expenditure may either be an actual outgo of money irretrievably (expended as per the cash system of accounting) or a putting aside of money towards an existing liability (laid out as per the mercantile system of accounting) . The decisions in 3 CIT v. Nathmal Tolaram, (1973) 88 ITR 234 (Gauhati) and Saurashtra Cement and Chemical Industries Ltd. v. CIT, (1995) 213 ITR 523 (Guj.) support this proposition.
The ESOP discount is an expenditure incurred for the purpose of business. In accordance with section 145, business income has to be computed in accordance with the method of accounting regularly followed by the assessee. As discussed earlier, the choice of ‘method’ of accounting is with the assessee. The computation of income and expenses should be in accordance with the ‘method of accounting’ so followed by the assessee. The term ‘method’ is defined in the Oxford Dictionary as ‘procedure for attaining an object’.
The operative portion of section 145 uses the phrase ‘system of accounting regularly employed’. The term ‘regularly’, as defined in Concise Oxford Dictionary means ‘following or exhibiting a principle, harmonious, constituent, systematic’. Such system/method of accounting for ESOP discount is prescribed by SEBI. The SEBI guidelines mandates the ESOP discount to be spread over the period of vesting. The company is therefore obliged to follow the guidelines and that forms its ‘regular system of accounting’ (for the purposes of section 145). Income-tax statute follows the system so mandated. A method/system of accounting may be disregarded only when the assessing officer is not satisfied about the correctness or completeness of accounts or where the method of accounting has not been regularly followed. Such system which is based on guidelines prescribed by the regulatory bodies cannot be negated on the grounds that there are alternative methods/systems possible. An aliquot portion of the ESOP discount may be allowed in each of the years and this is the position recommended by SEBI as well.
Part D — Judicial pronouncements
Certain favourable judicial pronouncements
The honorable Chennai Tribunal in the case of S.S.I. Limited v. DCIT, (2004) 85 TTJ 1049 (Chennai) held that the ESOP discount is an allowable expenditure. In the aforesaid case, the assessee amortised the ESOP discount over a period of three years and claimed it as staff welfare expense. The Assessing Officer (AO) allowed this claim of expenditure. The Commissioner of Income-tax initiated proceedings u/s.263 of the Act holding the AO’s order to be prejudicial to the interests of the Revenue. It enlisted various grounds in support of this. Specifically, ground number 5 reads as below:
“…..The Assessing Officer has allowed this claim without any application of mind inasmuch as no details have been called for. What was the basis of arriving at the difference has also not been ex-amined. The difference between the market value of the shares and the discounted value at which these were allotted to the employees cannot be a revenue expenditure.”
The CIT directed the AO to disallow the ESOP discount. The assessee appealed against such order before the Chennai Tribunal. The Tribunal’s decision is therefore with reference to appeal against the revision order passed by the CIT u/s.263 and not the basis of regular appeal.
The basis of the assumption of the jurisdiction u/s.263 by the CIT is that the AO had not applied his mind in deciding on the issues in his order. Typically, the Tribunal would examine this aspect and decide whether the exercise of such jurisdiction is justified or not. In the SSI’s case, the Tribunal gave its decision by discussing merits of each of the issues in detail. An extract of discussion on the ESOP discount is as follows :
“…..It was a benefit conferred on the employee and a benefit, which could not be taken back by the company. So far as the company is concerned, once the option is given and exercised by the employee, the liability in this behalf is ascertained. This fact is recognised even by SEBI and the entire ESOP scheme is governed by the guidelines issued by SEBI. It is not the case of contingent liability depending upon various factors on which the assessee had no control…. There can be no denial of the fact that in respect of ESOP, SEBI had issued guidelines and assessee-company had followed these guidelines to the core and the claim of expenditure was in accordance with the guidelines of SEBI…. ”
(Emphasis supplied by us)
The ESOP discount was held as an employee benefit. It was an ascertained liability which was recognised in the books of account. Reliance was placed on the SEBI regulations. The regulations mandated charge of such expense to profit and loss account.
In the case of Consolidated African Selection Trust v. Inland Revenue Commissioners, (1939) 7 ITR 442 (CA), the Court dealt with the issue of shares be-ing an alternate mode of liability discharge. It was observed:
“If an employer having two receptacles, one containing cash and the other containing goods, chooses to remunerate his employee by giving him goods out of the goods receptacle instead of cash out of the cash receptacle, the expenditure that he makes is the value of those goods, not their purchase price or anything else but their value, and that is the amount which he is entitled to deduct for income-tax purposes.”
Distinguishing certain judicial precedents
In this part, we discuss why the decisions of the Delhi Tribunal in Ranbaxy’s case (2009) 124 TTJ 771 (Del.) and Lowry’s case 8 ITR 88 (Supp) are distinguishable where the ESOP discount was held as not an allowable expenditure.
It is a trite law that a judgment has to be read in the context of a particular case. A judgment cannot be applied in a mechanical manner. A decision is a precedent on its own facts. In State of Orissa v. Md. Illiyas, AIR 2006 SC 258, the Supreme Court explained this principle in the following words:
“…..Reliance on the decision without looking into the factual background of the case before it is clearly impermissible. A decision is a precedent on its own facts. Each case presents its own features.”
The following words of Lord Denning in the mat-ter of applying precedents have become locus classicus:
“Each case depends on its own facts and a close similarity between one case and another is not enough because even a single significant detail may alter the entire aspect, in deciding such cases, one should avoid the temptation to decide cases (as said by Cardozo) by matching the colour of one case against the colour of another. To decide therefore, on which side of the line a case falls, the broad resemblance to another case is not at all decisive…..”
Precedent should be followed only so far as it marks the path of justice, but you must cut the dead wood and trim off the side branches, else you will find yourself lost in thickets and branches. My plea is to keep the path to justice clear of obstructions which could impede it.”
Ranbaxy case has largely relied on this decision of the House of Lords and accordingly, we have not provided any specific comments on this case. Here-inbelow are our comments/rebuttal on contentions raised in the Lowry’s case. These would apply for the Ranbaxy case also apart from what has been outlined hereinbefore.
Lowry’s case based on foreign law
The decision of the Court in Lowry’s case was based on the then prevailing English law. Before dwelling on the specific arguments/contentions in this case, it may be relevant to discuss the principle of interpretation in case of foreign judicial precedents.
- Aid from foreign decisions in interpretation
The words and expressions in one statute as judicially interpreted do not afford a guide to the construction of the same words or expressions in another statute unless both the statutes are pari materia legislations. English Acts are not pari materia with the Indian Income-tax Act. In some cases, English decisions may be misleading since the Act there may contain provisions that are not found in the Indian statute or vice versa. As a result, foreign decisions are to be used with great circumspection. They are not to be applied unless the legal and factual backgrounds are similar.
The Supreme Court in the case of Bangalore Water Supply and Sewerage Board v. A. Rajappa, AIR 1978 SC 548 held — “Statutory construction must be home-spun even if hospitable to alien thinking.”
The Supreme Court in the case of General Electric Company v. Renusagar Power Co., (1987) 4 SCC 213 held — “When guidance is available from binding Indian decisions, reference to foreign decisions may become unnecessary.”
The rationale of the ESOP discount being capital expenditure is largely based on the Lowry’s case. This was a landmark judgment by the House of Lords in the year 1940. However, the applicability of this judgment in the present age, case and context is debatable.
The Lowry’s case was adjudged on the principles prevailing then before the House of Lords. Lord Viscount Maugham (one of the judges who held the ESOP discount to be capital in nature) observed:
“The problem which arises under Schedule D seems to me to be a very different one, since it concerns profits of a trade and is subject to a large number of prohibitions as to the deductions which alone are permissible and no other statutory rules of some complexity.”
(Emphasis supplied by us)
From the above observation, one can infer that deductibility of any business expenditure was subject to strict prohibitions. An expense would not be a deductible unless specifically allowed. This is in total contrast to the provisions of deductibility under the Income-tax Act (as discussed earlier) which allows any business expenditure unless specifically prohibited. The provisions of law applied in the case of Lowry are not pari materia with the Act. Accordingly, the judgment cannot and should not be relied upon.
It is presumed that Parliament intends the Court to apply to an ongoing Act a construction that continuously updates its wording to allow for changes. The interpretation must keep pace with changing concepts and values and should undergo adjustments to meet the requirements of the developments in the economy, law, technology and the fast changing social conditions. The Supreme Court decisions in the cases of Bhagwati J. Gupta v. President of India, AIR 1982 SC 149 and CIT v. Poddar Cements, 226 ITR 625 (SC) can be referred in this regard.
In the treatise ‘The Principles of Statutory Interpre-tation’ by Justice G. P. Singh, (9th edition — page 228) the learned author observes:
“It is possible that in some special cases a statute may have to be historically interpreted “as if one were interpreting it the day after it was passed.” But generally statutes are of the “always speaking variety” and the court is free to apply the current meaning of the statute to present-day conditions. There are at least two strands covered by this principle. The first is that the court must apply a statute to the world as it exists today. The second strand is that the statute must be interpreted in the light of the legal system as it exists today.”
(Emphasis supplied by us)
The Apex Court in the case of CIT v. Poddar Cements, 226 ITR 625 (SC) relied on the treatise ‘Statutory Interpretation’ by Francis Bennion, (2nd edition — section 288) with the heading ‘Presumption that updating construction to be given’ (page 617, 618, 619) and observed as follows:
“It is presumed that Parliament intends the Court to apply to an ongoing Act a construction that continuously updates its wording to allow for changes since the Act was initially framed (an updating construction). While it remains law, it is to be treated as always speaking. This means that in its application on any date, the language of the Act, though necessarily embedded in its own time, is nevertheless to be construed in accordance with the need to treat it as current law.
In construing an ongoing Act, the interpreter is to presume that Parliament intended the Act to be applied at any future time in such a way as to give effect to the true original intention. Accordingly the interpreter is to make allowances for any relevant changes that have occurred, since the Act’s passing, in law, social conditions, technology, the meaning of words, and other matters…. That today’s construction involves the supposition that Parliament was catering long ago for a state of affairs that did not then exist is no argument against that construction. Parliament, in the wording of an enactment, is expected to anticipate temporal developments. The drafter will try to foresee the future, and allow for it in the wording.
An enactment of former days is thus to be read today, in the light of dynamic processing received over the years, with such modification of the current meaning of its language as will now give effect to the original legislative intention. The reality and effect of dynamic processing provides the gradual adjustment. It is constituted by judicial interpretation, year in and year out. It also comprises process-ing by executive officials.”
The Supreme Court in the case of Bhagwati J. Gupta v. President of India, AIR 1982 SC 149 held:
“The interpretation of every statutory provision must keep pace with changing concepts and values and it must, to the extent to which its language permits or rather does not prohibit, suffer adjustments through judicial interpretation so as to accord with the requirements of the fast changing society which is undergoing rapid special and economic transformation. The language of a statutory provision is not a static vehicle of ideas and concepts and as ideas and concepts change, as they are bound to do in a country like ours with the establishment of a democratic structure based on egalitarian values and aggressive developmental strategies, so must the meaning and content of the statutory provision undergo a change. It is elementary that law does not operate in a vacuum. It is not an antique to be taken down, dusted admired and put back on the shelf, but rather it is a powerful instrument fashioned by society for the purpose of adjusting conflicts and tensions which arise by reason of clash between conflicting interests. It is therefore intended to serve a social purpose and it cannot be interpreted without taking into account the social, economic and political setting in which it is intended to operate. It is here that the Judge is called upon to perform, a creative function. He has to inject flesh and blood in the dry skeleton provided by the Legislature and by a process of dynamic interpretation, invest it with a meaning which will harmonise, the law with the prevailing concepts and values and make it an effective, instrument for delivery of justice….”
In case of ESOP, the primary issue revolves around the character of discount — whether capital or revenue? In this context, it may be relevant to quote one of the observations of the Apex Court in the case of Alembic Chemical Works Co. Ltd. v. CIT, (1989) 177 ITR 377 (SC). The Court observed:
“The idea of ‘once for all’ payment and ‘enduring benefit’ are not to be treated as something akin to statutory conditions; nor are the notions of ‘capital’ or ‘revenue’ a judicial fetish. What is capital expenditure and what is revenue are not eternal verities, but must be flexible so as to respond to the changing economic realities of business. The expression ‘asset or advantage of an enduring nature’ was evolved to emphasise the element of a sufficient degree of durability appropriate to the context.”
Interpretation must be with reference to the law and circumstances as it exists when tax has to be paid. This helps in keeping the meaning updated with changing times. In the present eco-nomically advancing modern world, the purpose of ESOP should not be defeated by the narrow interpretation of colouring the transaction as a mere transaction of ‘issue of shares’. The approach of the present-day taxes is to recognise ESOP as a tool of employee compensation.
In Lowry’s case, as per the then prevailing law, a claim of deduction was subject to a large number of prohibitions which alone were permissible. This contradicts the rules of deductibility under the Act. This law is not pari materia with the Act. Accordingly, the binding nature of the Court is diluted. Even otherwise, the Court’s decision could be rebutted on the following points:
- Intention implied from erroneous documents
Intention of the parties to the transaction and objective were discerned by placing a huge reliance on the terms and conditions in the employee letters. However, Lord Russell (judge of the majority view) has himself acknowledged:
“The transactions as evidenced by the documents does not, I think, warrant the terminology.”
Any conclusion drawn by placing reliance on badly drafted document is not valid. Reliance was placed on employee letters which were tainted by erroneous drafting/wrong language and nomenclatures. The majority view that ESOP is primarily to issue shares and not employee remuneration (by deriving support from the impugned letters), is thus not a correct statement of fact. The Court seems to have given weightage to form over substance of the transaction.
- Impact on financial statements
The Court held that the ESOP discount is not an item of profit/trading transaction and there was no impact on the financial position.
This write -up has examined the treatment of the ESOP discount from various angles, namely, commercial accounting, international practices, statutory guidelines and from an income-tax perspective. All lead to the same conclusion that ESOP is a revenue item which needs to be treated as a charge against profits. It is a part of the financial statements.
- Reliance on some judicial precedents
All the judges deliberated on some of the judicial precedents (primarily, Usher’s case and Dexter case).
These cases are not applicable in the present case — they are factually distinguishable. Even otherwise, these judgments relate to foreign law which is not pari materia with the Act and hence are inconsequential.
- No monies worth given up by either the Company or the employees
Company’s perspective: The Court held that no money’s worth had been given up by the Company.
The ESOP discount is the difference between the strike price paid and the value of the share at the date the option is exercised. This difference is certainly a charge against the profits — as an expense, profit forgone or a loss. There is a loss of opportunity of issue of shares at the prevailing market price. It is certainly a money’s worth given up. In fact Lord Viscount (judge from majority view) said:
“If this House had regarded the transaction as one in which the company was giving “money’s worth” in the sense of an equivalent for cash in consider-ation of the promise to subscribe for shares the decision would have been the other way.”
In case of the ESOP discount, the Company has for-gone share premium receivable. The Company has given up a portion of money receivable on issue of its shares. Accordingly, the aforesaid contention is rebutted.
Employee’s perspective: ESOP was held to be gift to the employees and that employees had not given up anything for procuring these shares.
ESOP is a form of employee remuneration. It is a remuneration paid either for his past services or with intent to retain his services for the future. Thus it is an award in lieu of his services to the organisation rendered/expected to be rendered. This truth has been acknowledged by the regulatory bodies — OECD, SEBI and ICAI. The Karnataka High Court has acknowledged ESOP as an employee remuneration tool.
- Hypothetical proposition of ESOP being an application of salary
The Court held that ESOP being an application of salary to employees for share subscription — is only a hypothetical proposition.
The ESOP discount is amount notionally received on capital account and utilised on revenue account. Instead of salary being paid and inturn application of employees to ESOP, this two-way transaction has been short-circuited. Support can be drawn from Circular 731, dated 20-12-1995 and Apex Court decision in the case of J. B. Boda and Company Private Limited v. CBDT, (1996) 223 ITR 271 (SC).
- Share premium forgone is a capital item and hence ESOP discount is capital in nature
The Court held that share premium is a capital receipt. Forbearance of such capital receipt is not deductible.
It has been sufficiently put forth that the ESOP discount is a revenue item. The ESOP discount is not a capital receipt. The determination of capital v. revenue should be done based on the utilisation of expense. The ESOP discount is incurred for employee benefit and hence revenue in nature.
- Employee paying tax is inconsequential
The Court held that the fact that the employee paid tax on ESOP (on benefit of discount on share premium) was inconsequential in determining the allowability of the ESOP discount.
It is an accepted principle that ‘Income charge-ability’ is not the basis for ‘expenditure allowability’. The fact that amount receivable has the character of income in the hands of recipient, is not relevant for determining the expense allowability. The fact that it does not get taxed or is taxed at a later point of time or is taxed under a different head in the hands of the employee would not be relevant.
Additionally, comments of Lord Wright (judge from minority view) are worth men-tioning which held that ESOP was held taxable in employee’s hands, but was not correspondingly entitled to deduction in the hands of employer:
“….he was receiving by way of remuneration money’s worth at the expense of the company, and yet that the company which was incurring the expense for purposes of its trade to remunerate the directors was not entitled to deduct that expense in ascertaining the balance of its profits….”
- Discount on shares is a ‘choice’ and not an ‘obligation’
The Court held that the Company was entitled to issue shares at a lesser/discounted value and it did so. It was a matter of election or choice and not a discharge of any liability/debt.
It may be relevant to note that ESOP is a form of employee remuneration/salary. Salary is a consideration for services rendered by the employees. It is an obligation/liability incurred for the business. Accordingly, the ESOP discount is allowable expenditure. In fact Lord Viscount (judge of majority view) held as follows:
“….If in this case the employees were paying the par value of the shares and also releasing to the company some amounts of salary due to them, the case would be very different from what it is….”
This observation supports the view that the ESOP dis-count in discharge of salary due to employees could have been held deductible by the Court itself.
To summarise, there are judicial precedents supporting the ESOP discount to be an allowable revenue expenditure and judgments with contrary view can be distinguished on law and facts.
Closing comments
Typically, a payment to an employee is called as ‘Salary’. This payment may be ‘paid in meal or malt’. ESOP is just another form of such salary given to employees. Etymologically, the term ‘Salary’ owes it origin to the Latin term ‘salarium’ which means ‘money allowed to Roman soldiers for purchase of salt’. One could therefore trace back the concept of payment in kind to the Roman age. This payment of salary in kind has taken various forms over a period of time. Employees have been rewarded with assets such as gold, accommodation, motor vehicles; facilities such as personal expense reimbursement, insurance and medical facilities, etc.; sometimes not only for employees but for their family members as well. Employee rewards in kind have taken various shapes. ESOP is one among them. It is an employee welfare measure. Such measures need a boost from the income-tax authorities. Such support would only escalate into a supportive social measure.
The Karnataka High Court in the case of CIT and Anr. v. Infosys Technologies Ltd., (2007) 293 ITR 146 (Kar.) had an occasion to comment on the same issue of ESOP discount. It held:
“India is a growing country. The technological development of this country has resulted in economical prosperity of this country. Several giant undertakings have shown interest in this great country after taking note of the manpower and the intelligence available in this country. Stock option is nothing new and it is being continued in the larger interest of industrial harmony, industrial relations, better growth, better understanding with employees, etc. It is a laudable scheme evolved and accepted by the Government. Good old days of only master and only servant is no longer the mantra of today’s economy. Today sharing of wealth of an employer with his employees by way of stock option is recognised, respected and acted upon. Such stock option is way of participation and it has to be encouraged…. The Department, in our view, must approve such welfare participatory pro-labour activities of an employer. Of course, we do not mean that if law provides for taxation, no concession is to be shown. But wherever there are gray areas, it is preferable for the Department to wait and not hurriedly proceed and arrest the well-intended scheme of welfare of the employer. We would be failing in our duty if we do not note the Directive Principles of the Constitution in the matter of labour participation. Article 43A provides that the State shall take steps by suitable legislation or by any other way to secure participation of workers in the management of undertakings, establishment or other organisation engaged in other industries…. We would ultimately conclude by saying that any welfare measure has to be encouraged, but of course within the four corners of law. We do hope that other employers would follow this so that the economic and social justice is made available to the weaker sections of society also.”
Human resource management has evolved as a separate field of study. Today this study is not restricted populating a concern with right people. The challenge is not mere correct staffing. This human resource need to be nurtured, trained and developed. They should be transformed from ‘people in the organisation’ to ‘people for and of the organisation’. This transformation is not automatic. It is a result of the committed effort from the concern/company. It is a commitment to reward for the past services of its employees as well as their future endeavours. This reward kindles motivation in employees; seemingly the only antidote to attrition. ESOP is just another employee motivation tool. No statute or fiscal law should discourage an employee motivation/welfare measure. Our attempt in this write-up has been to uphold this very thought.
