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Deductibility of Discount on Employee Stock Options - An Analysis, Part1

Subject : Income Tax Law
Month-Year : Nov 2011
Author/s : H. Padamchand Khincha
P. Shivanand Nayak
Chartered Accountants
Topic : Deductibility of Discount on Employee Stock Options - An Analysis, Part1
Article Details :

Introduction

It is an accepted fact that employees if recognised will reciprocate in a thousand ways. By acknowledging employee efforts, organisations can increase employee satisfaction, morale and self-esteem leading to increased business and income. Employee Stock Option Plan [commonly known as ESOP(s)] is a fallout of this thought.

Sustained competitiveness by any company hinges upon the quality of its human resources. This in turn has much to do with employee loyalty and commitment. A widely acknowledged method of giving the right incentive signals and rewarding loyalty is through an ESOP.

ESOP is a share-based payment to an employee in lieu of remuneration for his services. The philosophy behind ESOP is to imbibe a ‘sense of belongingness’ to the company. It is to enable them to participate in the organisation’s growth and prosperity. This is achieved by inviting them to be part owners of the company.

ESOP has evolved as a very potent tool to employee compensation. Variants to ESOP have also evolved. ESOP guidelines issued by the Central Government of India (reported in 251 ITR [st] 230) has enlisted various kinds of ESOP(s) - Employee Stock Option Plan, Employee Stock Ownership Plan, Employee Stock Purchase Plan, Stock Appreciation rights etc.

In an ESOP scheme, the company issues shares to its employees at a price lesser than its prevailing market value. To achieve this, a plan is put in place. The plan is approved and adopted by the company. Regulatory approvals, if required, are obtained. The plan generally provides for a compensation committee for evaluating performance of employees and recommending the allotment of options. These options entitle employees to become shareholders of the company. The difference between the price at which the company could have issued the shares in the “open market” and the reduced price is the benefit to the employees. The employee is compensated by the concession.

In other words, the company/ employer forgoes it ability, of getting higher money for the shares. The discussion in the ensuing paragraphs is whether such amount forgone or ‘loss’ suffered can be claimed as a deduction from an Income-tax standpoint. This write-up is classified into the following segments:

A. Accounting Principles

B. Claim of ESOP under General Tax Principles

C. Claim of ESOP under specific provisions of Income-tax Act, 1961(the Act)

D. Some judicial pronouncements

PART A - Accounting Principles

Accounting/ regulatory aspects of ESOP(s) in India

When a company receives a sum which is lesser than the fair value of the share, it suffers a ‘loss’. This loss needs to be accounted for. A determination of the ‘nature of loss’ is important to enable the addressal of many issues. Whether this loss is compensation, and hence is to be accounted for in the profit and loss account? Or is it a premium on shares forgone and hence is a balance sheet item? Does it partake the character of benefit, hence a perquisite and thereby salary? Or is it in the nature of enabling employees to become shareholders of the company and hence a transaction inextricably linked to the share capital? Is the ‘discount’ a form of compensation? Or is the sufferance an abatement of the ability to get full value of shares? These are some questions associated with an ESOP.

A reference to the accounting principles or guidelines statutorily prescribed could help in ascertaining the nature of loss. Securities and Exchange Board of India (“SEBI”) and Institute of Chartered Accountants of India (“ICAI”), two of the premier regulatory and statutory bodies have issued guidelines in this matter.

ICAI has issued a Guidance Note on “Accounting for Employee Share-based payments”. The Guidance Note specifies the treatment of discount on issue of ESOP (hereinafter referred as ‘ESOP discount’).

A. Guidance Notes issued by ICAI

ICAI is empowered to issue Guidance Notes. These are designed to provide guidance to its members on matters arising in the course of their professional work. Guidance notes resolve issues which may pose difficulty or are debatable. The Guidance Notes are recommendatory in nature. Any deviation from such guidance mandates an appropriate disclosure in the financial statements or reports.

Financial statements form the substratum for incometax laws. These Financial statements of corporates have to be mandatorily prepared in accordance with accounting system/ standards prescribed by the ICAI. Thus the role of ICAI assumes significance. The courts have also recognised the importance of ICAI prescriptions in various cases.

The Gauhati High court in the case of MKB Asia (P) Limited v CIT (2008) 167 Taxman 256 (Gau) held that the income-tax authority has no option/ jurisdiction to meddle in the matter either by directing the assessee to maintain its accounts in a particular manner or adopt different method where the accounting system is approved by the ICAI.

The Madhya Pradesh High Court in the case of CIT v State Bank of Indore (2005) 196 CTR 153 (MP) held -

“it involves the manner and methodology of accountancy in claiming deduction. In cases of like nature, their Lordships of Supreme Court have always taken the help of methods adopted/ prescribed/recognised by the Indian Institute of Chartered Accountants as in the opinion of their Lordships, they are the best guide. In one of the cases CCE v. Dai Ichi Karkaria Ltd. (1999) 7 SCC 448, their Lordships while supporting their conclusion while examining the case of Central Excise, made following observations in para 26:

"Para 26-The view we take about the cost of the raw material is borne out by the guidance note of the Indian Institute of Chartered Accountants and there can be no doubt that this Institute is an authoritative body in the matter of laying down accountancy standards."

(Emphasis supplied)

The Supreme Court in the case of British Paints India Ltd. (1991) 188 ITR 44 (SC) relied on the guidance note issued by ICAI while adjudging a matter on stock valuation. Other instances are available of courts relying on guidance note. For example, guidance note on section 44AB has been relied on in understanding the total turnover of an agent (Kachha Arhatiya).

The Hyderabad Tribunal (Special Bench) in the case of DCIT v Nagarjuna Investment Trust Ltd (1998) 65 ITD 17 (Hyd) SB relied on the Accounting standard (IAS 17) and the guidance note issued by the ICAI while upholding the accounting methodology of lease equalisation.

As mentioned earlier, ICAI issued Guidance note on Accounting for Employee Share-based Payments (“ESOP Guidance note”). In the ESOP Guidance note, the discount on issue of shares is described as “Employee Compensation expense”. As the name suggests, this is viewed as ‘employee remuneration’ to be expensed in the Profit and loss account of the relevant year. It concurs with SEBI on the aspect of charge of such discounts against the profits. The Guidance Note acknowledges and thus approves the loss to be an item on revenue account.

The aforesaid accounting recommendations are guided by the principles of “Conservatism”, “Prudence” and “Matching Concept”. Conservatism and Prudence are concepts for recognising expenses and liabilities at the earliest point of time even if there is uncertainty about the outcome; and to recognise revenues and assets only when they are assured of being received. The concept of Prudence is now statutorily recognised by an explicit mention in Accounting Standard 1 issued u/s. 145 of the Income-tax Act, 1961 (“the Act”). ‘Matching principle’ signifies that in measuring the income for a period, revenue is to be adjusted against expenses incurred for producing that revenue.

Income referable to employee efforts gets captured in the ordinary course of accounting applying the principles of revenue recognition (Accounting Standard 9). It is essential that the associated expenditure is also booked. ESOP discount is an associated cost. Non-recognition of ESOP discount in the Profit and Loss Account could inflate the reported profits for the year. The accounts would then not be reflective of a true and fair position of the performance of an entity. From an accounting standpoint therefore, ESOP discount needs to be charged against the business income. It is an item on revenue account.

Some of the relevant portion of the Guidance note is highlighted below -

  • Preface

“Employee share-based payments generally involve grant of shares or stock options to the employees at a concessional price or a future cash payment based on the increase in the price of the shares from a specified level….The basic objective of such payments is to compensate employees for their services and/or to provide an incentive to the employees for remaining in the employment of the enterprise and for improving their performance…”

  • Recognition (para 10)

“An enterprise should recognise as an expense (except where service received qualifies to be included as a part of the cost of an asset) the services received in an equity-settled employee share-based payment plan when it receives the services, with a corresponding credit to an appropriate equity account, say, ‘Stock Options Outstanding Account.”

  • Measurement (para 15)

“Typically, shares (under ESPPs) or stock options (under ESOPs) are granted to employees as part of their remuneration package, in addition to a cash salary and other employment benefits… Furthermore, shares or stock options are sometimes granted as part of a bonus arrangement, rather than as a part of basic pay, eg, as an incentive to the employees to remain in the employment of the enterprise or to reward them for their efforts in improving the performance of the enterprise…”

B. SEBI guidelines

SEBI is a regulatory body established to protect the interests of investors in securities, regulate the securities market and for matters connected therewith. Newer types of financial instruments are emerging. Financial intermediaries have emerged performing a slew of complex functions. The implications of dealing/ investing in securities are continuously evolving, giving rise to a multitude of tax consequences. There is therefore an imperative need for such governing bodies to be involved in the matters of tax also. The increased interplay of SEBI and Income-tax Act is evidenced by SEBI provisions being incorporated in the Act. For instance the erstwhile proviso to section 17(2)(iii) [which was one of the sections on ESOP taxation] read -

"Provided that nothing in this sub-clause shall apply to the value of any benefit provided by a company free of cost or at a concessional rate to its employees by way of allotment of shares, debentures or warrants directly or indirectly under any Employees Stock Option Plan or Scheme of the company offered to such employees in accordance with the guidelines issued in this behalf by the Central Government".

The Central Government issued the guidelines referred to in the proviso above by Notification No. 323/2001 dated October 11, 2001, effective from April 1, 2000. The Guidelines enumerate various aspects that ought to be included in any Employees Stock Option Plan or Scheme. The guidelines, inter alia, provided that the plan or scheme shall be as per the SEBI Guidelines.

SEBI has also evidenced interest in ESOP taxation (although indirectly), by prescribing accounting guidelines. These guidelines require ESOP discount to be charged off to the profit and loss account over the period of vesting. Such prescriptions are bound to impact “total income” for tax purposes.

The SEBI guidelines prescribe not merely the accounting policies but also the precise accounting entries to be passed over the life of ESOP. As per the SEBI guidelines, discount associated with grant of stock options can be worked out by various methods. SEBI has prescribed its own method of calculation of the discount. It mandates deferring and spreading this discount over the vesting period. The aliquot share of discount required to be spread over is recognised as expenditure in the profit and loss account.

C. OECD recommendations

Organisation for Economic Co-operation and Development (“OECD”) is set up to promote policies that will improve the economic and social well-being of people around the globe. OECD provides a forum in which governments can work together to share experiences and seek solutions to their common problems. This organisation has framed its model tax convention and commentaries. The commentary is modified from time to time and is considered by tax authorities across the globe. From an income tax standpoint, they are relevant in interpreting and applying the provisions of bilateral tax conventions between countries.

Though India is not a member of the OECD, the model conventions and commentaries on OECD have been used as guidance in interpretation of the statute. The OECD Model Convention and commentary thereto though primarily meant for use by the OECD countries is often referred to and applied in interpreting Agreements of non-OECD countries also.

The Calcutta Income Tax Tribunal, in the case of Graphite India Ltd v DCIT (2003) 86 ITD 384 (Cal) acknowledged the importance and relevance of views of OECD. It observed as follows:

“In our considered view, the views expressed by these bodies, which have made immense contribution towards development of standardisation of tax treaties between various counties, constitute contemporanea expositio inasmuch as the meanings indicated by various expressions in tax treaties can be inferred as the meanings normally understood in, to use the words employed by Lord Radcliffe, international tax language developed by bodies like OECD and UN.”

In connection with ESOP also, the OECD convention and commentaries have made various observations. Some of the relevant portions are as follows:

  • Commentary to Model Tax Convention on Income and Capital (2010) has housed the ESOP income under Article 15 (Taxation of Income from Employment). It states that ESOP is a reward for the employment services. It reads as follows:

“While the Article applies to the employment benefit derived from a stock option granted to an employee regardless of when that benefit is taxed, there is a need to distinguish that employment benefit from the capital gain that may be derived from the alienation of shares acquired upon exercise of the option.”

  • ESOP impact on transfer pricing (page 7 & 8):

“b) Equity ownership vs. Remuneration The analysis in this study starts with the premise that the granting of stock options is an element of remuneration just like performance-related bonuses or benefits in kind, even when stock options are issued by an entity that is distinct from the employer. In fact in many MNE groups the shares subscribed to or purchased by employees under stock option plans are sold as soon as authorised by the plan and applicable regulations, i.e. employees do not seek to exercise their prerogative as shareholders, apart from benefiting from an increase in value between the strike price paid and the value of the share at the date the option is exercised. Moreover, a stock option is a financial instrument which is valuable and which can be exercised in order to realise such value. Although, upon exercise, the holders of such options may acquire and decide to retain a share in the capital of an enterprise, this investment decision made by each employee is a distinct step from that of the remuneration, one that is occurring at a different point in time and that is of no relevance to the transfer pricing issue under consideration…..”

(Emphasis supplied)

Thus, there are various accounting and statutory bodies governing the accounting and preparation of financial statements in India. Compliance with such prescribed norms is mandatory. The judicial precedents also have repeatedly respected such guidelines. This being the prevailing position, the tax treatment of ESOP discount should be in compliance with guidelines prescribed by ICAI and SEBI, as also OECD.

International practice

The international practices in relation to treatment of discount on ESOP to employees are on similar lines.

Statement of Financial Accounting Standards

Financial Accounting Standards Board (FASB) is a designated organisation whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States. These principles are recognised as authoritative by the Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants. Statement of Financial Accounting Standards is a formal document issued by the FASB, which details accounting standards and guidance on selected accounting policies set out by the FASB. All reporting companies listed on American stock exchanges have to adhere to these standards. Accounting Standard No. 123 details share based payments to employees. Some relevant portions from the same are as below:

Statement of Financial Accounting Standards No. 123 (revised 2004)

Para 1 - This Statement requires that the cost resulting from all share-based payment transactions be recognised in the financial statements. This Statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. However, this Statement provides certain exceptions to that measurement method if it is not possible to reasonably estimate the fair value of an award at the grant date. A nonpublic entity also may choose to measure its liabilities under share-based payment arrangements at intrinsic value. This Statement also establishes fair value as the measurement objective for transactions in which an entity acquires goods or services from nonemployees in share-based payment transactions. This Statement uses the terms compensation and payment in their broadest sense to refer to the consideration paid for goods or services, regardless of whether the supplier is an employee.

Para 9 - Accounting for Share-Based Payment Transactions with Employees

The objective of accounting for transactions under share-based payment arrangements with employees is to recognise in the financial statements the employee services received in exchange for equity instruments issued or liabilities incurred and the related cost to the entity as those services are consumed.

(Emphasis supplied)

International Financial Reporting Standard (IFRS)

The International Accounting Standards Board (IASB) is an independent, privately funded accounting standardsetter based in London, England. IFRS is a set of accounting standards developed by the IASB. IFRS 2 deals with the share based payment to employees.

IFRS 2 on Share-based payment

“Para 1 - The objective of this IFRS is to specify the financial reporting by an entity when it undertakes a share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees.

Para 12 - Typically, shares, share options or other equity instruments are granted to employees as part of their remuneration package, in addition to a cash salary and other employment benefits. Usually, it is not possible to measure directly the services received for particular components of the employee’s remuneration package. It might also not be possible to measure the fair value of the total remuneration package independently, without measuring directly the fair value of the equity instruments granted. Furthermore, shares or share options are sometimes granted as part of a bonus arrangement, rather than as a part of basic remuneration, eg as an incentive to the employees to remain in the entity’s employ or to reward them for their efforts in improving the entity’s performance. By granting shares or share options, in addition to other remuneration, the entity is paying additional remuneration to obtain additional benefits. Estimating the fair value of those additional benefits is likely to be difficult. Because of the difficulty of measuring directly the fair value of the services received, the entity shall measure the fair value of the employee services received by reference to the fair value of the equity instruments granted.”

(Emphasis supplied)

The above extracts demonstrate the consensus that ESOP discount is a charge against profits and hence a Profit and Loss Account item. This ensures true and correct disclosure of the financial performance of the Company.

Based on the aforesaid discussion, one could discern that from an accounting perspective ESOP is a revenue item. This is the understanding of the accounting and regulatory bodies in India. The same view is shared by some of the international bodies/ practices as well.

PART B - Claim of ESOP discount under

general tax principles

Income-tax relies on the general commercial and accounting principles in determining the taxable income. As a general principle, any expenditure incurred for the purposes of business is a ‘deductible expenditure’ for income-tax purposes.

Reliance of Income-tax laws on general/ commercial principles

“Tax accounting” is not essentially different from commercial accounting. Tax accounting recognises and accepts accounting which is consistent and statute compliant. Profit as per such commercial accounting is the base from which the taxable income is determined.

Tax laws may incorporate specific rules and departures from commercial accounting in determining the taxable income. To the extent, there are no specific departures, commercial accounting norms would prevail for tax purposes also. The earliest acknowledgement by the Courts of the relevance of appropriate accounting practices (while explaining the concept of accrual) can be found in the decision of the Privy Council in the decision CIT v Ahmedabad New Cotton Mills Co. Ltd (1930) 4 ITC 245 (PC). The Apex Court has thereafter upheld the significance of accounting practices on various occasions. Some of such judicial precedents and the relevant observations therein are as follows:

  • P.M. Mohammed Meerakhan v CIT (1969) 73 ITR 735 (SC) -

“In the case of a trading adventure the profits have to be calculated and adjusted in the light of the provisions of the Income-tax Act permitting allowances prescribed thereby. For that purpose it was the duty of the Income-tax Officer to find out that profit the business has made according to the true accountancy practices.”

  • Challapalli Sugars Limited v CIT (1975) 98 ITR 167 (SC) -

“As the expression "actual cost" has not been defined, it should, in our opinion, be construed in the sense which no commercial man would misunderstand. For this purpose it would be necessary to ascertain the connotation of the above expression in accordance with the normal rules of accountancy prevailing in commerce and industry.”

  • CIT v U.P. State Industrial Development Corporation (1997) 225 ITR 703 (SC) -

"for the purposes of ascertaining profits and gains, the ordinary principles of commercial accounting should be applied so long as they do not conflict with any express provision of the relevant statute".

  • Badridas Daga v CIT (1958) 34 ITR 10 (SC) -

“Profits and gains which are liable to be taxed under section 10(1) of the 1922 Act are what are understood to be such according to ordinary commercial principles”

  • Other judgments {Kedarnath Jute Mfg. Co. Ltd. v CIT (1971) 82 ITR 363 (SC)/ Madeva Upendra Sinai v Union of India (1975) 98 ITR 209 (SC)} -

“The assessable profits of a business must be real profits and they have to be ascertained on ordinary principles of trading and commercial accounting. Where the assessee is under a liability or is bound to make a certain payment from the gross profits, the profits and gains can only be the net amount after the said liability or amount is deducted from the gross profits or receipts”

The Act requires business income computation to be based on accounting practices and principles. Section 145 of the Act mandates business income for income-tax purposes to be computed under the ‘ordinary principles of commercial accounting’ regularly employed. The Gujarat High Court in the case of CIT v Advance Construction Co P Limited (2005) 275 ITR 30 (Guj) held -

“Section 145 is couched in mandatory terms and the department is bound to accept the assessee’s choice of method regularly employed, except for the situation wherein the Assessing officer is permitted to intervene in case it is found that the income, profits and gains cannot be arrived at by the method employed by the assessee. The position is further well settled that the regular method adopted by an assessee cannot be rejected merely because it gives benefit to an assessee in certain years.”

Subsection 2 to section 145 empowers Central Government to notify accounting standards to be followed by an assessee. Central Government has till date notified two accounting standards. Accounting Standard I (relating to disclosure of accounting policies) requires accounting policies to be adopted so as to represent true and fair view of the state of affairs of the business. The concepts of “prudence” and “conservatism” have been injected into the income-tax laws through this standard. The standard defines ‘Prudence’ to be provision made for all known liabilities and losses, even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.

The considerations of prudence and conservatism have been adopted and accepted for tax purposes in several judicial precedents of late. Tax laws have also veered towards the adoption of the concept of matching principles in determining the quantum of income to be offered to tax. The case of Madras Industrial Investment Corporation v CIT (1997) 225 ITR 802 (SC) acknowledges the concept of matching expenses and revenues. The matching principle is applied by matching expenditure against specific revenues - ‘as having been used in generating those specific revenues’ or by matching expenses against the revenues ‘of a given period in general on the basis that the expenditure pertains to that period’. The former is termed as "matching principle on revenue basis" and the latter is termed as "matching principle on time basis". The concept of ‘matching principle’ was again dealt with in detail by the Supreme court in the case of J K Industries Ltd v UOI (2008) 297 ITR 176 (SC).

As mentioned earlier, ESOP discount is an employee welfare measure. The income referable to the employee effort is recognised in the Profit and loss account. Matching principles would warrant the corresponding expenditure and/ or loss to be accounted in the Profit and loss account. Such discount when recognised in the Profit and loss account would also uphold the principle of prudence and conservatism.

Placing reliance on the commercial principles has been one of the elements of statutory interpretation. Interpretation postulates the search for the true meaning of the words used in the statute. It is presumed that a statute will be interpreted so as to be internally consistent. In other words, a section/ provision of the statute shall not be divorced from the rest of the Act. Similarly, a statute shall not be interpreted so as to be inconsistent with other contemporaneous statutes. Where there is an inconsistency, the judiciary will attempt to provide a harmonious interpretation.

A statute is an edict of legislature. The Government enacts laws to regulate economic, social behaviors and conduct. A series of legislation may be passed for this purpose. These laws have specific objectives. Their interplay helps in determining the larger purpose. When such is the interdependence, the tax laws must operate in tandem with other prevailing statutes. Income-tax law has to be interpreted taking cognizance of other statutes.

Aid from other statutes in interpreting Income-tax law

Income-tax Act is an integrated code. The interpretation of a taxing statute has to be on the basis of the language employed in the Act unless the words/ phrases are ambiguous or gives scope for more than one interpretation. The Act being a forward-looking statute does not operate in isolation.

With the modernisation and evolution of business, there could be occasions where one may have to refer other statutes to better understand certain terms or arrangements. This is done when the terms in the statute are technical in nature or dealing with a specialised matter. In such cases, the interpretation of income-tax law cannot be limited to the words in the Act itself. The Kerala High Court in the case of Moolamattom Electricity Board Employees' Co- Operative Bank Ltd In re (1999) 238 ITR 630 (Ker) held -

“Resort to a different provision of another Act may also be permissible in the absence of a definition or where the term is technical in nature.”

There could also be situations where certain provisions in the Act lean or depend upon other laws in a particular matter/ context. In such cases, the provisions of such other laws will have to be considered. The Apex court in the case of CIT v Bagyalakshmi & Co (1965) 55 ITR 660 (SC) held -

“The income-tax law gives the Income-tax Officer a power to assess the income of a person in the manner provided by the Act. Except where there is a specific provision of the Income-tax Act which derogates from any other statutory law or personal law, the provision will have to be considered in the light of the relevant branches of law.”

ESOP discount involves forgoing of share premium receivable by the company. In the absence of any specific provision in the Act dealing with such discount, one may have to dwell into the commercial understanding of such discount. In doing so, one may take guidance (even if not strict compliance) from other statutes and regulatory guidelines prescribed in this regard.

In ACIT, Delhi v Om Oils And Oil Seeds Exchange Ltd (1985) 152 ITR 552 (Delhi) the High Court acknowledged the treatment of share premium by placing reliance on the Companies Act, 1956 (“Companies Act”)

“Such a payment and the right can properly be regarded as a capital asset and the money paid as on capital account. This is more so in view of the provisions of s. 78 of the Companies Act, 1956. The effect of s. 78 of the said Act is to create a new class of capital of a company which is not share capital but not distribution of the share premium as dividend is not permitted and it is taken out of the category of the divisible profit.”

The court relied on the principles in the Companies Act to conclude that share premium is a capital receipt.

One may therefore look at the guidance note issued by ICAI and SEBI regulations for treatment of ESOP expenses as well along with the treatment under the OECD convention.

In summary, Income-tax relies on the general commercial and accounting principles in determining the taxable income. This principle has got a statutory mandate through section 145 of the Act. Further, one may refer other statutes for appropriate interpretation of the Income-tax statute. Accordingly, the guidelines prescribed by the regulatory bodies such as the SEBI, ICAI, OECD need to be reckoned in computing the taxable income.

PART C(1) - Claim of ESOP expense under specific provisions of the Act

Income-tax is a charge on income. The term ‘Income’ is defined in section 2(24) of the Act. The definition is an inclusive one and enlists various items which are to be regarded as income under the Act. Section 4 is the charging provision under the Act. The charge is defined vis-à-vis a person who is the recipient of income. The charge is in respect of the total income of a person for any year.

The scope of income chargeable to tax in India is dealt in section 5 of the Act. The income that is referred to in section 5 as chargeable to tax would have to be classified into 5 heads, by virtue of section 14. For each head of income, the law provides for a separate charging section and computation mechanism. Though section 5 is an omnibus charging section; for being taxed, the income would also have to satisfy, the separate charging and computation mechanism under the respective heads.

In the present case, the claim of ESOP expense is under the head “Income from profits and gains of business or profession” (“business income”). Section 28 outlines the charge in relation to such income. As per section 29, the income referred to in section 28 would be computed in accordance with the provisions contained in sections 30 to 43D.

As regards claim of deductions in business income, Lord Parker in the case of Usher’s Witshire Brewery Limited v Bruce 6 TC 399, 429 (HL) said -

“Where a deduction is proper and necessary to be made in order to ascertain the balance of profits and gains it ought to be allowed… provided there is no prohibition against such an allowance.”

Income connotes a monetary return ‘coming in’ from definite sources. It is a resultant figure derived after considering the receipts and payments made there for. Not every receipt of business is income. A receipt could be capital or a revenue receipt. The Privy Council in the case of CIT v Shaw Wallace and Co 6 ITC 178 (PC) laid out tests to find out whether a particular receipt is ‘income’. According to that test, income connotes a periodical monetary return coming in with some sort of regularity or expected regularity from definite sources. The source is not necessarily one which is expected to be continuously productive, but it must be one whose object is the production of a definite return excluding anything in the nature of a mere windfall. ‘Capital receipts’ are not to be brought into account in computing profits under business head, apart from express statutory provisions like section 28(ii) and section 41. Section 28 envisages revenue profits which arises or accrues in the course of business.

Similarly, a disbursement is not allowable if it is of a capital nature. Capital items can be deducted from receipts only when the statute expressly provides so. Generally, the criteria which are invoked in distinguishing capital receipts and revenue receipts will also serve to distinguish between capital and revenue disbursements. This view was expressed by the learned authors Kanga and Palkiwala and was upheld by the High Court in the case of Dalmia Dadri Cement Ltd v CIT (1969) 74 ITR 484 (P&H).

Accordingly, there is no single yardstick to determine whether an item (income or deductions therefrom) would be capital or revenue. There is no explicit statement or provision in the Act in this regard. This would be a fact specific exercise. What is generally an established fact is that disbursement of capital nature is not allowed/ deductible unless specifically provided for in the Act.

PART C(2) - Whether ESOP discount is capital in nature (not allowable)?

Claim of ESOP discount as a deduction is to be examined under the head “Profits and gains of business or profession”. This head of income is housed in sections 28 to 44DB. Under section 28(i) the profits and gains of any business or profession carried on by the assessee at any time during the previous year is chargeable to tax. As per section 29, the income referred to in section 28 should be computed in accordance with the provisions contained in sections 30 to 43D. Sections 30 to 36 confer specific deductions. Section 37 deals with expenditure which is general in nature and not covered within sections 30 to 36. The remaining sections enlist various categories of nondeductible expenditure (not relevant for the present discussion).

Sections 30 to 36 dealing with specific deductions do not deal with ESOP discount. The allowability of ESOP discount would have to be examined under section 37 - the residuary section. To examine eligibility of ESOP discount u/s. 37, the character of discount needs to be examined. If the discount is regarded as capital in nature, section 37 would prohibit its deduction. It is expenditure on revenue account that qualifies for deduction. From an accounting perspective ESOP discount is a revenue item (as discussed earlier). From an income-tax view point, whether such discount is capital or revenue in nature is the issue for consideration?

In the absence of an express definition of capital or revenue expenditure in the Act, one may have to rely on the various judicial precedents on this matter; the rationale adopted and the interpretation adjudged therein.

In the treatise ‘The Law and Practice of Income Tax’ by Kanga and Palkiwala, (9th edition - page 225) the learned authors observe -

“The problem of discriminating between capital receipts and income receipts, and between capital disbursements and income disbursements, has very frequently engaged the attention of the courts. In general, the distinction is well recognised and easily applied, but from time to time cases arise where the item lies on the border line and the task of assigning it to income or capital becomes much of refinement. As the Act does not define income except by way of adding artificial categories, it is to be decided cases that one must go in search of light.”

(Emphasis supplied)

In the context of ESOP discount, one notices two contradictory judgments - in the case of S.S.I. Limited v DCIT (2004) 85 TTJ 1049 (Chennai) and Ranbaxy Laboratories Limited (2009) 124 TTJ 771 (Del). The Chennai Tribunal held ESOP discount to be a revenue and allowable/ deductible business expenditure. The Delhi Tribunal however gave a contrary judgment. The Delhi Tribunal placed it reliance on the decision of the House of Lords in the case of Lowry v Consolidated African Selection Trust Ltd (1940) 8 ITR 88 (Supp) [This is discussed in detail later in the write-up].

Before application of tests whether ESOP discount is a revenue (and therefore deductible) expenditure, one needs to enlist the arguments put forth in some of the decisions which held that ESOP discount is NOT an allowable expenditure (largely for the reason that it is a capital expenditure).

  • ESOP discount are incurred in relation to issue of shares to employees. They are not relatable to profits and gains arising or accruing from a business/ trade. The Apex Court decision in the case of Punjab State Industrial Dev Corporation Ltd (1997) 225 ITR 792 (SC) and Brooke Bond India Ltd (1997) 225 ITR 798 (SC) have held that expenditure resulting in ‘increase in capital’ is not an allowable deduction even if such expenditure may incidentally help in business of the company.

  • ESOP discount does not diminish trading/ business receipts of the issuing company. The company does not suffer any pecuniary detriment. To claim a charge against income, it should inflict a detriment to the financial position. ESOP is a voluntary scheme launched by the employers to issue shares to employees. The intention is to only give a ‘stake’ to the employees in the organisation.

  • This discount is not incurred towards satisfaction of any trade liability as the employees have not given up anything to procure such ESOP.

  • Share premiums obtained on issue of shares are items of capital receipt. When such premium is forgone, it cannot be claimed as an ‘expenditure wholly and exclusively laid out or expended for the purposes of the trade’.

Each of these points has been addressed in the following paragraphs and specifically in Part D (Judicial pronouncements).

PART C(3) - Deductibility of ESOP discount under section 37

As discussed earlier, sections 30 to 36 enumerate specific deductions. The remaining deductions/ expenditure fall to be governed under the residuary section 37. Section 37 permits deduction of an “expenditure” (not being personal or capital in nature), which is wholly and exclusively incurred for the purpose of business of the assessee. ESOP discount is not specifically covered under sections 30 to 36. The allowability of such discount is therefore to be considered under section 37 of the Act.

Section 37, to the extent material reads as follows-

“37( 1) - Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head "Profits and gains of business or profession"……”

In order to be eligible for a deduction under section 37, the following conditions should be cumulatively satisfied:

(i) The impugned payment must constitute an expenditure;

(ii) The expenditure must not be governed by the provisions of sections 30 to 36;

(iii) The expenditure must not be personal in nature;

(iv) The expenditure must have been laid out or expended wholly and exclusively for the purposes of the business of the assessee;

and

(v) The expenditure must not be capital in nature.

Each of the above is examined in seriatim except point (ii) which is satisfied (as mentioned before).

Condition 1 – Payment must constitute expenditure

Claim of ESOP discount as “expenditure”

The existence of an “expenditure" is the sine qua non for attracting section 37. The phraseology "expenditure......laid out or expended wholly and exclusively for the purpose of such business, profession or vocation" in section 10(2)(xv) of the Indian Income-tax Act, 1922, is identical to the phraseology used in section 37 of the Act.

The term "expenditure" is not defined in the Act. In the absence of a definition, one may rely on the commercial understanding of the term; the definition in other enactments and deduce a meaning suitable to the context. Section 2(h) of the Expenditure Act, 1957 defines expenditure as follows:

“Expenditure: Any sum of money or money’s worth spent or disbursed or for the spending or disbursing of which a liability has been incurred by an assessee. The term includes any amount which, under the provision of the Expenditure Act is required to be included in the taxable expenditure.”

In the landmark decision of the Supreme Court in Indian Molasses Company (P) Ltd. v. CIT (1959) 37 ITR 66, the term "expenditure" was defined in the following manner :

"`Expenditure' is equal to `expense' and `expense' is money laid out by calculation and intention though in many uses of the word this element may not be present, as when we speak of a joke at another's expense. But the idea of `spending' in the sense of `paying out or away' money is the primary meaning and it is with that meaning that we are concerned. ` Expenditure' is thus what is `paid out or away' and is something which is gone irretrievably."

(Emphasis supplied)

The expression ‘lay out’ is defined in the Oxford Dictionary as ‘to spend, expend money’. The use of these words ‘laid out’ before ‘expenditure’ emphasise the irretrievable character of the expenditure.

In common usage, expenditure would mean outflow of money in satisfaction of a liability. This liability may be imposed or voluntarily agreed upon. A mere liability to satisfy an obligation is not "expenditure". When such obligation is met by delivery of property or by settlement of accounts, there is expenditure.

However, ‘Expenditure’ may not always involve actual parting with money or property; actual disbursement of legal currency. For instance, if there are crossclaims, each constitutes an admitted liability qua the other party. When one of them pays to the other the difference between the two counter liabilities, the payer in effect pays the value of his/ her liability against payment due to him from the other party. In making payment of that difference, the payer in fact lays out expenditure equal to the liability due by him.

Satisfaction of cross-claims to a transaction involves both retention/ payment of money. The amount which is debited/ adjusted in the account settlement would constitute expenditure. This principle was upheld by the Apex court in the case of CIT v Nainital Bank Ltd. (1966) 62 ITR 638 (SC). It is a ‘net off’ of receivables against payables. This ‘netting off’ effectively discharges the entire payables.

Stock options are issued to employees at discount. This discount represents the difference between the market value of the shares and the strike price on exercise of options. The company forbears from receiving the full value on its shares. The primary meaning of expenditure no doubt involves monies going away irretrievably. In its indirect connotation it would also include amount forgone. Forbearance of profit could also thus be covered within the gamut of section 37.

Claim of expense under section 37 as “amount forgone”

The question whether expenditure can be said to be incurred when an assessee ‘forgoes profit’ out of commercial considerations must be determined upon facts of the case. Amount forgone represents an act of relinquishment. It is a relinquishment of commercial or pecuniary prospect. If the relinquishment is for the purposes of business it would fall to be considered under section 37.

In the case of Usher's Wiltshire Brewery Ltd. v Bruce (1914) 84 L. J. KB 417; (1915) AC 433 a brewery company acquired freehold or leasehold interest in several premises in the ordinary course of its trade and let them to publicans who were tied to purchase their beer from the company. In consideration, the company charged the publicans a rent less than the full value of the licensed premises. The House of Lords held that the company was entitled to deduct the difference between the actual rent which it received from its tied tenants and the bonafide annual value as money wholly and exclusively laid out or expended for the purposes of trade. Lord Loreburn said -

“on ordinary principles of commercial trading, such loss arising from letting tied houses at reduced rents is obviously a sound commercial outlay”

The above was upheld by Supreme Court in the case of CIT v S.C. Kothari (1971) 82 ITR 794. The Apex court in the case of CIT v Chandulal Keshavlal & Co (1960) 38 ITR 601 held that amount forgone for the purpose of business is an allowable expenditure. Section 10(2)(xv) of the 1922 Act required that the expenses must be laid out for the purpose of business of the assessee, and further that they should not be in the nature of capital expenditure. In Chandulal Keshavlal’s case, the managing agent’s commission was agreed at ` 309,114. However, at the oral request of the board of directors of the managed company the managing agent agreed to accept a sum of ` 100,000 only as its commission. The question before the Supreme Court was whether the commission amount forgone constituted expenditure for the managing agents. The Supreme Court held:

(i) that in cases such as this case, in order to justify deduction the sum must be given up for reasons of commercial expediency: it might not be voluntary, but so long as it was incurred for the assessee's benefit the deduction was allowable;

(ii) that as the Appellate Tribunal had found that the amount was expended for reasons of commercial expediency, and was not given as a bounty but to strengthen the managed company so that if the financial position of the managed company became strong the assessee would benefit thereby, the Appellate Tribunal rightly came to the conclusion that it was a deductible expense under section 10(2)(xv).

Based on the aforesaid, one could claim the ESOP discount u/s. 37 as allowable. Such discount -

  • Is an amount forgone for the purposes of employee welfare

  • Is not a bounty/ gratuitous expense, but paid in lieu of employee service

  • Is aimed at retaining and encouraging the employees thereby benefitting the business of the Company

Claim of expense under section 37 as “losses”

As stated earlier, section 37 presupposes expenditure. Per contra, expenditure does not always mean that an amount should have gone out from one’s pocket. It could include a ‘loss’. A loss may be allowed as expenditure under section 37.

The Supreme Court in the case of CIT v Woodward Governor India (P) Ltd. and Honda Siel Power Products Ltd. (2009) 312 ITR 254 (SC) held that, loss arising on account of fluctuation in the rate of exchange in respect of loans taken for revenue purposes was allowable as deduction u/s. 37 of the Act.

In the case of M.P. Financial Corporation v CIT (1987) 165 ITR 765 (MP) the Madhya Pradesh High Court held that the expression "expenditure" as used in Section 37 may, in the circumstances of a particular case, cover an amount which is a "loss" even though the amount has not gone out from the pocket of the assessee.

Thus, ESOP discount satisfies the first condition irrespective of whether it is characterised as ‘expenditure’, ‘amount forgone’ or ‘loss’. Non-capital expenditure incurred for the purposes of business should be covered under the omnibus residuary section 37. Even otherwise, the same would be allowable under section 28. The deduction is founded on ordinary commercial principles of computing profits.

Condition 2 - Expenditure should not be personal in nature

A company is an artificial juridical person. It is a distinct assessable entity under the Act. A company being an artificial juridical person cannot have personal expenses. The ‘personal’ facet is associated with human beings. It is concerned with human body or physical being.

The Supreme Court in State of Madras v. G.J Coelho (1964) 53 ITR 186 (SC) held that personal expenses would include expenses on the person of the assessee or to satisfy his personal needs such as clothes, food, etc. Needs such as clothes, food are associated with human beings and not with any artificial juridical person. The Gujarat High court in the case of Sayaji Iron & Engineering Company v. CIT (2002) 253 ITR 749 held that a company cannot have any personal expenditure. Accordingly, ESOP discount cannot be disallowed branding it to be personal expenditure.

Condition 3 - Expenditure to be laid out wholly and exclusively for business

This is one of the most important and debated conditions of section 37. To qualify as a deduction u/s. 37:

  • The expense must be wholly and exclusively incurred; and

  • Such incurrence must be for the purposes of business.

Meaning of ‘wholly and exclusively’

The words “wholly and exclusively for the purposes of the business” have not been defined in the Act. Judicial precedents have explained the meaning of this phrase. “The adverb ‘wholly’ in the phrase ‘laid out or expended. . . for business’ refers to the quantum of expenditure. The adverb ‘exclusively’ has reference to the object or motive of the act behind the expenditure. Unless such motive is solely for promoting the business, the expenditure will not qualify for deduction” - C.J. Patel & Co. v. CIT (1986) 158 ITR 486 (Guj). ESOP discount concerns wholly and exclusively with employee welfare measures.

Meaning of ‘For the purposes of business’

The expression ‘for the purpose of business’ in section 37(1) of the Act (corresponding to section 10(2)(xv) of the 1922 Act) is wider in scope than the expression ‘for the purpose of earning profits’. The Apex court in the case of CIT v. Malayalam Plantations Ltd (1964) 53 ITR 140 (SC) elucidating the concept “for the purpose of business” held -

“Its range is wide; it may take in not only the day-to-day running of a business but also the relationship of its administration and modernisation of its machinery, it may include measures for the preservation of the business and for the protection of its assets and property from expropriation or coercive process; it may also comprehend payment of statutory dues and taxes imposed as a pre-condition to commence or for carrying on of a business; it may comprehend many other acts incidental to the carrying on of a business.”

(Emphasis supplied)

This decision of the Apex court upheld the wide scope of the phrase ‘for the purposes of business’. It covers within its ambit all expenditure which enables a person to carry on and maintain the business, including any incidental or ancillary activities thereto. The range of this phrase is broad to encompass not only routine business expenses but also incidental expenses.

The wide scope of this phrase can also be appreciated by contrasting with the language used in section 57 of the Act. Section 57 of the Act enlists deduction allowable under the head “Income from other sources”. Similar to section 37, clause (iii) of section 57 is a residuary deduction available in case of “Other sources” income. However, there is a difference in the language - section 57 requires expenditure to be incurred wholly and exclusively for the purpose of making or earning such income.

In the treatise ‘The Law and Practice of Income Tax’ by Kanga and Palkiwala, (9th edition - page 1211) the learned authors observe -

“There is a marked difference between the language of section 37(1) and section 57(iii), both of which are residuary provisions under the respective heads; whereas this section [section 57(iii)] allows expenditure ‘laid out or expended wholly and exclusively for the purposes of making or earning such income’, the allowance under section 37 is in wider terms - ‘laid out or expended wholly and exclusively for the purposes of business or profession’.

“For the purposes of business” alludes to business expediency. ‘Business expediency’ is a broad term. The best person to judge the business expediency is the businessman himself. Courts have consistently held that the necessity or otherwise of the commercial expediency is to be decided from the point of view of the businessman and not by the subjective standard of reasonableness of the revenue. The absence of business connection should not mar the application of the test of business expediency.

The Apex court in the case of S.A. Builders Limited v CIT (2007) 288 ITR 1 (SC) explaining the meaning and scope of the phrase “commercial expediency”, held -

“The expression "commercial expediency" is an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business. The expenditure may not have been incurred under any legal obligation, but yet it is allowable as business expenditure if it was incurred on grounds of commercial expediency.”

The test of the “need for expenditure” is alien to section 37. Any expenditure made on ground of commercial expediency is to be allowed even though there is no legal necessity or even if it is not for direct or immediate benefit of trade. A sum of money voluntarily expended indirectly to facilitate business is entitled to be allowed as expenditure on grounds of commercial expediency.

The following are some of the observations from judicial precedents which further explain “Commercial expediency”:

In the case of Atherton v British Insulated & Helsby Cables Limited 10 TC 155, 191 (HL), the court held -

“A sum of money expended, not necessarily and with a view to a direct and immediate benefit to the trade, but voluntarily and on the grounds of commercial expediency and in order indirectly to facilitate the carrying on of the business, may yet be expended wholly and exclusively for the purposes of trade.”

The Supreme Court in the case of CIT v Panipat Woollen & General Mills Co. Ltd. [1976] 103 ITR 66 (SC) observed -

“The test of commercial expediency cannot bereduced in the shape of a ritualistic formula, nor can it be put in a water-tight compartment so as to be confined in a strait-jacket. The test merely means that the Court will place itself in the position of a businessman and find out whether the expenses incurred could be said to have been laid out for the purpose of the business or the transaction was merely a subterfuge for the purpose of sharing or dividing the profits ascertained in a particular manner. It seems that in the ultimate analysis the matter would depend on the intention of the parties as spelt out from the terms of the agreement or the surrounding circumstances, the nature or character of the trade or venture, the purpose for which the expenses are incurred and the object which is sought to be achieved for incurring those expenses”

(Emphasis supplied)

Loss due to ESOP discount is necessitated by business expediency. The business expediency is the compensation and recognition to its employees. Over the years the concept of master-servant relationship is fading. Sharing of wealth of an employer with his employee is the order of the day. Stock option is one such mode of employee participation deserving fiscal encouragement. The Directive Principles of State Policy, enshrined in the Indian Constitution, lays down that “the State shall take steps by suitable legislation or in any other way, to secure the participation of workers in the management of undertakings, establishment or other organisations engaged in any industry” (Article 43A).

ESOP is an employee retention and recognition strategy. It enables the company to beat the pace of attrition. There is a direct nexus between incurrence of this expenditure and the business of the Company. The expenditure so incurred wholly and exclusively for the purpose of business and necessitated by commercial expediency, would satisfy the aforesaid condition.

Condition 4 - The expenditure must not be a capital expenditure

The demarcation between revenue and capital is not a straight jacket exercise. One may have to get into the facts of each case for such determination.

In Assam Bengal Cement Co. Ltd. v CIT (1955) 27 ITR 34, the Supreme Court held that due to diversity in the nature of business, a particular test cannot determine the nature of expenditure. The Supreme Court held that it is the object of expenditure which determines its nature. As per the Supreme Court “The aim and object of the expenditure would determine the character of the expenditure whether it is a capital expenditure or revenue expenditure. The source or the manner of the payment would then be of no consequence.”

(Emphasis supplied)

The nature of expenditure must be determined from the point of view of the payer. The Madras High Court in CIT v Ashok Leyland Ltd (1969) 72 ITR 137, 143 (affirmed by Supreme Court in (1972) 86 ITR 549) pointed out that the generally accepted distinction between ‘capital expenditure’ and ‘revenue expenditure’ is susceptible to modification under peculiar circumstances of a case. The relevant observations are as follows:

“A clear-cut dichotomy cannot be laid down in the absence of a statutory definition of "capital and revenue expenditure". Invariably it has to be considered from the point of view of the payer. In the ultimate analysis, the conclusion of the admissibility of an allowance claimed is one of law, if not a mixed question of law and fact. The word "capital" connotes permanency and capital expenditure is, therefore, closely akin to the concept of securing something tangible or intangible property, corporeal or incorporeal rights, so that they could be of a lasting or enduring benefit to the enterprise in issue. Revenue expenditure, on the other hand, is operational in its perspective and solely intended for the furtherance of the enterprise. This distinction, though candid and well accepted, yet is susceptible to modification under peculiar and distinct circumstances”.

(Emphasis supplied)

The nature of business and expenditure are decisive factors in determining the answer to the controversy. Temptation to use decided cases must be avoided in answering the question whether a particular expenditure constitutes capital or revenue expenditure. The Supreme Court in Abdul Kayoom (KTMKM) v CIT (1962) 44 ITR 689 (SC) held -

“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 Cordozo) by matching the colour of one case against the colour of another. To decide, therefore, on which side of the line a case falls, its broad resemblance to another case is not at all decisive. What is decisive is the nature of the business, the nature of the expenditure, the nature of the right acquired, and their relation inter se, and this is the only key to resolve the issue in the light of the general principles, which are followed in such cases.”

The aim and object of the expenditure is thus the decisive factor for determining whether a particular expenditure constitutes revenue or capital expenditure. This is ascertained by examining all aspects and surrounding circumstances. The nature of the business has to be seen. The issue must be viewed from the point of a practical and prudent businessman.

One has to determine ‘why’ the expenditure has been incurred by a businessman and not ‘how’ the expenditure has been funded by him. As observed by Supreme Court in Assam Bengal Cement Co. Ltd. case (supra), the source and manner of the payment is inconsequential for determining the nature of a particular expenditure. It is the aim and object of the expenditure that would determine its character. The Madras High Court in India Manufactures (P) Ltd v. CIT (1985) 155 ITR 770 held that for determining the nature of a particular expenditure, the manner of payment is not relevant. The Calcutta High Court in Parshva Properties Ltd v CIT (1976) 104 ITR 631 held

“…in order to determine whether the expenditure was deductible or not, it is necessary to find out in what capacity the expenditure was incurred.”

If the examination is limited to “how” the funds have been secured, the answer (to all share capital issue expenses) would be the same. It is the aspect of “why” that would help in appreciating the underlying difference in the motive, object and aim of the expenditure. The question “why” may involve determination whether the funds are for:

  • future expansion of the business;

  • the prolongation of life of an existing business;

  • forming a conceivable nucleus for posterior profit earning;

  • conduct of the business;

  • avoiding inroads and incursions into its concrete presence;

  • commercial expediency;

  • profit earning enhancement.

All of the above do not have the same purpose. The involvement and intensity with the business or its existence may not be uniform. The degree of association with the business or its conduct may vary. Some have their objective of profit earning or enhancement. Others concern the substratum of business. It would be unwise to characterise expenses associated with all the above as same. If the characterisation is not uniform, the associated expenditure is not to be branded in the same light. The attendant circumstances would have to be examined. These circumstances influence the characterisation of the associated payments.

The expenditure under discussion [viz., ESOP discount] would be allowed as business deduction only if the aim and object of the expenditure falls in the revenue field. As discussed repeatedly, the test of determining a disbursement to be ‘revenue’ in nature is fact specific. Characterisation of amounts as ‘income’ or ‘capital’ is determined as a matter of commercial substance, and not by subtleties of drafting, or by unduly literal or technical interpretations. The Apex Court in the case of Dalmia Jain and Co. Ltd. v CIT (1971) 81 ITR 754 (SC) while holding that expenditure incurred for maintenance of business is revenue in nature, observed -

"The principle which has to be deduced from decided cases is that, where the expenditure laid out for the acquisition or improvement of a fixed capital asset is attributable to capital, it is a capital expenditure, but if it is incurred to protect the trade or business of the assessee then it is a revenue expenditure. In deciding whether a particular expenditure is capital or revenue in nature, what the courts have to see is whether the expenditure in question was incurred to create any new asset or was incurred for maintaining the business of the company. If it is the former it is capital expenditure, if it is the latter, it is revenue expenditure."

As a general principle, an amount spent by an assessee for labour/ employee welfare would be deductible as revenue expenditure. Even if such expense results in an asset to the employees or third party - it is ‘revenue’ as far as it does not result in creation of capital asset for employer. Employee emoluments are revenue in nature. The Calcutta High Court in the case of CIT v Machinery Manufacturing Corporation Ltd (1992) 198 ITR 559 (Cal) held -

“In our view, the question is now well settled. If the employer pays any amount to the employee which is by way of an incentive, in that event such amount shall be treated as additional emoluments and such payment is inextricably connected with the business and necessarily for commercial expediency. It cannot be said that the claim which has been made is de hors the business of the assessee. As will appear from the narration of facts, it was found that it was the payment made by the assessee for better performance and, accordingly, it must be held that such payment was for commercial expediency and incurred wholly and exclusively for the purpose of business.”

The following points support the proposition that ESOP discount is an employee welfare measure and is bonafide revenue expenditure:

1. Support in the Income-tax statute

ESOP benefit is taxable in the hands of the employees as ‘perquisites’ under section 17(2) of the Act. There is no dispute that salary is bona fide revenue expenditure eligible for deduction. Salary and its components would remain on revenue account whether it is paid in cash or in kind.

ESOP is remuneration in kind. It is a perquisite. It is a benefit or amenity. It is consideration for employment. The concept of ESOP evolves/ springs out from the employer-employee relationship.

Consideration for employment in the form of amenity, benefit was the subject matter of levy of fringe benefit tax. The circular of CBDT explaining and clarifying various aspects of ESOP is relevant in the context of the issue under consideration.

  • Fringe Benefit Tax Circulars

The Central Board of Direct Taxes released a circular No 9/2007 dated September 20, 2007 containing frequently asked questions on ESOP. A number of issues had been raised by trade and industry at different fora after the presentation of the Finance Bill, 2007, after its enactment and also after the notification of Rule 40C.

In answer to question no. 9, the Board observed “Therefore, an employer does not have an option to tax the benefit arising on account of shares allotted or transferred under ESOPs as perquisite which otherwise is to be taxed as fringe benefit.”

FBT is a charge on expenditure. The circular acknowledges the fact that ESOP is a salary expense from the employer/ payer’s perspective. Once the payment is established as a salary, its deductibility should be unquestioned. ESOP discount is an allowable expenditure - being perquisite paid by the employer.

The FBT regime was amended to make the ESOP benefit, as susceptible to a levy of FBT. FBT by definition was a ‘consideration for employment’ in certain specified forms. ESOP discount thus constituted ‘employment related expenditure’ by the Act itself.

Section 115W(1)(b) provided for a levy of FBT on the value of concession in the context of travel. A ‘concession’ was thus conceptually encompassed within FBT since 2006. Finance Act 2008 extended the regime to cover “ESOP concession”.

As discussed earlier, section 37 is not limited to actual expenditure but also covers amount forgone. ESOP being a concession given to the employees, the same is squarely covered within the ambit of section 37. Initially ESOP benefit was held to be outside the ambit of FBT due to the absence of computation mechanism. The law was amended and ESOP was subjected to FBT. The essence of ESOP continuing to remain a benefit or amenity to an employee and constituting a consideration for employment was confirmed.

Various questions and answer thereto in the Board circular have upheld the concept of determining nature of expenditure based on the proximate purpose. If the same yardstick is used in the case of ESOP discount, the proximate purpose is salary disbursement, incidentally resulting in increased share capital. ESOP discount thus remains revenue in nature.

  • Tax withholding on salary payments under section 192

Section 192 in the Act imposes a responsibility on the employer to withhold taxes on salary payments. Salary includes perquisites. Perquisites would include benefit granted to an employee as ESOP(s). Section 192(1) of the Act reads -

“Any person responsible for paying any income chargeable under the head “Salaries” shall, at the time of payment, deduct income tax on the amount payable at the average rate of income-tax computed on the basis of the rates in force for the financial year in which the payment is made, on the estimated income of the assessee under this head for that financial year.”

(Emphasis supplied)

On a perusal of the above definition it is apparent that accrual of income and the act of payment must co-exist for the purposes of withholding tax under this provision. In the case of CIT v Tej Quebecor Printing Limited (2006) 281 ITR 170 (Del), it was held that if the salary due to the employee is not paid, there is no obligation to deduct tax at source. Conversely, if section 192 is applicable, then the law presumes a payment to have been made to an employee. Section 192 requires deduction of tax at the time of payment.

The Board issues a circular each year outlining the obligations of an employer relating to the deduction u/s. 192. Circular No. 8/2010, dated 13-12-2010 outlines such obligations for the financial year 2010-11. Paragraph 5 of the circular mandates an employer to consider the “ESOP benefit” to an employee as a part of perquisite. Once it is a part of perquisites, it forms part of salary on which the liability to deduct tax at source fastens. The allotment of shares triggering the perquisite would constitute the act as well as the fact of payment. The circular reinforces the conclusion that ESOP benefit constitutes salary to an employee. Being a part of the salary, it should be regarded as revenue in nature and allowable as a deduction much like other perquisites.

2. Nexus between benefit and expenditure

Under general principles, allowability of a deduction is not dependent upon character of income in the hands of the payee. In other words, the fact that a certain payment constitutes an income or capital in the hands of the recipient is not material in determining whether the payment is a revenue or capital disbursement qua the payer.

Macnaghten J said in Racecourse Betting Control Board v Wild 22 TC 182 “The payment may be a revenue payment from the point of view of the payer and a capital payment from the point of view of the receiver, and vice-versa.”

The Calcutta High Court in the case of Anglo-Persian Oil Co. (India), Ltd. v CIT (1933) 1 ITR 129 (Cal) held -“The principle that capital receipt spells capital expenditure or vice versa is simple but it is not necessarily sound. Whether a sum is received on capital or revenue account depends or may depend upon the character of the business of the recipient. Whether a payment is or is not in the nature of capital expenditure depends or may depend upon the character of the business of the payer and upon other factors related thereto.”

Income is taxable unless and otherwise exempt under the Act. However, expenditure operates on the principles of commercial expediency - it is allowable unless specifically prohibited by the Act. Based on commercial principles, ESOP discount should be an allowable expenditure in the hands of employer/ company. 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.

The function of the ESOP discount forming part of employee’s income (and suffering tax accordingly) would thus support and sustain a claim for the same being reckoned as a revenue deduction in the hands of the employer. This principle has been supported by the courts on various occasions. Some of them are as below:

The Calcutta High court in the case of CIT v Britannia Industries Co Ltd (1982) 135 ITR 35 (Cal) held -

“We are fully in agreement with the view of the Tribunal that there cannot be any two different standards for assessment in respect of the employee and the employer. It is also equitable that what the payer gives is what the receiver receives.”

In the case of Weight v Salmon (1935) 19 Tax Case 174; 153 L.T.55, E.Lord Atkin said -

“..it would be a startling inconsistency to say that the director was to be taxed because 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 and gains..”

3. The ‘Act of giving’ and ‘act of receiving’ are two separate events

Issue of shares under ESOP scheme involves two actions. One is the giving of benefit to the employee (in the form of discount on share premium) and the other is receipt of premium by the employer/ company. They are distinct and separate from each other. The discount emerging out of the transaction is revenue in nature. It is different from the ‘premium receipt activity’ which is a capital item. Although they are inter-linked, they are two independent transactions. The act of giving a benefit would precede the act of receipt of premium. One cannot receive premium unless, the benefit is parted with. The sequence of occurrence of these two events is thus critical.

The purpose of ESOP discount has proximity to giving of benefit and not receipt of premium. Such discount emerges out of the act of giving benefit. The mere fact that subsequent receipt of premium is ‘capital’ in nature, should not militate the revenue character of the ESOP discount.

4. There is no creation of capital asset

The expenditure is to be attributed to capital if it be made ‘with a view’ to bringing an asset or advantage, although it is not necessary that it should always result in an asset or advantage. Lord Viscount LC, in the course of the case [10 TC 155 (1926) AC 205] said -

“When an expenditure is made, not only for once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.”

The test of enduring benefit or advantage cannot be reduced to a straight jacket formula. There may be cases where expenditure, even if incurred for obtaining an advantage of enduring benefit, may, nonetheless, be on revenue account. The test of enduring benefit may break down. Every advantage of enduring nature does not render the expenditure to be capital in character. It is only where the advantage is in the capital field that the expenditure would be disallowed for income-tax purposes. If the expenditure is incurred only to facilitate and promote business, then it would necessarily have to be considered revenue in nature and allowed as a deduction.

ESOP is a share-based payment of employee remuneration. Issue of ESOP(s) creates an ‘asset’ for the employees (in form of share investment in the Company). From a Company’s standpoint, such issue of ESOP results in emergence of a liability. It is an acknowledgment by the Company of an increase in the amount due to the shareholders. There is no capital asset created out of this transaction.

5. ESOP - a consideration for employment services

An offer made to employee under ESOP is a mode of employee remuneration. This offer has direct nexus with the employment of a person with the organisation. Evidences of linkage with employee can be evidenced through terms of the ESOP agreement. Some of the typical clauses/ conditions are:

Eligibility criterion - wherein the person eligible for an ESOP would be employee of a particular class, or could be employee serving a certain span of time in the organisation; or could be employee who meets certain thresholds/ targets etc.

Vesting Schedule - The vesting of stock options is generally spread over a number of years of service. There could be different vesting schedule depending on the caliber and hierarchy of the employees in the organisation ladder, as also the philosophy adopted by the employee.

Transfer Restrictions or Lock in - Transfer of vested stock options are generally restricted and subject to particular occasions. The employees are not allowed to transfer options freely to others.

Termination/ Exit Clause - This clause generally provides the lapse of options on termination of employment.

The various conditions in the ESOP agreement provide the employment nexus to such stock options. The stock options are generally in appreciation of their past performances and an incentive to stay with the organisation on its growth path. They represent payment for services of the employees. These are payments/ losses borne by the employer. The discounts are offered in the course of employment. They are a form of salary payments for the services rendered. Accordingly, they are business expenditure allowable under the Act.

6. Documentation

Documentation of any transaction is critical. Documents serve as the proof to decipher the intent of any transaction. These documents need to be interpreted based on the intention of the parties contained therein. The Apex Court in the case of Ishikawajma-Harima Heavy Industries Ltd v Director of Income-tax (2007) 288 ITR 408 (SC) commented on interpretation of documents. It held:

“In construing a contract, the terms and conditions thereof are to be read as a whole. A contract must be construed keeping in view the intention of the parties. No doubt, the applicability of the tax laws would depend upon the nature of the contract, but the same should not be construed keeping in view the taxing provisions.”

Commercial expediency and business intentions can be better understood when supported with appropriate and adequate documentation. A company is mandatorily required to maintain various documents.

An ESOP scheme also entails a huge amount of documentation. Most of these are available in the public domain. Commencing from the preliminary intent of the Board resolution, to issue of employee share certificate - there are various documents that are exchanged/ maintained.

The significance of documentation has been upheld by the Apex court in the case of CIT v Motors & General Stores (1967) 66 ITR 692 (SC) which quoted another landmark decision in the case of Lord Russell of Killowen in Inland Revenue Commissioners v Duke of Westminster. It held -

“It is therefore obvious that it is not open to the income-tax authorities to deduce the nature of the document from the purported intention by going behind the documents or to consider the substance of the matter or to accept it in part and reject it in part or to re-write the document merely to suit the purpose of revenue.”

The Kerala High Court in the case of CIT v. M. Sreedharan (1991) 190 ITR 604 (Ker) held -

“Ground realities cannot be ignored. Existence of contemporaneous evidence and agreements should also be considered and interpreted having regard to the factual matrices.”

Documentation helps in determining tax incidence. They act as an evidence of the fact. Indian courts have repeatedly upheld the role of an agreement in the interpretation of the legal rights and obligations. A document has to be read as a whole. Neither the nomenclature of the documents nor any particular activity undertaken by the parties to the contract alone would be decisive.

It is an established principle of law that commercial documents must be construed in commercial parlance. These are business agreements and must be read as business men would read them. This principle was upheld by W T Suren & Co. v CIT (1971) 80 ITR 602 (Bom). In all taxation matters, emphasis must be placed on the business aspect of a transaction rather than the purely legal and technical aspect. This principle has been upheld in various judicial precedents; few of which are as follows:

  • CIT v Kolhia (1949) 17 ITR 545 (Bom)

  • Suren v CIT (1971) 80 ITR 602 (Bom)

  • Nilkantha v CIT (1951) 20 ITR 8 (Pat)

The following documents would assist in determining the nature of ESOP transaction:

  • Director’s report

The intentions of the company are disclosed through the director report. Through their report, the directors spell out the impact on the revenue on account of ESOP. The reason to accommodate the loss is accounted to the shareholders. They are an intrinsic evidence to show that the shares were allotted by way of remuneration to compensate the services rendered in promoting, forming or running the company.

  • ESOP agreement

This is an agreement between the company/employer and the employee detailing the objectives, terms and conditions of the ESOP issue. This agreement details the aspects of scheme eligibility, terms, time-frames, rights and duties of each of the parties etc. This serves as a primary document of the ESOP transaction.

It is the drafting of this agreement and the nomenclature employed herein that has been the subject of a severe scrutiny of the Revenue authorities. ESOP is essentially an employee remuneration contract (in addition to the employee contract). However, as per the Revenue’s interpretation, the emergence of shares is to be superimposed on the employee remuneration element, coloring and converting the entire transaction as a “share issue” transaction.

The mere fact that the agreement intends to make the employees the stakeholders does not dilute or dilate the character of the transaction. The intent is to remunerate. It is recognition tool. The transaction is not to be re-written to say that it is a “share issue” transaction. By describing the allotment of ESOP as "towards giving equity stake", the motive for conferring the benefit cannot be confounded.

It is a trite saying that remuneration need not generally be effected by systematic and recurring monetary payments. There could also be compensation in kind. ESOP is a typical example of a payment in kind.

7. Utilisation of expenditure is important - not the source

A reason why ESOP discount is not regarded as revenue is possibly the attribute of ‘resultant permanency’. Share capital and the company’s existence are inseparable. Shares survive as long as the company exists. Possibly therefore, expenditure referable to increase in share capital is regarded as ‘capital in nature’.

The question is - whether the aspect of life of share capital is determinative? Or is it the purpose of utilisation that is decisive? Share capital may be utilised for creating a profit making apparatus. It may, on the other hands be utilised for a profit making activity. In the latter utilisation, the capital is churned over. It keeps changing form. In the former, the form remains largely unimpaired - save the depletion in value due to lapse of time or usage. This distinction should govern characterisation for tax purposes also.

It is not that every expenditure involving/ pertaining to the subject of share capital that is to be pigeonholed as not allowable as a deduction under section 37. The Supreme Court in its decision in CIT v General Insurance Corporation (2006) 286 ITR 232 held that expenses by way of stamp duty and registration fee for issue of bonus shares are revenue in nature. The Supreme Court held that the allotment of bonus shares did not result in the acquisition of any benefit or advantage of an enduring nature. In this decision, the Supreme Court no doubt approved the principle in the cases Brooke Bond India Limited v CIT (supra) and Punjab Industrial Development Corporation Ltd v. CIT (supra). However, it recognised that every expenditure connected with share capital is not necessarily capital in nature.

The Supreme Court in General Insurance Corporation’s case approved the decision of Bombay High Court in Bombay Burmah Trading Corpn Ltd v CIT (1984) 145 ITR 793. In the said decision, the Bombay High Court held it is not essential or mandatory that an expenditure incurred in connection with the raising of additional capital requires disallowance. The Bombay High Court in Shri Ram Mills Ltd v. CIT 195 ITR 295 interpreting its decision in Bombay Burmah Trading Corporation’s case made the following observation:

“In the case of Bombay Burmah Trading Corpn Ltd. v. CIT [1984] 145 ITR 793, this Court held that it was not that every expenditure incurred in connection with the raising of additional capital that required disallowance. Expenditure such as legal expenses, printing expenses, which a trader is expected, to incur in the course of its capacity as trader have to be allowed as revenue expenditure even though a part of them might relate to the raising of the additional capital”

It is to be noted that the Supreme Court in Brooke Bond India Limited v. CIT (supra) and Punjab Industrial Development Corporation Ltd v. CIT (supra) had affirmed the decision of Bombay High Court in Bombay Burmah Trading Corporation’s case.

The Jodhpur bench of Rajasthan High Court in CIT v. Secure Meters Ltd (2008) 321 ITR 611 held that expenses incurred in connection with issue of quasi equity viz., convertible debentures would constitute revenue expenditure. The Karnataka High Court recently in CIT v ITC Hotels Ltd. (2010) 190 Taxman 430 has held to the same effect.

The Andhra Pradesh High Court in Warner Hindustan Ltd v CIT (1988) 171 ITR 224 was called upon to adjudicate on two issues. The first issue was whether claim of the assessee-company that the legal and consultation fees in connection with the issue of bonus shares is an allowable business expenditure is correct or not? The second issue was whether the amount spent by the assessee-company by way of fees paid to Registrar of Companies for increasing its authorised capital was deductible as revenue expenditure? The High Court held that both would constitute revenue expenditure in the hands of the assessee-company. It is to be noted that the Supreme Court in Punjab Industrial Development Corporation Ltd v CIT (supra) disapproved the decision of Andhra Pradesh High Court only with regard to the second issue and not the first issue. In other words, the Supreme Court had not questioned the revenue character of legal and consultation fees paid in connection with issue of bonus shares.

Besides, one could look at various instances wherein the utilisation of expenditure is important - the form or source is irrelevant. Today’s fast track business world does not intend to issue shares only for increasing the capital base. The Department of Industrial Policy and Promotion (DIPP) has released Discussion Papers on various aspects related to Foreign Direct Investment. In a series of these Discussion Papers, ‘Issue of shares for considerations other than cash’ has also been included. This discussion paper enlists some of the instances wherein shares are issued on non-cash considerations towards the following:

  • Trade Payables

  • Pre-operative expenses/pre-incorporation expenses (including payment of rent)

  • Others

These transactions when viewed from the incometax standpoint, leaves us with the question - whether these are allowable expenses, when discharged in the form of shares. Would it be possible to hold that payment of ‘rent’ is not an allowable expenditure as the same has been discharged through issue of shares? Rent is certainly allowable for tax purposes. So would be fee for technical services which is paid for in shares. The same analogy should be extended to ESOP discount. ESOP discount arising on discharge of salary liability should be allowable in the hands of the employer/ company.

In summary, ESOP discount satisfies all the conditions stipulated for claim of expense under section 37 based on the following counts:

  • ESOP discount is a forbearance of profit and hence would qualify as an ‘expenditure’;

  • Even if such discount does not qualify as ‘expenditure’, it may be allowed as ‘profit forgone’;

  • It is not a an expenditure of personal nature;

  • Being an employee remuneration, the expenditure is laid out or expended wholly and exclusively for the purposes of the business of the assessee – employee retention and recognition; and

  • The expenditure is not capital in nature.

(to be continued.........)

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