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TMI Blog2015 (11) TMI 867X X X X Extracts X X X X X X X X Extracts X X X X ..... assessee company and against the Revenue that discount under ESOP is in the nature of employees cost and is hence deductible during the vesting period w.r.t the market price of share at the time of grant of options to the employees. The amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvesting/lapsing options at the appropriate time, however, an adjustment to the income is called for at the time of exercise of option by the amount of difference in the amount of discount calculated with reference to the market price at the time of grant of option and the market price at the time of exercise of option. Thus, we hold that discount on issue of Employees Stock option is allowable as deduction in computing the income under the head 'Profit and gains of Business or Profession' In the instant case we have noticed that the AO has refused to grant the deduction of the discount on ESOP at the very threshold and the CIT(A) has allowed the said claim based on the decision of Hon'ble Special Bench in the case of Biocon Limited(supra). Resultantly, the verification of correctness of calculation of discount stood ousted and have be ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... allotted to the employees and the price at which shares are allotted to employees and the same were claimed as revenue expenses by the assessee company. In the view of the AO, the said expenses are notional expenditure which can not be allowed as deduction under the Act as the same is not revenue expenditure rather the same is merely share premium foregone on allotment of shares which can not be allowed as expenditure under the Act. 4. The assessee company challenged the re-opening of assessment u/s 147 read with Section 148 of the Act by submitting that the AO does not have any tangible material, additional information or fresh evidence to re-open the assessment and rather it is a case of change of opinion of the AO based on same set of facts, material and evidences which were already on record with the AO and hence it was submitted by the assessee company that re-opening is bad in law, illegal and may by dropped and withdrawn by the AO.The assessee company submitted that reopening is not authorised in accordance with Section 151 of the Act and hence not legal. 5. On merits, the assessing company submitted as under: a) That the assessee company has not claimed any notion ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... penses in the hands of the assesse company. k) The ESOP expenses are not capital as there is no increase in the capital base of the company which is ₹ 3,46,75,325 as at 31-03-2006 and also as at 31-03-2007. 6. The AO did not accepted the contentions of the assessee company and held that these are notional expenses and assessee has not actually incurred any expenditure. The said expenditure relates to increase in share capital of the company and hence are capital expenditure. The AO relied upon the decision of Hon'ble Supreme Court in M/s Punjab State Industrial Corporation Limited v. CIT (1997) 225 ITR 792(SC) and Brooke Bond India Limited v. CIT(1997) 225 ITR 798 (SC) and held these expenses as capital expenditure not allowable as revenue expenses, more so these are merely share premium foregone and no such actual expenditure is incurred by the assessee company. Thus, AO disallowed the ESOP expenditure of ₹ 81,93,150/- and added the same to income of the assessee company in the orders dated 25th October 2012 u/s 143(3) read with section 147 of the Act. 7. Aggrieved the assesee company filed first appeal with the CIT(A) and reiterated its submissions as mad ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ct read with section 115WB(1)(d) of the Act and hence the same are allowable expenses in the hands of the assesse company. k) The ESOP expenses are not capital as there is no increase in the capital base of the company which is ₹ 3,46,75,325 as at 31-03-2006 and also as at 31-03-2007. l) The assessee company also relied upon the decision of Hon'ble Special Bench- ITAT Bangalore in the case of Biocon Ltd. V. DCIT(LTU) in appeal no. 368 to 371 1206 all of 2010 for assessment year 2003-04, 2004-05, 2005-06, 2006-07 and 2007-08 and appeal no. 248/Bang/2010 in CIT(LTU) Bangalore v. Biocon Ltd. for assessment year 2004-05 and submitted that the Special Bench has held that the difference(discount) between the market price of the shares and their issue price is expenditure in the hands of the assesse because it is a substitute to giving direct incentive in cash for availing the services of employees and is a mode of compensating employees for their continued services to company and is a part of their remuneration which is an ascertained liability and cannot be described as a notional or contingent liability nor it could be described as a share capital/share premium rece ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he similar facts. h) The assessee company submitted that Chandigarh Bench of Tribunal has allowed deduction with respect to issue sweat equity shares at predetermined price for consideration other than cash. i) The liability for ESOP has accrued and arisen during the assessment year and it has been debited to Profit and Loss A/c and is an allowable expenditure. j) These ESOP expenses are taxable as perquisite in the hands of the employees u/s 17(2)(vi) of the Act read with section 115WB(1)(d) of the Act and hence the same are allowable expenses in the hands of the assesse company. k) The ESOP expenses are not capital as there is no increase in the capital base of the company which is ₹ 3,46,75,325 as at 31-03-2006 and also as at 31-03-2007. l) The assessee company also relied upon the decision of Hon'ble Special Bench- ITAT Bangalore in the case of (2013) 35 taxmann.com 335(SB)- Biocon Ltd. V. DCIT(LTU) in appeal no. 368 to 371 1026 all of 2010 for assessment year 2003- 04, 2004-05, 2005-06, 2006-07 and 2007-08 and appeal no. 248/Bang/2010 in CIT(LTU) Bangalore v. Biocon Ltd. for assessment year 2004-05 and submitted that the Special Bench has held that t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... count 8. We will take up these three steps one by one for consideration and decision. I. WHETHER ANY DEDUCTION OF SUCH DISCOUNT IS ALLOWABLE? 9.1 The crux of the arguments put forth by the ld. AR is that discount under ESOP is nothing but employees cost incurred by the assessee for which deduction is warranted. On the other hand, the Revenue has set up a case that no deduction can be allowed as such discount is not only a short capital receipt but also a contingent liability. A. Is discount under ESOP a short capital receipt? 9.2.1 The ld. DR stated that the question of deduction u/s 37 can arise only if the assessee incurs any expenditure, which thereafter satisfies the requisite conditions of the sub-section (1). He submitted that the word expenditure has been described by the Hon'ble Supreme Court in the case of Indian Molasses Co. (P.) Ltd. v. CIT [1959] 37 ITR 66 as denoting spending or paying out, i.e. something going out of the coffers of the assessee. It was put forth that by issuing shares at discounted premium, nothing is paid out by the company. Once there is no paying out or away , the same cannot constitute an expenditure and resultantly ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ann.com 267/53 SOT 70 (URO). 9.2.3 Let us examine the facts of the case of Ranbaxy Laboratories Ltd. (supra), which has been strongly relied by the learned Departmental Representative. It deals with a situation in which the assessee granted stock option to its employees. The shares were to be issued at ₹ 559 per share as against the face value of ₹ 10 and the market price on the date of grant at ₹ 738.95 per share. The assessee treated the difference between ₹ 738.95 and ₹ 595 as employees compensation in the books of account and charged the same to its Profit and loss account by spreading it over the vesting period. It was one of the years of the vesting period for which the assessee claimed deduction that came up for consideration before the Tribunal. It was held by the Tribunal that the market price of ₹ 738.55 per share would have resulted in realization of higher share premium. Since the assessee did not account for the difference between ₹ 738.55 and ₹ 10 as its income during the year, there was no loss of income. It was further noticed that by issuing shares at below the market price, there was no incurring of any expendit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ences with the grant of option and terminates when the options so granted vest in the employees after serving the company for the agreed period. By granting the options, the company gets a sort of assurance from its employee for rendering uninterrupted services during the vesting period and as a quid pro quo it undertakes to compensate the employees with a certain amount given in the shape of discounted premium on the issue of shares. 9.2.5 The core of the arguments of the ld. DR in this regard is two-fold. First, that it is not an expenditure in itself and secondly, it is a short capital receipt or at the most a sort of capital expenditure. In our considered opinion both the legs of this contention are legally unsustainable. 9.2.6 There is no doubt that the amount of share premium is otherwise a capital receipt and hence not chargeable to tax in the hands of company. The Finance Act, 2012 has inserted clause (viib) of section 56(2) w.e.f. 1.4.2013 providing that: 'where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ence between ₹ 100 and ₹ 40, is again nothing but a different mode of awarding remuneration to employees for their continued services. In both the cases, the object is to compensate employees to the tune of ₹ 60. It follows that the discount on premium under ESOP is simply one of the modes of compensating the employees for their services and is a part of their remuneration. Thus, the contention of the ld. DR that by issuing shares to employees at a discounted premium, the company got a lower capital receipt, is bereft of an force. The sole object of issuing shares to employees at a discounted premium is to compensate them for the continuity of their services to the company. By no stretch of imagination, we can describe such discount as either a short capital receipt or a capital expenditure. It is nothing but the employees cost incurred by the company. The substance of this transaction is disbursing compensation to the employees for their services, for which the form of issuing shares at a discounted premium is adopted. 9.2.7 Now we espouse the second part of the submission of the ld. DR in this regard. He canvassed a view that an expenditure denotes paying ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... under section 2(h) of the Expenditure Act, 1957, viz., not only 'paying out' but also 'incurring'. Coming back to our context, it is seen that by undertaking to issue shares at discounted premium, the company does not pay anything to its employees but incurs obligation of issuing shares at a discounted price on a future date in lieu of their services, which is nothing but an expenditure u/s 37(1) of the Act. 9.2.8 Though discount on premium is nothing but an expenditure u/s 37(1), it is worth noting that the Hon'ble Supreme Court in the case of CIT v. Woodward Governor India (P.) Ltd. [2009] 312 ITR 254/179 Taxman 326 has gone to the extent of covering loss in certain circumstances within the purview of expenditure as used in section in 37(1). In that case, the assessee incurred additional liability due to exchange rate fluctuation on a revenue account. The Assessing Officer did not allow deduction u/s 37. When the matter finally reached the Hon'ble Supreme Court, their Lordships noticed that the word expenditure has not been defined in the Act. They held that : the word expenditure is, therefore, required to be understood in the context in wh ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... submitted that the amount of discount claimed by the assessee as deduction is not a contingent liability but an ascertained liability. He stated that in the ESOP 2000, there is a vesting period of four years, which means that the options to the extent of 25% of the total grant would vest with the eligible employees at the end of first year after rendering unhindered service for one year and it would go on till the completion of four years. 9.3.2 It is a trite law and there can be no quarrel over the settled legal position that deduction is permissible in respect of an ascertained liability and not a contingent liability. Section 31 of the Indian Contract Act, 1872 defines contingent contract as a contract to do or not do something, if some event, collateral to such contract does not happen . We need to determine as to whether the liability arising on the assessee-company for issuing shares at a discounted premium can be characterized as a contingent liability in the light of the definition of contingent contract. From the stand point of the company, the options under ESOP 2000 vest with the employees at the rate of 25% only on putting in service for one year by the employee ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for deduction even though the liability may have to be quantified and discharged at a future date. We consider it our earnest duty to mention that the legislature has inserted clause (f) to section 43B by providing that any sum payable by the assessee as an employer in lieu of any leave at the credit of his employee shall be allowed as deduction in computing the income of the previous year in which such sum is actually paid. With this legislative amendment, the application of the ratio decidendi in the case of Bharat Earth Movers (supra) to the provision for leave encashment has been nullified. However, the principle laid down in the said judgment is absolutely intact that a liability definitely incurred by an assessee is deductible notwithstanding the fact that its quantification may take place in a later year. The mere fact that the quantification is not precisely possible at the time of incurring the liability would not make an ascertained liability a contingent. 9.3.4 Almost to the similar effect, there is another judgment of the Hon'ble Supreme Court in the case of Rotork Controls India (P.) Ltd. v. CIT [2009] 314 ITR 62/180 Taxman 422. In that case, the assessee-c ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ise, would be available for grant at a future date or would be available for being re-granted at a future date. If we consider it at micro level qua each individual employee, it may sound contingent, but if view it at macro level qua the group of employees as a whole, it loses the tag of 'contingent' because such lapsing options are up for grabs to the other eligible employees. In any case, if some of the options remain unvested or are not exercised, the discount hitherto claimed as deduction is required to be reversed and offered for taxation in such later year. We, therefore, hold that the discount in relation to options vesting during the year cannot be held as a contingent liability. C. Fringe benefit 9.4.1 There is another important dimension of this issue. Chapter XII-H of the Act consisting of sections 115W to 115WL with the caption : Income-Tax on Fringe Benefits has been inserted by the Finance Act, 2005 w.e.f. 1.4.2006. Memorandum explaining the provisions of the Finance Bill, 2005 highlights the details of the Fringe Benefits Tax. It provides that : 'Fringe benefits as outlined in section 115WB, mean any privilege, service, facility or amenity dir ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... anted ? 10.2 The assessee is a limited company and hence it is obliged to maintain its accounts on mercantile basis. Under such system of accounting, an item of income becomes taxable when a right to receive it is finally acquired notwithstanding the fact that when such income is actually received. Even if such income is actually received in a later year, its taxability would not be evaded for the year in which right to receive was finally acquired. In the same manner, an expense becomes deductible when liability to pay arises irrespective of its actual discharge. The incurring of liability and the resultant deduction cannot be marred by mere reason of some difficulty in proper quantification of such liability at that stage. The very point of incurring the liability enables the assessee to claim deduction under mercantile system of accounting. We have noticed the mandate of the Hon'ble Supreme Court in Bharat Earth Movers (supra) that if a business liability has definitely arisen in an accounting year, then the deduction should be allowed in that year itself notwithstanding the fact that such liability is incapable of proper quantification at that stage and is dischargeabl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... obligation falls upon the company to allot shares at the time of exercise of option depending upon the length of service rendered by the employee during the vesting period. The incurring of liability towards the discounted premium, being compensation to employee, is directly linked with the span of service put in by the employee. In the above illustration, when 25 out of 100 shares vest in the employee after rendering one year's service, the company also incurs equal obligation at the end of the first year for which it becomes entitled to rightfully claim deduction u/s 37(1) of the Act. Similarly at the end of the second year of service by the employees, the company can claim deduction for discounted premium in respect of further 25 shares so on and so forth till fourth year when the last tranche of discounted premium in respect of 25 shares becomes available for deduction. It, therefore, transpires that a company under the mercantile system can lawfully claim deduction for total discounted premium representing the employees cost over the vesting period at the rate at which there is vesting of options in the employees. 10.5 From the above discussion it is lucid that at the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... I Guidelines in this regard. These Guidelines provide for granting of deduction on account of discount on issue of options during the vesting period. It has been so explained with the help of an example in Schedule I to the Guidelines. For the sake of simplicity, we are taking an instance under which an option of share with face value of ₹ 10 is given under ESOP to employees at the option price of ₹ 10 as against the market price of such shares at ₹ 110 on that date. Further suppose that the vesting period is four years with equal vesting @ 25% at the end of each year. Total discount comes to ₹ 100 (Rs. 110 - ₹ 10). These Guidelines provide for claiming deduction in the accounts for a total discount of ₹ 100 divided over the vesting period of four years on straight line basis at the rate of ₹ 25 each. The case of S.S.I. Ltd. (supra) deals with a controversy relating to one of the vesting years. The tribunal entitled the assessee to proportionate deduction. Thus it is evident that the view taken by the tribunal in that case not only matches with the SEBI Guidelines but also the 'accrual concept' in the mercantile system of accounting ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... laimed as deduction by the company during the period starting with the date of grant till the happening of this event, such discount needs to be reversed and taken as income. It is so because logically when the options have not eventually vested in the employees, to that extent, the company has incurred no employee cost. And if there is no cost to the company, the tentative amount of deduction earlier claimed on the basis of the market price at the time of grant of option ceases to be admissible and hence needs to be reversed. The ld. AR stated that the discount in respect of the unvested/lapsing options has been reversed on the happening of such events and the overall employee cost has been correspondingly reduced. We find that the SEBI Guidelines also provide that the discount written off in respect of unvested options and the options lapsing at the end of the exercise period shall be reversed at the appropriate time. As the accounting treatment directed through the Guidelines accords with the taxation principle of not allowing deduction for the amount of discount on unvested/lapsing options and further the assessee has admitted to have offered such amount as income in the releva ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uch security or shares'. Two things surface from the above provisions. First, that the perquisite arises on the 'allotment' of shares and second, the value of such perquisite is to be computed by considering the fair market value of the shares on 'the date on which the option is exercised' by the assessee as reduced by the amount actually paid. The position that such amount was or was not taxable during some of the years in the hands of the employees is not relevant in considering the occasion and the amount of benefit accruing to the employee under ESOP. Any exemption or the deductibility of an allowance or benefit to employee from taxation does not obliterate the benefit itself. It simply means that the benefit accrued to the assessee but the same did not attract tax. The position has now been clarified beyond doubt by the legislature that the ESOP discount, which is nothing but the reward for services, is a taxable perquisite to the employee at the time of exercise of option, and its valuation is to be done by considering the fair market value of the shares on the date on which the option is exercised. 11.1.5 The other side of the coin is the amount of r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... mple with the assumption of vesting period of four years and the benefit vesting at 25% each at the end of 1st to 4th years:- At the time of granting option Market value per share 110 Option price 10 Employees compensation or Discount 100 11.1.7 From the above table it can be noticed that the market price of the shares at the time of grant of option was ₹ 110 against the option price of ₹ 10, which resulted in discount at ₹ 100. With the vesting period of four years with the equal vesting, the company can rightly claim deduction at the rate of ₹ 25 each at the end of first, second, third and fourth year of vesting. But this total deduction for discount of ₹ 100 over the vesting period needs to be adjusted at the time of exercise of option by the employee when the shares are issued. In Situation I, the market price of shares at the time of exercise of option is at ₹ 110, which is similar to the market price at the time of grant of option. As the total amount of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e in a particular manner, then the germane provision should be followed. If, however, there is no specific provision dealing with an issue in the Act, then the accounting principles should be adhered to while determining the total income of the assessee. In this regard, he relied on the judgment in the case of Challapalli Sugars Ltd.'s (supra), wherein the Hon'ble Supreme Court has held that the interest payable on capital borrowed by the assessee for purchase of plant and machinery before the commencement of business should be capitalized on the basis of accepted accountancy rule. Similarly in the case of U.P. State Industrial Development Corpn. (supra), the Hon'ble Apex Court held in the case of an underwriter that it would be right to consider the net investment, that is the purchase price less the underwriting commission received by the underwriter as investment as against treating the gross amount by taking into consideration the principles of commercial accounting. He stated that since there is no specific provision in the Act providing for the treatment of discount on ESOP in the computation of total income, the accounting principles formulated by way of the SEBI ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... head 'Profits and gains of business or profession', there are sections granting deductions in respect of specific expenses or allowances. Similarly, there is section 37(1), which grants deduction for expenses not specifically set out in other sections, if the conditions stipulated in the section, are fulfilled. All other items of expenses, which fulfil the requisite conditions, gain deductibility under section 37(1). To put it in simple words, this section is a specific provision for granting deduction in respect of the unspecified or the general categories of expenses. Discount on ESOP is a general expense and hence covered by the specific provision of section 37. The contention of the ld. AR that there is no provision in the Act dealing with the deductibility of ESOP discount, is therefore, devoid of any merit. This concludes the question of granting of deduction of discount during the vesting period. 11.2.5 The SEBI Guidelines have been taken shelter of to contend that there is no requirement for the adjustment of discount at the time of exercise of options. Primarily, we are unable to trace the proposition anywhere from the Act that the accounting principles are al ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... principle has been followed and the accounting principle, which is in line with such taxation principle, has been simply taken note of. If however, an accounting principle runs counter to the taxation principle, then there is no prize for guessing that it is only the taxation principle which shall prevail. 11.2.8 The plea now raised before us by the ld. AR, relying on the case of Challapalli Sugars Ltd. (supra), was also taken up before the Hon'ble Supreme Court in the case ofTuticorin Alkalis Chemicals Fertilizers Ltd (supra). Dealing with the same, the Hon'ble Supreme Court held that : The question in Challapalli Sugars Ltd.'s case (supra) was about computation of depreciation and development rebate under the Indian Income-tax Act, 1922. In order to calculate depreciation and development rebate it was necessary to find out the actual cost of the plant and machinery purchased by the company. This court held that cost is a word of wider connotation than price . There was a difference between the price of a machinery and its cost. This court thereafter pointed out that the expression actual cost had not been defined in the Act. It was, therefore, necessary ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e SEBI Guidelines, matches with the treatment under the mercantile system of accounting. To that extent, we also hold that the SEBI guidelines are applicable in the matter of deduction of discount. Neither there was any issue before the Hon'ble Madras High Court nor it dealt with a situation in which the market price of the shares at the time of exercise of option is more or less than the market price at the time of grant of option. It is a situation which has also not been dealt with by the Guidelines. Accordingly, the aforenoted taxation principle of granting deduction for the additional discount and reversing deduction for the short amount of discount at the time of exercise of option, needs to be scrupulously followed. 11.3 We, therefore, sum up the position that the discount under ESOP is in the nature of employees cost and is hence deductible during the vesting period w.r.t. the market price of shares at the time of grant of options to the employees. The amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvesting/lapsing options at the appropriate time. However, an adjustment to the income is called for at ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... stated that the face value of shares is at ₹ 10 against which the deduction for discounted premium over the vesting period has been claimed at ₹ 909, meaning thereby that the market price of the share on the date of grant of option was taken at ₹ 919. No material worth the name has been placed on record to indicate as to how a share with face value of ₹ 10 has been valued at ₹ 919 for claiming deduction towards discount at ₹ 909 per share. This aspect of valuation of shares at ₹ 919 per share needs to be examined by the Assessing Officer. b. We have held above that the deduction of the discounted premium is to be claimed over the vesting period. The assessee claimed deduction for discount amounting to ₹ 3.38 crore for the A.Y. 2003-04. On being called upon to furnish bifurcation of such claim, the assessee filed a chart showing its detail comprising of four amounts. First amount of ₹ 1.62 crore has been shown as the first tranche of 25% option. Second amount of ₹ 81.25 lakh as the second tranche of 25% option; third amount of ₹ 54.16 lakh as the third tranche of 25% option and the last amount of ₹ 40.62 la ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ction in the earlier years in respect of unvesting/lapsing options has been reversed at the relevant time. There is no finding either in the assessment or the impugned order in this regard. This fact should also be verified by the AO to ensure that the overall expenditure booked by the company is restricted only to the extent of the exercised options. The Hon'ble Special Bench in the case of Biocon Limited(supra) has held that discount under ESOP is in the nature of employees cost and is hence deductible during the vesting period w.r.t the market price of share at the time of grant of options to the employees. The Hon'ble Special Bench has held that the amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvesting/lapsing options at the appropriate time , however, an adjustment to the income is called for at the time of exercise of option by the amount of difference in the amount of discount calculated with reference to the market price at the time of grant of option and the market price at the time of exercise of option. No contrary decision is brought to our notice by the Revenue. We hold that this discou ..... X X X X Extracts X X X X X X X X Extracts X X X X
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