ESOP: Being Used As A Double Edged Sword By The Department

CA Vidhan Surana & CA Sunil Maloo

ESOP: Being Used As A Double Edged Sword By The Department

CA Vidhan Surana & CA Sunil Maloo
The authors have carefully studied the recent landmark judgement of the Special Bench in Biocon Ltd on the deductibility of ESOPs in the hands of the employer and identified several important aspects in it. They argue that the Department is wrong in adopting the “double edged sword” stand of taxing ESOPs in the hands of the employee while denying a deduction to the employer

Today, organizations realize that they have to go that extra mile to make their employees stay. Sharing their wealth and helping employees create wealth in the form of ‘Employee Stock Option Plan (ESOP)’ is one such initiative, which is gaining immense popularity in recent times.

An employee stock ownership plan (ESOP) is an employee-owner scheme that provides a company’s workforce with an ownership interest in the company. This is the latest trend in the industry. This is a very important tool in almost all industries. Where, the greatest assets are the employees and their knowledge. The organization loses on this if the employee were to leave. So in order to retain the employees they are offered direct participation in the form of shares of the company.

1. Accounting Treatment of ESOP Costs:-

The ESOP scheme has to be constituted in accordance with the SEBI guidelines, provisions of Companies Act, 1956 and compliance of accounting treatments as laid down in guidance note issued by ICAI. In this regard, the ICAI has issued Guidance Note on Accounting for Employee Share-based Payments.

2. Allowability of ESOP Costs to Employers

Following are the justification for claiming a deduction of ESOP costs debited to the profit and Loss Account as an allowable deduction while computing “Profits and gains of business or profession”:-

Justification of ESOP expenses could be summarized on the basis of following bullet points:-

(a) Business Expediency of ESOP’s in the present scenario

Employee Stock Option Plan (ESOP): Meaning

Section 2(15A) of the Indian Companies Act, 1956 defines "employee stock option" to mean ‘the option given to the whole-time Directors, Officers or employees of a company, which gives such Directors, Officers or employees, the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a predetermined price".

An ESOP is a right to buy shares at a pre-determined price. The option granted under the plan confers a right but not an obligation on the employee. Stock options are subject to vesting, requiring continued service over a specified period of time. Upon vesting of options, employees can exercise the options to get shares, by paying the pre-determined exercise price.

ESOPs are being increasingly used as a compensation tool to attract and retain talented employees. Companies believe that ESOPs enhance productivity, motivate employees and increase employees’ interest in the company’s overall performance. With the market bouncing back, job opportunities are being created at large. Hence, in the interest of company such type of incentive required and accordingly SEBI also approved such mechanism. Companies are looking at competent employees who can stay with them for a longer period. This means giving them something more than just cash reward; thus, organizations are coming up with an ESOP scheme for their employees. In this cut – throat competitive business environment, ESOPs are one of the important tools to attract and retain employees. The feeling of ownership encourages employees to have long term career aspirations in the organization.

Today, globalization and competition are pushing every organization to employ various techniques to retain and motivate employees, and the practice of giving ESOPs to employees certainly emerges as a winner.

Attracting and retaining competent personnel / employees is an uphill task faced by all organizations. Besides cash rewards, it is important for an organization to make its employees believe that their personal growth is linked with the growth of the organization. ESOP’s are one of the important tools to achieve this objective. The feeling of ownership aligns employees’ aspirations with the long-term objectives of the organization. Therefore, in such situations, there is exerting obligation on part of the employers to retain its competent & qualified work force.

Accordingly in present scenario more and more companies are considering equity-linked incentive plans as an avenue to incentivize their employees. The companies consider ESOPs for the following key reasons:

– The market pays the upside to its employees.
– There is no cash outflow for the company.
-Helps in retaining and attracting talent.
– Provides sense of ownership to employees.

Thus it is clear that the ESOPs costs are incurred by the employers for the purpose of business. It is settled principle of law that no businessman can be compelled to maximize his profit. While considering the claim of deduction of any expenditure, Income-tax authorities must put themselves in the shoes of the Assessee and see how a prudent businessman would act. The authorities must not look at the matter from their own viewpoint, but that of a prudent businessman.

It is axiomatic that the taxation rules are always embodied in the relevant Act, either in a specific or a general manner. Under the head ‘Profits and gains of business or profession’, 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. 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. Therefore, Discount on ESOP is a general expense not specified anywhere else in the head of ‘Profits and gains of business or profession’ and hence shall be covered by the general provision of section 37.

b) Allowability based on principle of avoidance of double taxation in hands of employer as well as in hands of employees of the same item

The Action of the department in denying the allowability of the claim of ESOP Cost shall result into double taxation of the same item as under:-

Taxable in hands of the Employer as not allowable deduction; and

Taxable in hands of employees as “Perquisite” u/s 17(2) of the Act.

Taxation of ESOPs in India has witnessed continuous change. Up to the financial year ending March 1999, there were no specific provisions for taxing the benefits arising from ESOPs.

The ESOPs were generally taxed as a perquisite in the hands of the employees on the difference between the FMV of the stock on the date of vesting of the options and the exercise price. Subsequently, there was a concessional tax treatment for ESOPs, which were designed in accordance with prescribed ESOP Guidelines. The taxation triggered only at the time of sale of the shares for such qualified ESOPs. Unqualified ESOPs were taxable as a perquisite on the difference between the FMV on the date of vesting/exercise and the exercise price.

During the period April 2007 to March 2009, employer was required to pay Fringe Benefit Tax (FBT) on benefit derived by employee from ESOPs. The employer was allowed to recover such FBT from the employees.

Currently, ESOP benefits are taxable as perquisite and form part of employee’s salary income. The employer is required to withhold tax at source in respect of such perquisite. Section 17(2)(vi) of the Act (as inserted by Finance (No. 2) Act, 2009) in this regard is reproduced as under for ready reference:-

17(2) "perquisite" includes—
(vi)  the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at concessional rate to the assessee.
Explanation.—For the purposes of this sub-clause,—
(a)  "specified security" means the securities as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and, where employees’ stock option has been granted under any plan or scheme therefor, includes the securities offered under such plan or scheme;

The perquisite value is computed as the difference between the FMV of the share on the date of exercise and the exercise price. There are specific valuation rules prescribed for listed and unlisted companies. Unlisted companies need to determine the FMV by a Category I Merchant Banker registered with SEBI.

It is important to note that under the scheme of the Income Tax, allowability of expenditure is absolutely linked with the method of the accounting consistently followed by the Assessee irrespective of the actual cash flow payment of the said transaction except specifically provided in the Act.  Disallowance of claim of ESOP cost by the AO would tantamount to the double taxation of the same income, which has no sanctity under the scheme of Income Tax Act.

It is a cardinal principle of law that No one should be twice harassed for the same cause. The Department & Assessing Officer should not act like Sherlock Holmes —"Head I win and tail you lose" it would be alien to the principles of justice.

According to unambiguous provisions of section 17(2) of the Act, said item is taxable in the hands of employees as Perquisite, therefore, now there is no reason to again make double taxation in hands of employer of same item.

The doctrine of `approbate and reprobate‘ as borrowed in our jurisprudence from the scotch law gives strength to this basic rule. There cannot be approval and rejection in the same stream. To attempt to take advantage of one part and to reject the rest is against the fine norms of jurisprudence.

Denial of the claim of ESOP expenses debited to profit and loss statement shall result into clear cut breach of this tenet of law. It is abundantly clear from law as on date that the amount of ESOP Expenses is taxable to employees as perquisite. Then it is incumbent on the department to consider the claim of the ESOP cost judicially.

3. Judicial Pronouncements in this respect:-

Allowability of the ESOP cost has been a matter of scrutiny by various tribunals and diverse views on both sides were expressed. In the case of Ranbaxy Laboratories Limited v. DCIT [ITA Nos. 1666 & 2050/Del/2006] on 24.07.2009, the ITAT has upheld the action of the AO with respect to the denial of allowability of the claim of ESOP Cost and held that since the receipt of share premium is not taxable, any short receipt of such premium on issuing options to employees will be notional loss and not actual loss for which any liability is incurred.

However, Hon’ble Delhi High Court has admitted the further appeal against the judgment of the Delhi Tribunal in ITA No. 767/2010, which is pending before the Court. The Delhi High Court has admitted following questions of the law:-

(i) Whether on the facts and in the circumstances of the case, the tribunal erred in law in holding that the difference between the price at which stock options were offered to the employees of the appellant company under the ESOP Scheme and the prevailing market price of the stock on the date of grant of such options was not allowable expenditure under Section 37(1) of the Act?

(ii) Whether on the facts and in the circumstances of the case, the tribunal erred in law in not holding that the difference between the prevailing market price of the stock and the price at which stock options were offered to the employees under the ESOP Scheme, resulting in benefit to the employees and thus constituting remuneration of the employees was, allowable deduction under Section 37 of the Act?

And also the statue book has been amended vide the Finance Act, 2012 by inserting 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 the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares’, then such excess share premium shall be charged to tax under the head ‘Income from other sources’.

Further, recently the Special Bench of Bangalore ITAT in case of Biocon Ltd. Vs DCIT, reported in [2013] 35 335 (Bangalore – Trib.) (SB) has considered this issue after detailed, careful and deep analysis of the law available on this issue as well as of all the earlier judicial pronouncements available in the matter.

The Special bench of Bangalore ITAT has answers very important questions as under:-

Sr. No.


Answer given by the Special Bench


Whether any deduction of such discount is allowable ?


A. Is discount under ESOP a short capital receipt?

Para 9.2.6
“It is quite basic that the object of issuing shares can never be lost sight of. Having seen the rationale and modus operandi of the ESOP, it becomes out-and-out clear that when a company undertakes to issue shares to its employees at a discounted premium on a future date, the primary object of this exercise is not to raise share capital but to earn profit by securing the consistent and concentrated efforts of its dedicated employees during the vesting period. Such discount is construed, both by the employees and company, as nothing but a part of package of 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.
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.”

B. Is discount a Contingent liability ?

Para 9.3.6
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

Para 9.4.1
Thus it is discernible from the above provisions of the Act that the legislature itself contemplates the discount on premium under ESOP as a benefit provided by the employer to its employees during the course of service. If the legislature considers such discounted premium to the employees as a fringe benefit or ‘any consideration for employment’, it is not open to argue contrary. Once it is held as a consideration for employment, the natural corollary which follows is that such discount (i) is an expenditure; (ii) such expenditure is on account of an ascertained (not contingent) liability ; and (iii) it cannot be treated as a short capital receipt. In view of the foregoing discussion, we are of the considered opinion that discount on shares under the ESOP is an allowable deduction.


If yes, then when and how much?

Para 10.8
We, therefore, agree with the conclusion drawn by the tribunal in SSI Ltd.’s case allowing deduction of the discounted premium during the years of vesting on a straight line basis, which coincides with our above reasoning.


Subsequent adjustment to discount

Para 11.1.6
11.1.6 The amount of discount at the stage of granting of options w.r.t. the market price of shares at the time of grant of options is always a tentative employees cost because of the impossibility in correctly visualizing the likely market price of shares at the time of exercise of option by the employees, which, in turn, would reflect the correct employees cost. Since the definite liability is incurred during the vesting period, it has to be quantified on some logical basis. It is this market price at the time of the grant of options which is considered for working out the amount of discount during the vesting period. But, since actual amount of employees cost can be precisely determined only at the time of the exercise of option by the employees, the provisional amount of discount availed as deduction during the vesting period needs to be adjusted in the light of the actual discount on the basis of the market price of the shares at the time of exercise of options. It can be done by making suitable northwards or southwards adjustment at the time of exercise of option.

Other judicial pronouncements allowing deduction for ESOP Costs:-

1. S.S.I Ltd vs. DCIT 85 TTJ 1049

2. CIT v. PVP Ventures Ltd. 23 286 (Madras) in context of Section 263

3. Spray Engineering Devices Ltd. v. ACIT 23 267 (Chandigarh – Trib.)


Thus, under the above background of the legal and judicial position as on date, it can be precisely concluded that ESOP costs debited by the Employers in the statement of Profit and Loss is not at all notional loss or contingent liability, on the contrary same is a business expenditure incurred wholly and exclusively for the purpose of the business and same deserves allowability under the Income Tax Act while computing ‘Profits and gains of business or profession’. As by granting these options, the employer 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. However, still the verdict of higher forums such as High Courts and Supreme Court is lacking in this matter, having implications on all the employers Assessee’s through out India.

Disclaimer: The contents of this document are solely for informational purpose. It does not constitute professional advice or a formal recommendation. While due care has been taken in preparing this document, the existence of mistakes and omissions herein is not ruled out. Neither the author nor and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any inaccurate or incomplete information in this document nor for any actions taken in reliance thereon. No part of this document should be distributed or copied (except for personal, non-commercial use) without express written permission of

One comment on “ESOP: Being Used As A Double Edged Sword By The Department
  1. Shreyas says:

    Hi, have a small generic query – Can stock options be issued to “Consultants” by private companies under an ESOP Scheme? If yes, can you please provide an authority for the same?

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