An Employee Stock Option Plan (ESOP) is a mode to remunerate key employees for their performances. ESOP involves giving an option to the employees of a company the right to purchase or subscribe at a future date, the shares offered by the company, at a pre-determined price. ESOPs have been a significant component of the compensation for employees and is granted in addition to the base pay as it permits the employers to employ highly talented employees. In recent years, ESOPs have been used by companies as an effective tool to hire and retain high-level talents. In their initial years, it is also common for start-ups to offer ESOPs to attract and retain expert talent since they may not be able to pay high compensation to key managerial employees.
ESOPs provide an opportunity to employees to become owners of stock in the company they work for, at a discounted price, as compared to the market price. The employees of Indian multinational corporations MNCs are also typically granted ESOPs of foreign companies. It financially benefits the employees in future payouts by the company in the form of dividend and appreciation of value of shares. This encourages employees, to go the extra mile for earning higher profits and to continue working in the organisation for a longer duration, to avail their ESOPs.
Other types of plans also used by employers to reward employees include employee stock purchase plan wherein employees are offered shares with a lock-in period, or stock appreciation rights, wherein employees are entitled to future payments based on the increase in the stock prices over a specified period of time, subject to certain parameters.
Mechanics of ESOP plan
ESOPs are granted subject to a vesting period, which is normally linked to a tenure and/or performance/sales targets, etc. An employee obtains the right to exercise the option on vesting the same. Once the payment of exercise price is made, the shares are issued to the employee.
Tax implications on issue of ESOPs
Tax implications in the hands of the employee
Currently, ESOPs are taxed as perquisites under section 17(2) of the Income Tax Act, 1961 (the Act) read with Rule 3(8)(iii) of the Income Tax Rules, 1962. The taxation of ESOPs is split into two components:
i. Tax on perquisite as income from salary at the time of exercise;
ii. Tax on income from capital gain at the time of sale.
Taxability of perquisite
ESOPs are taxable in the hands of employees as perquisites at the time of exercise on the difference between the Fair Market Value (FMV) as reduced by the exercise price. As a result, even though there is no cash flow to the employees, they are subject to tax and the employer is required to deduct tax at source. This causes cash flow issues for employees as they are required to pay tax in the absence of any actual receipt of cash. Recognising this difficulty, the Hon'ble Finance Minister in the Union Budget 2020, announced deferment of taxation of perquisite in case of start-ups from date of allotment to the earliest of the following three dates:
• Expiry of 48 months from the end of the relevant assessment year;
• Sale of such shares by the employees;
• Date on which employee ceases to be employee of the start-up.
The eligible start-up shall accordingly, be required to deposit tax with the government within 14 days of the happening of any of the above events (whichever is earlier).
It is worthwhile to note that the above relaxation is proposed only in case of eligible start-ups based on various representations received by the government.
The employee continues to be liable to pay tax on the capital gains arising on sale of shares on the difference between the sale consideration, less the FMV considered as perquisite on sale of ESOPs.
Tax implications in the hands of the employer
• The employer would be required to withhold taxes on perquisite value, taxable in the hands of employees.
• While the tax treatment of ESOPs in the hands of the employees is settled, the availability of deduction in relation to the ESOP cost still remains a debatable issue in the absence of any specific provision under the Act. Further, the timing when the deduction for such expenditure is allowable, i.e. whether at the time of grant, vesting or exercise, and the quantum of deductions are also some of the questions to ponder upon.
At various instances, Courts had occasions to analyse these issues, as discussed below:
• The Chennai Tribunal1 held that the ESOP expenditure debited to profit and loss account under the head 'staff welfare' should be allowed as deductible expenditure. The Madras High Court2 has also affirmed the decision of the Chennai Tribunal in June 2012.
• Contrary to the above decision, the Delhi Tribunal3 held that issue of shares at below market price results into short receipt of share premium. Accordingly, it was held that since it is not an actual loss for which no liability is incurred, the same is not allowable under the provisions of the Act. Subsequently Mumbai4 and Hyderabad5 Tribunals followed the decision of Delhi Tribunal and held that the difference between the market price and the grant price, being contingent in nature and a notional loss, is therefore not allowable.
• However, Bangalore Special bench, in a significant ruling6 on the allowability of ESOP expenditure held that the discount on issue of shares cannot be treated as a short receipt of share premium or capital expenditure. The fact that the quantification of the liability may not be precisely possible at the time of incurring the liability, will not make it a contingent liability. It held that ESOP expenditure is a remuneration to employees and issue of shares at discounted price at a future date in lieu of their services, is an allowable deduction under section 37(1) of the Act. The Special Bench decision was followed by Bangalore Tribunal7 which held that difference between fair market value of shares on date of issue of shares and issue price would be regarded as an allowable expenditure under section 37(1) of the Act.
In the absence of clarity under the provisions of the Act and in view of the contrary rulings, there continues to be uncertainty on the issue. While the Special Bench Ruling can help tilt the scales in favour of the employers, litigation by the tax department relying on the contrary rulings, cannot be ruled out.
In view of the above, the Budget could have provided some clarity on the allowability of ESOP expenditure and the timing of deduction. In the absence of any amendment relevant to the same, it continues to be a vexed issue.
Information for the editor for reference purposes only
Deepa Bakhru is Senior Manager with Deloitte Haskins and Sells LLP
Pratik Gupta is Deputy Manager with Deloitte Haskins and Sells LLP
1. S.S.I. Limited v. DCIT ( 85 TTJ 1049) (Chennai Tribunal) (2005)
2. CIT v. PVP Ventures Ltd (earlier known as S.S.I.) (23 taxmann.com 286) (Madras)
3. Ranbaxy laboratories ltd. vs ACIT (124 TTJ 771) (Delhi Tribunal)
4. M/s. VIP Industries Ltd. (2010-TIOL-654) (Mumbai Tribunal)
5. Medha Servo Drivers (P) Ltd. vs. ACIT (I.T.A. 1099/Hyd/2006, Assessment Year 2003-04, I.T.A. 1114/Hyd/2008, Assessment Year 2004-05, ITA. 749/Hyd/2009, Assessment Year 2003-04) (Hyderabad Tribunal)
6. M/s Biocon Limited (35 taxmann.com 335) (Bangalore Tribunal) (SB)
7. Novo Nordisk India (P.) Ltd. (42 taxmann.com 168) (Bangalore Tribunal)