THE issues before the Bench are - Whether when assessee issues shares to employees without the premium price under ESOP, the same is to be construed as short capital receipt and Whether when the company does not pay anything to its employees, but incurs obligation of issuing shares at a discounted price on a future date, it is not a deductible expenditure u/s 37(1). And the verdict partly goes in favour of the assessee.
Facts of the case
The assessee is engaged in the manufacture of Enzymes and Pharmaceutical ingredients. It formulated the ESOP 2000. A trust was set up under the name and style of “Biocon India Limited Employees Welfare Trust” for giving effect to the ESOP 2000 and another ESOP 2004 which was launched subsequently but during one of the years under consideration. The assessee granted option of shares with face value of Rs.10 at the same rate by claiming that the market price of such shares was Rs.919, thereby claiming the total discount per option at Rs.909. During the previous year relevant to the AY 2003- 04, the assessee granted 71,510 options to its employees. The difference between the alleged market price and the exercise price, at Rs.909 per option totaling Rs.6.52 crore was claimed as compensation to the employees to be spread over the vesting period of four years. A deduction of Rs.3.38 crore was claimed for the AY 2003-2004 on the strength of the SEBI Guidelines.
In the assessment completed u/s 143(3), the AO disallowed the said claim on the ground that there was no specific provision entitling the assessee to deduction u/s 37(1) in this regard. He further held that the Securities and Exchange Board of India (Employee Stock Option Scheme And Employee Stock Purchase Scheme) Guidelines, 1999 ('the SEBI Guidelines' or 'the Guidelines'), on which the assessee had placed strong reliance in support of the deduction, would not apply as these cannot supersede the taxing principles. The AO observed that the options received by the employees were subject to risk of its forfeiture as the eligible employees were required to fulfill number of conditions in an ongoing manner before becoming absolutely entitled to such shares. It was further noticed that the vesting period in this case was four years and an employee must continue to remain in employment so as to be eligible for deduction. In the backdrop of these facts, it was opined that the deduction could be allowed only in respect of real expenditure and not the hypothetical or notional or imaginary expenditure. As no actual expenditure was incurred, the claim for such deduction was denied. The CIT(A) upheld the disallowance of ESOP expenditure of Rs.3.38 crore.
Aggrieved, the assessee has filed an appeal before this Special Bench of the Tribunal.
Contentions of the Assessee
The crux of the arguments put forth by the AR was that discount under ESOP was nothing but employees cost incurred by the assessee for which deduction was warranted. The AR placed heavily relied on SEBI Guidelines for allowing the deduction and the necessary adjustments in the amount of actual discount at the time of exercise of the option by the employees. The AR argued that merely because the liability was arising in future did not make it a contingent liability. On certain downward adjustments on the amount of ESOP discount arising due to differences between the market price at the time of granting of options and the time of exercise, the AR contended that since there is no specific provision in the Income Tax Act to deal with the ESOP discount, it is the accounting principles and SEBI Guidelines which needs to be followed. On the basis of these principles, the AR submitted that no downwards adjustment was warranted.
The assessee relied on the judgment of the Supreme Court in the case of Challapalli Sugar Ltd. v. CIT and CIT v. U.P. State Industrial Development Corporation by contending that these judgments are authorities for the proposition that the accountancy rules also guide the deductibility or otherwise of expenses in the computation of total income. The assessee chiefly relied on the direct order on the issue passed by the Chennai Bench of the Tribunal in the case of S.S.I. Ltd. v. DCIT upholding the claim for deduction of discount under ESOP on the basis of the SEBI Guidelines. The AR has also heavily relied on the Madras High Court in CIT v. PVP Ventures Limited wherein the discount on issuance of such ESOP was treated as an employee cost.
Contentions of the Revenue
On the other hand, the Departmental Representative contended that no deduction can be allowed as such discount is not only a short capital receipt but also a contingent liability. The 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 options so granted may lapse during the vesting period itself by reason of termination of employment or some of the employees may not choose to exercise the option even after rendering the services during the vesting period. It was, therefore, argued that the discount was nothing but a contingent liability during the vesting period not calling for any deduction.
He also submitted that the word “expenditure” has been described by the Supreme Court in the case of Indian Molasses Co. Ltd. v. CIT 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 was paid out by the assessee. He further explained that there was no revenue expenditure involved in the transaction of issuance of ESOP at discount. The so called 'discount' represents the difference between market price of the shares at the time of grant of options and the price at which such options are granted, which is in the nature of short capital receipts on the lines of share premium.
Further, the DR relied on the order passed by the Delhi Bench of the Tribunal in Ranbaxy Laboratories Limited v. Addl.CIT wherein it was 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.
Having heard the parties, the Tribunal held that,
Rationale and modus operandi of ESOP
++ in order to appreciate the rival submissions, it is of the utmost importance to understand the concept of ESOP. 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” . In an ESOP, the given company undertakes to issue shares to its employees at a future date at a price lower than the current market price. This is achieved by granting stock options to its employees at discount. The amount of discount represents the difference between market price of the shares at the time of the grant of option and the offer price. In order to be eligible for acquiring the shares under the ESOP, the concerned employees are obliged to render services to the company during the vesting period as given in the scheme. On the completion of the vesting period in the service of the company, such options vest with the employees;
++ the options are then exercised by the employees by making application to the employer for the issue of shares against the options vested in them. The gap between the completion of vesting period and the time for exercising the options is usually negligible. The company, on the exercise of option by the employees, allots shares to them who can then freely sell such shares in the open market subject to the terms of the ESOP. Thus it can be seen that it is during the vesting period that the options granted to the employees vest with them. This period commences 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;
++ the core of the arguments of the DR in this regard is two-fold. First, that it is not 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;
Discount under ESOP a "short capital receipt"
++ if a company issues shares to the public or the existing shareholders at less than the otherwise prevailing premium due to market sentiment or otherwise, such short receipt of premium would be a case of a receipt of a lower amount on capital account. It is so because the object of issuing such shares at a lower price is nowhere directly connected with the earning of income. It is in such like situation that the contention of the Departmental Representative would properly fit in, thereby debarring the company from claiming any deduction towards discounted premium. 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;
++ in other words, such discounted premium on shares is a substitute to giving direct incentive in cash for availing the services of the employees. There is no difference in two situations viz., one, when the company issues shares to public at market price and a part of the premium is given to the employees in lieu of their services and two, when the shares are directly issued to employees at a reduced rate. In both the situations, the employees stand compensated for their effort. Thus, the contention of the 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;
Interpretation of the term "Expenditure"
++ when we read the definition of the word “paid” u/s 43(2) in juxtaposition to section 37(1), the position which emerges is that it is not only paying of expenditure but also incurring of the expenditure which entails deduction u/s 37(1) subject to the fulfillment of other conditions. At this juncture, it is imperative to note that the word 'expenditure' has not been defined in the Act. However, sec. 2(h) of the Expenditure Act, 1957 defines 'expenditure' as : '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……'. When section 43(2) of the Act is read in conjunction with section 37(1), the meaning of the term 'expenditure' turns out to be the same as is there in the afore quoted part of the definition 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;
++ it is worth noting that the Supreme Court in the case of CIT v. Woodward Governor India (P) Limited has gone to the extent of covering “ loss ” in certain circumstances within the purview of “expenditure” as used in section in 37(1);
++ therefore, the expression “expenditure” as used in section 37 made in the circumstances of a particular case, covers an amount which is really a “loss” even though the said amount has not gone out from the pocket of the assessee'. From the above enunciation of law by the Summit Court, there remains no doubt whatsoever that the term 'expenditure' in certain circumstances can also encompass 'loss' even though no amount is actually paid out. Ex consequenti, the alternative argument of the DR that discount on shares is 'loss' and hence can't be covered u/s 37(1), also does not hold water in the light of the above judgment. In view of the above discussion, we, with utmost respect, are unable to concur with the view taken in Ranbaxy Laboratories Limited;
Discount towards ESOP a contingent liability
++ 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 employees. Unless such service is rendered, the employees do not qualify for such options. In other words, rendering of service for one year is sine qua non for becoming eligible to avail the benefit under the scheme. Once the service is rendered for one year, it becomes obligatory on the part of the company to honor its commitment of allowing the vesting of 25% of the option. It is at the end of the first year that the company incurs liability of fulfilling its promise of allowing proportionate discount, which liability would be actually discharged at the end of the fourth year when the options are exercised by the employees. Now the question arises as to whether the liability at the end of each year can be construed as a contingent one?;
++ w hen we consider the facts of the present case in the backdrop of the ratio laid down by the Supreme Court in Bharat Earth Movers and Rotork Controls India P. Ltd., it becomes vivid that the mandate of these cases is applicable with full force to the deductibility of the discount on incurring of liability on the rendition of service by the employees. The factum of the employees becoming entitled to exercise options at the end of the vesting period and it is only then that the actual amount of discount would be determined, is akin to the quantification of the precise liability taking place at a future date, thereby not disturbing the otherwise liability which stood incurred at the end of the each year on availing the services;
++ as regards the contention of the DR about the contingent liability arising on account of the options lapsing during the vesting period or the employees not choosing to exercise the option, we find that normally it is provided in the schemes of ESOP that the vested options that lapse due to non-exercise and/or unvested options that get cancelled due to resignation of the employees or otherwise, 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;
Fringe benefit
++ 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;
Quantum and point of obligation
++ a line of distinction needs to be drawn between a situation in which a liability is not incurred and a situation in which the liability is incurred but its quantification is not possible at the material time. Whereas in the first case, there cannot be any question of allowing deduction, in the second case, deduction has to be allowed for a sum determined on some rational basis representing the amount of liability incurred. 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;
++ from the above discussion it is lucid that at the event of granting options, the company does not incur any obligation to issue the shares at discounted premium. Mere granting of option does neither entitle the employee to exercise such option nor allow the company to claim deduction for the discounted premium. It is during the vesting period that the company incurs obligation to issue discounted shares at the time of exercise of option;
++ before proceeding further it would be befitting to take stock of the nutshell of the SEBI 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 Rs.10 is given under ESOP to employees at the option price of Rs.10 as against the market price of such shares at Rs.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 Rs.100 (Rs.110 - Rs.10). These Guidelines provide for claiming deduction in the accounts for a total discount of Rs.100 divided over the vesting period of four years on straight line basis at the rate of Rs.25 each;
++ reverting to the questions of 'when' and 'how much' of deduction for discount on options is to be granted, we hold that the liability to pay the discounted premium is incurred during the vesting period and the amount of such deduction is to be found out as per the terms of the ESOP scheme by considering the period and percentage of vesting during such period. 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 of ESOP discount on lapse of options
++ as regards the adjustment of discount when the options remain unvested or lapse at the end of the exercise period, it is but natural that there is no employee cost to that extent and hence there can be no deduction of discount qua such part of unvested or lapsing options. But, as the amount was claimed 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 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 relevant years, we stop here by holding that the amount of discount claimed as deduction earlier in respect of unvested/lapsing options, has to be taxed as income on the happening of such events;
Subsequent adjustment to ESOP discount on exercise of options
++ 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;
++ if the value of perquisite in the hands of the employee, whether or not taxable, is 'x', then its cost in the hands of the company has also to be 'x'. It can neither be 'x++ 1' nor 'x-1'. It is simple and plain that the amount of remuneration which percolates to the employees will always be equal to the amount flowing from the company and such remuneration to the employee in the present context is the amount which he actually becomes entitled to on the exercise of options. Thus, it is palpable that since the remuneration to the employees under the ESOP is the amount of discount w.r.t. the market price of shares at the time of exercise of option, the employees cost in the hands of the company should also be w.r.t. the same base;
++ 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;
Taxation principle Vis-à-vis accounting principle
++ we are not persuaded by the submissions put forth by the AR that, in the absence of any specific provision in the Act, the accounting principles should be followed for determining the total income of the assessee. What is true for accounting purpose need not necessarily be true for taxation. Taxation principles are enshrined in the legislature. Power to legislate lies with the Parliament. Accounting standards or Guidance Note or Guidelines etc., by whatever name called, issued by any autonomous or even statutory bodies including the Institute of Chartered Accountants of India, or for that matter, the SEBI are meant only to prescribe the way in which the transactions should be recorded in books or reflected in the annual accounts. These guidelines do not have the force of an Act of Parliament. Since the subject matter of tax on income falls in the Union List as per Part XI of the Indian Constitution, it is only the Parliament which can legislate on its scope;
++ 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 fulfill 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 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;
++ it follows that accounting principles have absolutely no role to play in the matter of determination of total income under the Act. If an accounting principle is referred to by the higher judiciary, then there is an underlying presumption that such accounting principle is in conformity with and not in conflict with the taxation principle. The essence of the matter is that taxation principles are to be followed. If an accounting principle is in conformity with the mandate of taxing principle and reference is made to such accounting principle while deciding the issue, it does not mean that the accounting principle has been followed. It simply means that the taxation 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;
Adherence to SEBI Guidelines
++ it is evident from the SEBI Guidelines that these deal with the deductibility of discount in the hands of company during the years of vesting period. These Guidelines are silent on the position emanating from variation in the market price of the shares at the time of exercise of option by the employees vis-à-vis the market price at the time of grant of option. In other words, the SEBI Guidelines prescribe accounting treatment only in respect of the period of vesting of the options and the situation arising out of unvested options or vested options lapsing. The very reference by the Chennai Bench of the Tribunal in SSI Limited to the SEBI Guidelines is indicative of the fact that it dealt with a year during which the options were vesting with the employees and the company claimed discount during the vesting period. The Madras High Court in the case of PVP Ventures has upheld the view taken by the Chennai Bench in the case of SSI Limited. The granting of the binding force to the SEBI Guidelines by the Madras High Court should be viewed in the context of the issue before it, which was about the deductibility of discount during one of the vesting years;
Conclusion
++ 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 the time of exercise of option by the amount of difference in the amount of discount calculated with reference the market price at the time of grant of option and the market price at the time of exercise of option. No accounting principle can be determinative in the matter of computation of total income under the Act. The question before the special bench is thus answered in affirmative by holding that discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head 'Profits and gains of business or profession'.
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