Rewarding employees through share-based benefit schemes has been an effective tool for the companies to not just recognise their contribution to the company, but also retain them by imbibing a sense of belonging and ownership. One such scheme, popular among the companies for almost last two decades, has been grant of Employee Stock Option Plans (“ESOPs”). In simple terms, an ESOP is an option and not an obligation, provided by a company to its employees, to purchase its shares at a future date at a pre-determined price, which is ordinarily less than the market price, on satisfaction of certain prescribed conditions. While the issuance of ESOPs entail various tax implications for both the employer and the employees, the scope of this blog is limited to ascertaining the validity of an employer’s right to claim the perceived discount granted on the issue of shares as a tax deductible business expenditure. Recently, the Karnataka High Court (“HC”) affirmed the ruling of the special bench of the Bangalore Income Tax Appellate Tribunal (“ITAT SB”) in the case of Biocon Ltd., wherein it was held that discount on issuance of ESOPs is an allowable business expenditure under Section 37(1) of the Income-tax Act, 1961 (“IT Act”) for the employer.
Biocon Ltd. (“Assessee”), a company engaged in the business of manufacturing of enzymes and pharmaceutical ingredients, had set up a trust and floated an ESOP scheme under which it granted option to its employees to purchase shares of the Assessee at their face value of INR 10. The Assessee stated that the market price of such shares was INR 919 and hence, it claimed that the discount (difference between market price and offer price) of INR 909 per option was a compensation to the employees i.e. revenue expenditure deductible under Section 37(1) of the IT Act to be spread over the vesting period of four years. For AY 2004-05, the Assessing Officer stated that the expenditure was contingent in nature and disallowed the expense claimed by the Assessee. The action of the Assessing Officer was confirmed by the Commissioner of Income-tax (Appeals). On appeal, ITAT SB ruled that discount on issue of stock option was an allowable expenditure under Section 37(1) of the IT Act. The revenue authorities filed an appeal against this order of the ITAT SB before the Karnataka HC.
Issues and arguments
The revenue authorities argued that as the control of the shares remained with the Assessee for the period of ESOP scheme, the expenses claimed by the Assessee towards ESOP had neither incurred nor accrued during the relevant assessment year. They further argued that expenditure towards ESOPs was contingent and not a crystallized liability. The revenue authorities also argued that since no amount was actually paid by the Assessee to any other party, no expenditure was allowable under Section 37(1) of the IT Act.
On the other hand, the Assessee argued that the discount on issue of ESOPs was not a contingent liability, but an ascertained liability. The Assessee placed reliance on the judgment of the Hon’ble Supreme Court (“SC”) in the case of Bharat Earth Movers and submitted that as ESOPs were vested over a period of four years, the expenditure with respect to 25% of the shares was incurred at the end of each year. The Asseesee further submitted that deduction of discount on ESOP over the vesting period was in accordance with accounting principles and Stock Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchaser Scheme) Guidelines, 1999 (“SEBI Regulations”). The Assessee also placed reliance on decisions of Madras HC and Delhi HC on similar issue in case of PVP Ventures Ltd. and Lemon Tree Hotels, respectively. The Assessee also submitted that the deduction on the same issue was allowed by the AO in the Assessee’s case in AY 2009-10 and hence, the revenue authorities could not alter their stand now.
The HC stated that deduction under Section 37(1) of the IT Act is permissible when the expenditure is incurred, even if the pay-out or expenditure is not incurred in cash Further, the HC held that expression ‘expenditure’ under Section 37(1) of the IT Act includes a loss and, therefore, covers discount on issuance of shares (due to the difference between the issue price and the market price) within its ambit.
The HC noted that it is a settled principle of law that if a business liability has arisen in an accounting year, the same is permissible as deduction in the same accounting year, irrespective of the fact that the liability is quantified and discharged in future. The HC placed reliance on the decision of the SC in the case of Bharat Earth Movers (supra), to hold that discount on issue of ESOPs was not a contingent liability but an ascertained liability. Notably, the HC also accepted the contention of the Assessee that deduction on discount of ESOP over the vesting period was is accordance with accounting principles and SEBI Regulations. Further, agreeing to the other HC judgments of PVP Ventures Ltd. (supra) and Lemon Tree Hotels (supra), the HC also noted that the ESOP expense is a definite legal liability and has to be debited as expense in the books of accounts following mercantile system of accounting. Also, as the expense has been allowed to the Assessee for AY 2009-10 onwards, the HC placed reliance on the SC decision in the case of Radhasoami Satsang to hold that the revenue authorities cannot be permitted to take a different stances on a year-on-year basis.
The issue of deductibility of discount on issue of ESOPs had been a contentious one. Before the judgment of the ITAT SB, certain ITATs across the country ruled that the discount on issue of ESOPs was a contingent liability and notional loss and, therefore, was not a deductible expense. However, the judgment of ITAT SB provided certainty to an extent and had been followed in a number of subsequent decisions. The present judgment of the HC affirming the earlier judgment of ITAT SB is a welcome ruling, as it provides further certainty to the taxpayers. However, please note that the SLP against the decision of the Delhi HC in Lemon Tree Hotels is pending before the SC and a similar issue is also pending before the Bombay HC. Therefore, the taxpayers would have to keep a close eye to ensure that their position is not contrary to the judicial approach followed in their jurisdiction.
The primary argument of the tax authorities to disallow the discount on issue of ESOP as a deductible expenditure has been that such a discount is a notional loss and, therefore, should not be a deductible expense. In this regard, it is pertinent to note that the SC in the case of Woodward Governor India (P.) Ltd. has held that the expression “expenditure” as used in Section 37(1) of the IT Act may cover “loss” in certain circumstances. Therefore, in case discount on issue of ESOPs is treated as a loss, it may be covered within the scope of expression ‘expenditure’ under Section 37(1) of the IT Act.
It is pertinent to note that the decision of the ITAT SB was comprehensive and provided guidance on other associated issues such as period of deduction, method of computation of discount, subsequent adjustments in the year in which the employees exercised the option and shares were allotted to them or the adjustments required when they left the company. Since the HC has remained silent on these ancillary issues, the possibility of further litigation involving them cannot be ruled out.
As the issuance of ESOPs has been a preferred scheme for companies to reward their employees, certainty on the tax treatment of such issuance is required. While the above stated judicial precedents have provided certainty to an extent, the litigation on the issue has persisted, and therefore, it is fair to expect that a decision by the SC or a formal clarification by the CBDT may put the issue to rest.
 Commissioner of Income Tax v. Biocon Ltd., ITA No. 653 of 2013 (Karnataka HC); (2013) 35 taxmann.com 335 (Bangalore – ITAT) (SB).
 Bharat Earth Movers v. CIT, (2000) 122 Taxman 61 (SC).
 CIT v. PVP Ventures Ltd., (2012) 23 taxmann.com 286 (Mad.).
 PCIT v. Lemon Tree Hotels (P) Ltd., (2019) 104 taxmann.com 26 (Delhi).
 (1992) 193 ITR 321 (SC).
 Asstt. CIT v. Ranbaxy Laboratories Ltd., (2012) 20 taxmann.com 334; VIP Industries Ltd. v. DCIT, ITA No. 7242/Mum/2008 (Mumbai ITAT).
 PCIT v. New Delhi Television Ltd. v. ACIT, (2018) 99 taxmann.com 401 (Delhi HC); DCIT v. Kotak Mahindra Bank Ltd., (2018) 89 taxmann.com 223 (Mumbai ITAT); Mahindra & Mahindra Ltd. v. DCIT, (2020) 117 taxmann.com 518 (Mumbai ITAT); HDFC Bank Ltd. v DCIT, (2015) 61 taxmann.com 361 (Mumbai ITAT).
 (2019) 104 taxmann.com 27 (SC).
 PCIT v. Goldman Sachs (India) Securities Pvt. Ltd., ITA No. 30 of 2017.
 CIT v, Woodward Governor India (P.) Ltd. (2009) 312 ITR 254/179 Taxman 326.