TMI Blog2013 (8) TMI 629X X X X Extracts X X X X X X X X Extracts X X X X ..... year on his rendering service for the respective year. If during the interregnum, he leaves the service, say after one year, he will still remain entitled to exercise option for 25 shares at the discounted premium at the time of exercise of option. In that case, the benefit which would have accrued to him at the end of the second, third and fourth years would stand forfeited. Thus it becomes abundantly clear that an employee becomes entitled to the shares at a discounted premium over the vesting period depending upon the length of service provided by him to the company. In all such schemes, it is at the end of the vesting period that option is exercisable albeit the proportionate right to option is acquired by rendering service at the end of each year. Quantification of ESOP discount – Subsequent adjustment at the time of exercise of options – Held that:- Company incurs a definite liability during the vesting period, but its proper quantification is not possible at that stage as the actual amount of employees cost to the company, can be finally determined at the time of the exercise of option or when the options remain unvested or lapse at the end of the exercise period. It is a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... laimed deduction runs contrary even to the SEBI Guidelines, which also provide for deduction on straight line basis. The manner of the assessee's claiming deduction has resulted in needlessly increasing the amount of deduction for the first year at the cost of deduction for the subsequent three years. It needs to be set right by apportioning the total amount of the discounted premium evenly over the vesting period of four years. - ITA No.368/Bang/2010, ITA No.369/Bang/2010, ITA No.370/Bang/2010, ITA No.371/Bang/2010, ITA No.1206/Bang/2010, ITA No.248/Bang/2010 - - - Dated:- 16-7-2013 - Shri H. L. Karwa, Shri R. S. Syal, AM And Shri N. V. Vasudevan, JM For the Petitioner : Shri S. K. Ambastha - CIT(DR) For the Respondent : Shri Padam Chand Khincha ORDER Per R. S. Syal (AM) :- The Hon ble President of the Income Tax Appellate Tribunal has, on a reference made by a Division Bench, constituted this Special Bench for adjudicating the following question of law : Whether discount on issue of Employee Stock Options is allowable as deduction in computing the income under the head profits and gains of business? 2. Since the subject matter of the above ques ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ities. He, therefore, made disallowance of ₹ 16.92 lakh in this regard. In the appeal against the said order passed u/s 143(3) read with section 147, the assessee, inter alia, assailed the said disallowance of ₹ 16.92 lakh. The learned CIT(A), vide the impugned order dated 13.11.2009, upheld the disallowance of ESOP expenditure of ₹ 3.38 crore, which forms the subject matter of the question before the special bench. 4. Before proceeding further, we want to clarify that the disallowance of ₹ 3.38 crore was made in the original assessment order passed u/s 143(3). As this disallowance stood already made, there could have been no question of taking up this issue again in the reassessment order, which was, inter alia, confined to denial of weighted deduction u/s 35(2AB) towards ESOP expenses incurred in relation to employees engaged in software research. Since the learned CIT(A) has decided the question of disallowance of ESOP expenditure of ₹ 3.38 crore in the impugned order, we are refraining from expressing any opinion on the sustainability or otherwise of his action in taking up an issue for decision which did not arise from the order impugned before ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ourt in the case of Tuticorin Alkali Chemicals Fertilizers Ltd. v. CIT (1997) 227 ITR 172 (SC) and Godhra Electricity Co. Ltd. v. CIT (1997) 225 ITR 746 (SC). It was noticed that all the options vested over a period of four years from the date of its grant. The physical custody of shares was not with the employees but rested with the trust. The trust was empowered to transfer back the same where the conditions precedent for ESOP were not fulfilled. 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 decision in the case of SSI Ltd. (supra) was also distinguished as not applicable to the fact ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s in explaining that there is 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. Since the amount over and above the face value of the shares, being the share premium, is itself a capital receipt, any under- recovery of such share premium on account of obligation to issue shares to employees in future at a lower premium, would be a case of short capital receipt. If at all it is to be viewed in terms of expenditure, then, at best, it would be in the nature of a capital expenditure. He supported his view by relying on the order passed by the Delhi Bench of the Tribunal in Ranbaxy Laboratories Limited v. Addl.CIT [ITA Nos. 1855 3387/Del/2004] on 12.06.2009. It was stated that the Tribunal in that case has 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. The learned Departmental Representative contended that the Mumbai bench of the T ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tled to. As the receipt of share premium is not taxable, any short receipt of such premium will only be a notional loss and not actual loss requiring any deduction. The Tribunal further noticed that incurring of such notional loss cannot be considered as expenditure within the meaning of section 37(1) as there was no spending or paying out or away . The contention of the assessee that SEBI Guidelines recommend claim for deduction of discount over the vesting period, did not find favour with the Tribunal on the ground that the SEBI Guidelines were not relevant in determining the total income chargeable to tax. 9.2.4. 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 lowe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... value of the shares , then such excess share premium shall be charged to tax under the head Income from other sources . But for that, the amount of share premium has always been understood and accepted as a 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 learned 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 concent ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... u/s 37. Sub-section (1) of the section provides that any expenditure (not being expenditure in the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head Profits and gains of business or profession . To put it differently, an expenditure must be laid out or expended wholly and exclusively for the purpose of business so as to be eligible for deduction u/s 37(1). There is absolutely no doubt that section 37(1) talks of granting deduction for an expenditure , and the Hon ble Supreme Court in Indian Molasses Company (supra) has described expenditure to mean what is paid out or away and is something which has gone irretrievably. However, it is pertinent to note that this section does not restrict paying out of expenditure in cash alone. Section 43 contains the definition of certain terms relevant to income from profits of business or profession covering sections 28 to 41. Section 37 obviously falls under Chapter IV-D. Sub-section (2) of section 43 define ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uting the income chargeable under the head profits and gains of business or profession . In sections 30 to 36 the expression expenditure incurred , as well as allowance and depreciation, has also been used. For example depreciation and allowances are dealt with in section 32, therefore, the parliament has used expression any expenditure in section 37 to cover both. 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 Hon ble 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 ld. 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 (supra). B. Is discount a Contingent liability ? 9.3 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... omes 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? 9.3.3. The Hon ble Supreme Court in Bharat Earth Movers v. CIT [(2000) 245 ITR 428 (SC)] dealt with the deductibility or otherwise of provision for liability towards encashment of earned leave. In that case, the company floated beneficial scheme for its employees for encashment of leave. The earned leave could be accumulated up to certain days. The assessee created provision of ₹ 62.25 lakh for encashment of accrued leave and claimed deduction for the same. The Assessing Officer held it to be a contingent liability and hence not a permissible deduction. When the matter finally came up before the Hon ble Supreme Court, it was held that the provision for meeting the liability for encashment of earned l ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... eplace the defective parts free of charge. This warranty was given under certain conditions stipulated in the warranty clause. The assessee made a provision for warranty at ₹ 5.18 lakh towards the warranty claim likely to arise on the sales effected by the assessee. The Assessing Officer disallowed the same on the ground that the liability was merely a contingent liability and hence not allowable as deduction u/s 37 of the Act. When the matter finally came up before the Hon ble Supreme court, it entitled the assessee to deduction on the accrual concept by holding that a provision is recognized when : (a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources will be required to settle the obligation : and (c) a reliable estimate can be made of the amount of the obligation . Resultantly, the provision was held to be deductible. 9.3.5. When we consider the facts of the present case in the backdrop of the ratio laid down by the Hon ble Supreme Court in Bharat Earth Movers (supra) and Rotork Controls India P. Ltd. (supra), it becomes vivid that the mandate of these cases is applicable with full force to the deduct ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... benefits provided or deemed to have been provided by an employee to his employees during the previous year............. . Section 115WB gives meaning to the expression Fringe Benefits . Sub- section (1) provides that for the purposes of this Chapter, fringe benefits means any consideration for employment as provided under clauses (a) to (d). Clause (d), which is relevant for our purpose, states that : any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer free of cost or at concessional rate to his employees (including former employee or employees) shall be taken as fringe benefit. Explanation to this clause clarifies that for the purposes of this clause,-- (i) 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 thereof, includes the securities offered under such plan or scheme. 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 it ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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. 10.3. We have earlier underlined the concepts of grant of options, vesting of options and exercise of options. The period from grant of option to the vesting of option is the vesting period . It is during such period that an employee is supposed to render service to the company so as to earn an entitlement to the shares at a discounted premium. The vesting period may vary from a case to case. If the vesting period is, say, four years with equal vesting at the end of each year, then it is at the end of the vesting period or during the exercise period, which in turn immediately succeeds the vesting period, that the employee becomes entitled to exercise 100 options or qualify for receipt of 100 shares at discount. Though the shares are allotted at the end of the vesting period, but it is during such vesting period that the entitlement is earned. It means that 25 options vest with the employee at the end of each year on his rendering se ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Thus the event of granting options does not cast any liability on the company. On the other end is the date of exercising the options. Though the employees become entitled to exercise the option at such stage but the fact is that it is simply a result of vesting of options with them over the vesting period on the rendition of services to the company. In other words, it is a stage of realization of income earned during the vesting period. In the same manner, though the company becomes liable to issue shares at the time of the exercise of option, but it is in lieu of the employees compensation liability which it incurred over the vesting period by obtaining their services. From the above it is apparent that the company incurs liability to issue shares at the discounted premium only during the vesting period. The liability is neither incurred at the stage of the grant of options nor when such options are exercised. 10.6. Let us consider the facts of the case of SSI Industries Ltd. (supra), which has been strongly relied by the ld. AR in support of his claim for deduction of discount during the years of vesting of options. In that case the vesting period was three years and the asse ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nd 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. III. SUBSEQUENT ADJUSTMENT TO DISCOUNT 11.1.1. Having answered the first major issue in affirmative that the discount on options under ESOP is an ascertained liability and the second major issue that the discount is deductible over the vesting period on straight line basis unless the vesting is not uniform, then arises the present issue as to whether any subsequent adjustment is warranted at the time of exercise of options, to the deductions earlier allowed for the amount of discount. It is noticed that the assessment years 2003-2004 to 2007-2008 are under consideration and during these years ESOP 2000 has come to an end and the ESOP 2004 has started. Further, the extant issue is a vital part of the overall question of the deductibility or otherwise of the amount of discount under ESOP. 11.1.2. We have noticed above that the company incurs a definite liability during the vesting period, but its proper quantifi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ount of actual discounted premium at the time of exercise of option. The Hon ble Supreme Court in the case of CIT v. Infosys Technologies Limited [(2008) 297 ITR 167 (SC)] relevant to the assessment years 1997-98 to 1999-2000 has held that the allotment of shares to employees under ESOP subject to a lock in period of five years and other conditions could not be treated as a perquisite as there was no benefit and the value of benefit, if any, was unascertainable at the time when options were exercised. The Finance Act, 1999 inserted section 17(2)(iiia) with effect from 1st April, 2000 providing that : the value of any specified security allotted or transferred, directly or indirectly, by any person free of cost or at a concessional rate to an individual who is or has been in employment of that person shall be treated as a perquisite. It further provides that in a case the allotment or transfer of specified securities is made in pursuance of an option exercised by an individual, the value of the specified securities shall be taxable in the previous year in which such option is exercised by such individual. Such clause (iiia) was subsequently deleted with effect from 1st April, 2001 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... an never be different. 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. 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e time of exercise of option has gone up to ₹ 130. The amount of real compensation to employee is ₹ 120 as against the tentative compensation of ₹ 100 per share which was accounted for and allowed as deduction during the vesting period. As the actual quantification of the compensation has turned out to be ₹ 120, the company is entitled to a further deduction of ₹ 20 at the time of exercise of option. In Situation III, the market price of the share at the time of exercise of option has come down to ₹ 90. The amount of real compensation to employees is ₹ 80 as against the tentative compensation of ₹ 100, which was allowed as deduction during the vesting period. As the actual quantification of the compensation has turned out to be ₹ 80, the company is liable to reverse the deduction of ₹ 20 at the time of exercise of option. Taxation vis- -vis Accountancy principles 11.2.1. It has been noticed that broadly there are three stages having effect on the total income of the company in the life cycle of ESOP, viz., i) during the vesting period, ii) at the time of unvesting/lapse of options and iii) finally at the time of exer ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t. He relied on the judgments of the Hon ble Supreme Court in Tuticorin Alkali Chemicals Fertilizers Ltd. (supra) and Godhra Electricity Company Ltd. (supra) in support of this proposition. 11.2.3. We are not persuaded by the submissions put forth by the ld. 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. 11.2.4. Be that a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... teps of the accounting principles. At this juncture, it would be useful to have a glimpse at the following observations of the Hon ble Supreme Court in the afore noted case: It is true that this court has very often referred to accounting practice for ascertainment of profit made by a company or value of the assets of a company. But when the question is whether a receipt of money is taxable or not or whether certain deductions from that receipt are permissible in law or not, the question has to be decided according to the principles of law and not in accordance with accountancy practice. Accounting practice cannot override section 56 or any other provision of the Act. As was pointed out by Lord Russell in the case of B. S. C. Footwear Ltd. [1970] 77 ITR 857, 860 (CA), the income-tax law does not march step by step in the footprints of the accountancy profession. 11.2.6. The same view has been adopted by the Hon ble Supreme Court in Godhra Electricity Company Ltd. (supra), by holding that : Income-tax is a levy on income. No doubt, the Income-tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of the income or its receipt ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f doubt in our minds that there can be no question of following the accounting principle or Guidance notes etc. in the matter of determination of total income. 11.2.8. The trump card of the ld. AR to bolster his submission for assigning the status of binding force to the SEBI Guidelines is the order in the case of SSI Limited (supra) which came to be affirmed by the Hon ble Madras High Court in PVP Ventures (supra). We have noticed above that the said case dealt a situation falling within one of the three years of the vesting period, in which it was held that one third of the total amount of discount computed on the basis of the market price of the shares at the time of grant of option, is deductible. 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- -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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... l 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 . SOME RELEVANT FACTORS IN ASSESSEE S CASE 12.1. Having answered the question in affirmative, let us examine its applicability to the facts of the appellant s case. It has been seen above that the authorities below refused to grant deduction of the discount at the very threshold. Resultantly, the verification of the correctness of calculation of discount stood ousted. Since we have overturned such view in above terms, the verification of calculation in accordance with our directions becomes imperative. We, therefore, set aside the impugned orders on this issue and remit the matter to the file of the AO for finding out the correct amount of deduction accordingly. 12.2. It would be imperative to highlight certain points having bearing on the issue which have come to our notice during the course of hearing. The AO is directed to look , inter alia, into these aspects in quantifying the amount of eligible deduction. a. The assessee-company was a closely held company in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of options vested in the employees at the end of the first to fourth year each. This defies all logics and rationalities. When the options vest equally over a period of four years, it is but natural that the company would incur equal liability for the discounted premium @ 25% of total discount on receipt of services of the employees at the end of each year. The way in which the assessee has claimed deduction runs contrary even to the SEBI Guidelines, which also provide for deduction on straight line basis. The manner of the assessee s claiming deduction has resulted in needlessly increasing the amount of deduction for the first year at the cost of deduction for the subsequent three years. It needs to be set right by apportioning the total amount of the discounted premium evenly over the vesting period of four years. c. It has been noticed above that the stage for the grant of deduction of discount is on the respective vesting of the options. In ESOP 2000, the vesting takes place @ 25% after each year of service. It means that the first part of 25% deduction would be available on the completion of one year from the date of grant of option. The assessee was required to indicate th ..... X X X X Extracts X X X X X X X X Extracts X X X X
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