Focus Point
ESOP – Allowability as an expense in Income-tax Act,1961
Recently, the Employee Stock Options Plan (ESOP) has been introduced in many corporates as a reward scheme for an employee. ESOPs are used to create a sense of ownership in the company with an intent to retain highly productive and skillful employees. Such plans are options provided to employees to purchase shares of the company at a price lower than the Fair Market Value (FMV) of such shares. The price at which an employee exercises such options is known as the exercise price. The difference between the FMV and the exercise price of such shares is a cost for the employer that is amortized in the books of accounts as per the accounting standards and guidance notes.
Important terms related to ESOP
Grant Date– The date of the agreement between the employer and employee wherein the employer agrees to give the option to own shares to an employee.
Vesting of options- Vest means becoming an entitlement. Under an ESOP, the employee's right to receive shares vests when the employee fulfills all the vesting conditions. The vesting period is when the conditions are to be satisfied by the employee.
Exercise period- The period after vesting within which the employee should exercise his right to apply for the shares.
Taxation of ESOPs
In the hands of employees: ESOPs are taxed under the head salaries as a perquisite under Section 17(2)(vi) of the Income-tax Act, 1961 (the Act). The taxable amount is the difference between the FMV of the share on the exercise date and the exercise price.
For the employers
Accounting of ESOP costs – ICAI Guidance Note
The ICAI Guidance Note on Accounting for share-based payments(2020) establishes the financial accounting and reporting principles for share-based payments. As per the Guidance Note, the services rendered by an employee during the vesting period are treated as a consideration for the ESOPs and it requires companies to account for the services on a time proportion basis with a credit to equity account.
Litigative issue as per income tax provisions
There has been prolonged litigation regarding the allowability of such costs of services booked on a time proportion basis while computing the "Profits and gains from Business and Profession" of the employer. The Revenue Authorities are of the view that no expenditure has been incurred by the company at the time of grant/during the vesting period of shares under the ESOP scheme, and the expenditure has not crystallized or ascertained till the date on which the employee exercises the option. Hence, it has been the position of the Revenue Authorities that any cost debited to the profit and loss account during the vesting period remains contingent in nature and, hence, cannot be allowed as a deduction.
Another contention of the Revenue Authorities is that the expenditure is capital in nature, as the ultimate objective is related to the issuance of shares, which is not a business activity.
In response to the same, the assessee has contended that the liability is crystallized during the vesting period on the performance of the services by the employee, and it is only the quantification that remains pending.
Also, it is explained that the primary objective of ESOP is not to issue shares; rather, it is to award the employees to boost their productivity, leading to higher profits. Thus, this should be treated as Revenue Expenditure.
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