ALLOWABILITY OF ESOP EXPENDITURE: BY CA NITIN NANDA

A scheme of Employee Stock Option (‘ESOP’) is one such process where employers reward employees by making them partners/ rightful owners in wealth which they have build together by issuing shares in the entity at a discounted price which otherwise is available at higher price in the market due to various reasons such as market expecting to reap the reserves sitting in the books of accounts, goodwill generated by the Company in the market, expected discounted cash flow forecasts of the Company etc .

ESOP is a plan wherein an option is provided by the employer to employee to opt for issue of shares in the company at the end of vesting period on satisfying specific conditions set in by employer at an agreed pre-determined discounted price against a commitment from the employee of provision of uninterrupted services to the company.

The major benefits out of such ESOP scheme are (i) Employers do not have immediate payout obligation while they continue to lure the employees and receive their uninterrupted services. (ii) Employees feel a sense of ownership and their efforts can directly be remunerated in an employee oriented industry (iii) Employees may get a sense of getting retained with the company for atleast a near future time period (iv) Employees get a very good opportunity to become partners in wealth creation in a twofold manner wherein on one side they are issued shares at a discounted price when compared to market price or sometimes even at free of cost and on the other side they become eligible for all the future shareholder payouts whether be it dividends or buyback/ redemption of capital.

 

Accounting treatment of ESOP:

As per the Guidance Note issued by Institute of Chartered Accounts of India (‘ICAI’) and SEBI the main objective to issue an ESOP share or say sweat equity share is to remunerate the employee for, his past services, for making available intellectual property rights to the employer.

 However, due to the issue of ESOP the rights of the existing shareholders get diluted and therefore there is a need to compensate such dilution by creating an artificial reserve. The only resource available with any company is the corporate profits. Hence the ICAI and SEBI have suggests to create such reserve from the current profits earned by the company. The methodology to be adopted as suggested by ICAI and SEBI to compute the quantum of reserve is the difference between market value as computed under SEBI rules on the date of grant and the price at which the shares are issued to the employees in order to compensate the payout obligation which might arise on ESOP shares either at buyback or at liquidation.

 

Jargons of an ESOP plan:

An employer who wishes to issue ESOP proposes a plan to the employees on a certain date i.e. grant date with certain conditions attached to it which inter-alia includes a minimum period of employment with the company i.e. vesting period. There is a certain time period within which the employee after the ESOP getting vest gets an opportunity to exercise the option i.e. Exercise period. The value at which the shares are issued to employees is technically called exercise price. Some companies also keep a lock in period for the exercised ESOP within which an employee cannot sell those shares in the market.

 

Legal Issues in claiming Tax Deduction (‘TD’)

There is no specific section under which ESOP expenditure is allowable under the Income Tax Act 1961 (‘Act’). The only provision where a company can claim the expenditure is section 37 of the Act. Hence, it is pertinent to test the conditions mentioned in section 37 in order to conclude whether the expenditure is allowable?

Section 37 of the Act allows an assessee to claim expenditure if it fulfills the following conditions:

• It should be an expenditure,
• It should not be dealt in section 30 to 36,
• It should not be a capital expenditure, and
• It should be incurred or laid out wholly and exclusively for the purpose of business.

 

Further, there is an alternative argument that one can make in the above context, though not taken in the above ruling, that debiting the ESOP expense leads to creation of artificial reserve which goes and sits in the reserves in the balance sheet, be it either securities premium account or any specific reserve created for ESOP. Hence at the time of liquidation or buyback there is a liability to payout the shareholders from not only the amounts lying in share capital account and general free reserves but also from the above mentioned reserves. Hence, these amounts which are debited to P&L, which are located in reserves during buyback/ liquidation, are ultimately liable to be paid to shareholders which also means that company has not only incurred the ESOP expense but also is be liable to pay such amounts to employees who have become shareholders during the process of ESOP plans or has to be paid to persons who have become shareholders by buying those ESOP shares from employees.

Further, it is pertinent to note that the company has not received any money against the portion of reserves created for ESOP which it will pay during the process of buyback/ liquidation.

The SB has also pondered on the issue of whether the ESOP expenditure is of contingent in nature. The major reasons of revenue authorities treating such expense as contingent in nature was because In the case of ESOP the question whether share will be ultimately issued is not clear since it contains restrictions and various other eligibility criteria on employees in order to make them eligible for ESOP, the clouds on which get clear only on exercise of ESOP options by employees.

However, the SB has ruled that since the companies follow mercantile system of accounting in which any income or expense is booked in the books based on the accrual concept.  Accordingly in the present context once the employer has committed the issue of shares at the end of the vesting period, the expenditure no longer remains contingent and the company has to issue shares at the vesting period. However, the SB has also ruled that based on the actual number of options exercised at the end of the vesting period the company needs to make a downward adjustment to the discount on ESOP which are lapsed and such discount should be offered it to tax.