Taxation of ESOPs and Tax deductibility of ESOP Expenses

Taxation - Tax - Deductibility - ESOP - Expenses - Taxscan1

Overview

Under an ESOS, a company grants options (right without any obligation) to acquire a certain number of shares in the company or its holding/subsidiary company generally at a predetermined price (exercise price) within a pre-determined period (exercise period) to its employees. The option to acquire shares can be exercised once the conditions are fulfilled, referred to as ‘vesting conditions. Such vesting conditions may be continued employment for a defined time or performance-based or both. Upon vesting, the employee gets an unfettered right to ‘exercise’ the vested options by payment of the exercise price. On exercise, the shares are allotted/transferred to the employees who may sell them subject to a lock-in period, if any, specified under the scheme.

Taxation

The analysis of the taxation provisions of ESOPs under the Income-tax Act, 1961 (the Act) are presented in two parts

1. Taxability from Employees point of view and

2. Tax Deductibility of ESOP Expenses from employers’ point of view

Taxability from employees point of view

How is the benefit obtained under ESOS taxable in the hands of an employee?

The benefit received under an ESOS is taxed as a perquisite according to the provisions of section 17(2)(vi) of the Act. Section 17(2)(vi) provides that the value of any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer, or former employer, free of cost or at a concessional rate to the assessee shall be treated as perquisite.

Thus, taxation arises at the time when the specified security is allotted or transferred to the employee.

The important aspects of section 17(2)(vi) are as under:

  • Value means the fair market value (FMV) of specified securities on the exercise date less any amount actually paid or recovered from the employee for such specified securities. The mechanism for determining FMV has been prescribed under Rule 3(8) & 3(9) of the Income tax Rules, 1962 (the Rules)
  • Specified security means securities as defined in section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). Where stock options are granted under any plan or scheme, then the securities offered under such plan or scheme i.e., the resultant securities arising on exercise of such options is included therein. The resultant securities could be shares, debentures or any other securities.
  • Allotted or transferred – specified security must be allotted or transferred. Allotment signifies primary issue by the Company while transfer would include secondary transaction by way of purchase from the Trust / other entity.
  • Directly or indirectly – wide enough to cover options granted through a trust especially when the trust is settled or controlled by the Company.
  • By the employer or former employer – For ESOPs to be taxed, the grant / benefit should flow from the employer or former employer. Interesting issue arises where the ESOPs are granted by the holding company or by a promoter.

Rule 3(8) & 3(9) – Determination of FMV

  • In case of listed equity shares
  • If it is listed on any recognized stock exchange on the date of exercise, the FMV shall be average of the opening and the closing price.
  • If it is listed on more than one stock exchange on the date of exercise, the FMV shall be the average of the opening and the closing price on the recognised stock exchange with the highest trading volume.
  • In considering both the opening or the closing price, the first settlement or the last settlement respectively on such exchange shall be considered. Where both ‘buy’ and ‘sell’ quotes are available, the sell quotes shall be considered.
  • Where there is no trading recorded on a particular day, the FMV shall be closing price on the recognised stock exchange or recognised stock exchange with highest trading volume on the closest date immediately preceding the date of exercise. It may be noted that here only the closing price is to be considered as opposed to average of opening and closing price for considered for regularly traded shares.
  • Recognised stock exchange shall have the meaning as per section 2(f) of the SCRA which refers to the stock exchange as recognised by the Central Government under section 4 of the SCRA. Thus, if equity shares are listed on a stock exchange outside India, then such equity shares shall not be considered as listed on a recognised stock exchange. Accordingly, such equity shares are considered as unlisted shares for the purpose of this Rule.
  • In case of unlisted equity shares or securities other than equity shares
  • The FMV shall be the value as determined by Category 1 Merchant Banker (registered with SEBI). The FMV shall be determined either on the exercise date or any earlier date not more than 180 days prior to the exercise date. The date of report of the merchant banker is not relevant but what is relevant is the valuation date as of which the merchant banker determines the underlying valuation of the share. Thus, a valuation report once obtained will be valid for 180 days.

How are gains arising on subsequent sale of shares taxed?


Gains arising on subsequent sale of shares shall be taxable as ‘capital gains’ – long term or short term, depending upon the period of holding of such shares. The period of holding shall be computed from the date of allotment of such shares as per section 2(42A). As per section 49(2AA), the FMV as per Rule 3(8) considered for determining the perquisite value u/s 17(2)(vi) shall be taken as cost of acquisition. This ensures that the employee does not suffer double taxation on the perquisite value already taxed as salaries.

Long term capital gain on subsequent sale of shares

The Finance Act, 2018 has withdrawn the exemption under section10(38) of the Income-tax Act, 1961 and has introduced a new section 112A which provides that long-term capital gains (LTCG) arising from transfer of a long-term capital asset, being an equity share in a company or a unit of an equity-oriented fund or a unit of a business trust, shall be taxed at 10% of such capital gains exceeding Rs. 1 lakh. The provision is applicable with effect from Assessment Year 2019-20. Section 112A provides that the concessional rate of 10% shall be available if Securities Transaction Tax (STT) is paid both on acquisition and transfer of long-term capital asset, being listed equity shares. Therefore, in case STT is not paid at the time of acquisition of equity shares, the resultant long-term capital gains arising from its sale shall be governed by section 112 and not by Section 112A. However, the exemption from payment of STT has been given for the shares which are acquired under ESOP (Notification No. 60/2018, dated 01-10-2018).

Exemption from long term capital gains tax arising on subsequent sale of shares.

Section 54F is one of the provisions which provides exemption in respect of capital gains. This section provides exemption in respect of capital gain arising from transfer of a long-term capital asset (other than a residential house property). The exemption is allowed if the assessee acquires or constructs a residential house property.

The exemption under Section 54F is available only if capital gain arises from transfer of a long-term capital asset other than a residential house property (‘original asset’). Thus, long-term capital gain arising from the transfer of jewellery, shares, securities, and plot of land, etc., may qualify for exemption.

The exemption is allowed if net consideration is invested in one residential house property. This investment can be made by way of purchase or construction of house property. The exemption is allowed only if such house is situated in India. Thus, if residential house is located outside India, no exemption shall be available. The exemption under Section 54F can be denied if assessee owns more than one residential house on the date of transfer. However, this does not include a house, which is acquired within one year prior to the date of transfer of the original asset. Thus, in all, he may own two residential houses on the date of transfer (i.e., one which is already owned and the other which is acquired within one year prior to the date of transfer of the original asset under the scheme). If he owns more than two residential houses, income from which is chargeable under the head income from house property, no exemption is applicable.

Are ESOPs offered by Holding Co. to the employees of Subsidiary Co. taxable as salary?


In the case of Microsoft Corporation USA, the Authority for Advance Rulings (‘AAR’) held that the benefit arising to the employee of Indian subsidiary from stock option granted by its US parent company was taxable in the hands of Indian employee as ‘salary’. The AAR, by lifting the corporate veil, held that ‘the parent company has made such offer to the employees of the subsidiary company only because it regards its subsidiary and itself as the same concern’. In another decision, the Tribunal (Special Bench – Mumbai) relying on the decision of the Supreme Court held that employer-employee relationship is not necessary for an income to be taxed under the head ‘Salaries’. It is enough if the sum earned is a reward for services rendered by the employee. Similar view has also been taken in other cases. In most such cases, the parent company may be recovering the benefit so provided by way of cross charge from the subsidiary. Further the obligation to deduct rightful taxes on the salaries paid to employees will be on the employer company. Keeping all these aspects in mind, in most cases, the benefit received is accordingly treated as taxable under the head ‘salaries’ and appropriate TDS is being done. Even if the same is not taxable under the head ‘salaries’, it may be taxable under ‘income from other sources’.

Is the Employer Company required to withhold any taxes on account of perquisite element under an ESOP?

The employer shall be liable to deduct taxes at source on the perquisite under an ESOP. The perquisite u/s 17(2)(vi) is taxable at the time when the shares are allotted or transferred. Under Rule 3(8), the underlying FMV of the shares is to be determined as on the date of exercise. Nevertheless, the perquisite arises only at the time of allotment or transfer of shares and hence, the TDS obligation will also arise at the time of such allotment or transfer and not on the date of exercise.

Northern Operating Services Pvt. Ltd.’s case

The Bangalore Tribunal in the case of Northern Operating Services (P.) Ltd. v. Jt. CIT(TP) Appeal No. 759(Bang.) of 2017, dated 11-9-2021 AY 2012-13 dealt with the issue of allowability of ESOP related expenditure where tax has not been deducted on discount component of such ESOP.

The taxpayer floated an ESOP scheme, where the shares were issued at a price below the market price. Accordingly, the taxpayer claimed the difference between the market price of shares and the issue price (discount) as ESOP expenditure under section 37(1) of the Act. Relying on the decision of the Karnataka High Court in the case of CIT v. Biocon Ltd. [2020] 121 taxmann.com 351/276 Taxman 1/430 ITR 151, the Bangalore Tribunal held that the taxpayer was entitled for deduction of ESOP expenses when the rights were vested. The Bangalore Tribunal further observed that, as there will be time different between ‘vesting of option’ and ‘exercise of option’, accordingly the period of taxability of ESOP benefits as perquisite may also differ. Hence, the tax authorities were not justified in holding that the taxpayer should have deducted tax at source from the discount amount by assessing the same as perquisite in the hands of the taxpayer in the year in which ESOP was vested in them.

The Bangalore Tribunal, however, observed that the AO is entitled to satisfy himself that the taxpayer has either deducted tax at source when the option is exercised by the employee or has reversed the expenditure when the concerned employee did not exercise the option if it is considered necessary by the AO.

What is the taxability of stock options exercised by the legal heirs in case of death of the employee?

As per the Companies Act, 2013 as well as the SEBI SBEB Regulations, 2014, upon the death of an employee, all options granted, shall vest and such vested options, may be exercised by the legal heirs or nominees, as the case may be. In the context of gratuity payment, the CBDT has clarified that lumpsum gratuity paid to legal heirs of deceased employees is not taxable. Similarly, exemption is available in case of leave encashment paid to legal heirs of deceased employees. It may also be pointed out that there are several judicial precedents which have held that amount received by legal heirs of deceased person amounts to a capital receipt not chargeable to tax. It can also be contended that in absence of any employer-employee relationship, the same should not be taxable as perquisite u/s 17(2)(vi). Hence it seems to be a very good case to argue that no amount will be taxable in the hands of the legal heirs on exercise of the vested options. However, where such shares are allotted or transferred at a price which is lower than the FMV under Rule 11UA, whether the difference can be brought to tax u/s 56(2)(x) is a matter of debate. Exceptions to applicability of section 56(2)(x) do not provide for any carve out in respect of any
property received on exercise of options by legal heirs. The carve out for property received under inheritance or will may not apply in this case as the shares will be received from the Company and not from the deceased employee. It may be argued that the right to exercise the vested options devolves upon the legal heirs pursuant to the contract of the Company with the deceased employee and hence, the benefit is flowing on account of inheritance or will and should be covered by the carve out u/s 56(2)(x).

In case of an amalgamation or demerger, if the ESOPs of the amalgamating company or demerged company are substituted with similar ESOPs of the amalgamated company or the resulting company, would any taxability arise in the hands of the employees?

It is common that vested or unvested ESOPs of an amalgamating company or demerged company are substituted for similar ESOPs from the amalgamated company or the resulting company on an equitable basis. Section 47(vii) and section 47(vid) provide exemption only to shareholders of the amalgamating company or demerged company. There is no specific exemption for ESOP holders. Since capital gains arise only upon transfer of a capital asset, it is necessary to examine whether ESOPs are a capital asset. Further, ESOPs by their very nature are non-transferable and hence, their realizable value is Nil. It will be a good case to argue that receipt of ESOPs from the amalgamated company or the resulting company cannot be taxed as capital gains as ESOPs are only notional in nature and benefit, if any, crystallizes only upon exercise. In any case, on exercise, the perquisite element will be taxed in the hands of the employees as per section 17(2)(vi) read with Rule 3(8). Hence, the taxability of capital gains ought not to take place.

In case an employee surrenders his right under the ESOP and receives a cash pay-out, whether the same will be taxed as salary or capital gains?

In case of corporate actions, it is quite common that the acquirer may insist that all outstanding ESOPs be settled before the acquisition is completed. In such cases, the compensation committee administering the ESOP may decide to pay in cash the fair value of the shares less exercise price to the employees for the vested / unvested options. Taxability u/s 17(2)(vi) arises only when the shares are allotted or transferred upon exercise of ESOPs. Hence, if the ESOPs are surrendered, the same will not come within the purview of section 17(2)(vi) of the Act. As per section 2(14) of the Act, a capital asset is defined to include “property, of any kind, whether or not connected with his business or profession’. The judicial authorities have held that the definition of property is wide enough to cover even rights to subscribe to the shares of the company. Accordingly, rights granted under ESOPs should also be treated as capital assets. Where such rights are surrendered to the Company / third party, the income arising therefrom may be taxed under the head ‘capital gains’ and not as ‘income from salary’ and the period of holding shall be reckoned from the date of grant of the option.

Tax Deductibility of ESOP Expenses from employers’ point of view

There is no specific section under which ESOP expenditure is allowable under the Act. The only provision where a company can claim the expenditure is section 37(1) of the Act, which is a residuary section, hence, it is pertinent to test the conditions mentioned in section 37(1) in order to conclude whether the expenditure is allowable or not.

Allowability under section 37(1) of the Act
Section 37(1) of the Act allows an assessee to claim expenditure if it fulfils the following conditions:

(1) It should be an expenditure,
(2) It should not be dealt in section 30 to 36,
(3) It should not be a capital expenditure or personal expense of the assessee, and
(4) It should be incurred or laid out wholly and exclusively for the purpose of business or profession

However, there have been various judgements ruled in the favor of the employer, wherein the expense incurred by the employer is to be treated as allowable.

In the case of CIT vs Lemon Tree Hotels Limited., August 2015, the Assessing Officer (AO) had disallowed expenses related to ESOP of Rs. 1,28, 19, 169/- which the court then rejected. The Delhi High Court then upheld that the expense related to ESOP was to be allowed as an expense.

The recent judgement that came to light was in the year 2020, wherein the case was between M/s Biocon Limited versus Deputy Commissioner of Income Tax, Bengaluru. The matter at hand was the question of law regarding whether the discount on the issue of ESOPs is allowable as a deduction in the calculation of income under the head Profits and Gains in Business.

The Karnataka High Court ruled in favor of the taxpayer and dismissed the appeal of the Income Tax authorities on the grounds that the primary objective of issuing shares to the employees at a discount is to compensate them for their continued service, and this amounts to employee cost incurred by the company. Therefore, the expense related to ESOPs is allowable as a deduction.

The most recent judgement that came to light is in the current year where The Bangalore Tribunal in the case of Northern Operating Services (P.) Ltd. v. Jt. CIT(TP) Appeal No. 759(Bang.) of 2017, dated 11-9-2021 AY 2012-13 dealt with the issue of allowability of ESOP related expenditure where tax has not been deducted on discount component of such ESOP. Relying on the decision of the Karnataka High Court in the case of CIT v. Biocon Ltd. [2020] 121 taxmann.com 351/276 Taxman 1/430 ITR 151, the Bangalore Tribunal held that the taxpayer was entitled for deduction of ESOP expenses when the rights were vested. The Bangalore Tribunal further observed that, as there will be time different between ‘vesting of option’ and ‘exercise of option’, accordingly the period of taxability of ESOP benefits as perquisite may also differ. Hence, the tax authorities were not justified in holding that the taxpayer should have deducted tax at source from the discount amount by assessing the same as perquisite in the hands of the taxpayer in the year in which ESOP was vested in them.

Nishant Sejpal - Taxscan

CA Nishant Sejpal is a Direct Tax Manager at PharmEasy and has been in the field of direct taxation since 2015 and has been writing and researching on issues of Startup taxation

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