Tax Deductibility of ESOP Expenses

Employee Stock Option Plan (ESOP) is a scheme wherein the employees can buy the shares of the company at a discounted rate compared to the market price. Startups often use ESOPs to attract top employees because they don't usually have a lot of money to offer high salaries. ESOPs give companies the flexibility of paying relatively lower salaries while offering these options as an incentive in the bargain. During the COVID pandemic, some companies offered ESOPs in lieu of pay cuts to their employees.

Implication of Taxes on ESOPs

Initially, ESOPs were taxable within the scope of fringe benefit tax. However, subject to amendments made post Finance Act, 2009, the taxability of ESOPs lies in the employees’ hands.

In the case of ESOPs, taxability arises at two stages from the point of view of the employee:-

At the Time of Exercise of Options (When the Shares are Allotted to the Employees)

Under this, the difference between the Fair Market Value (FMV) of the shares allotted and the exercise price of the shares under ESOP is treated as a perquisite.

Where the shares allotted are that of a listed company, the fair market value shall be the average of the opening price and closing price as of that date. In case the shares in question are unlisted, the value of shares as determined by a Merchant Banker on a specified date will be taken to be the fair market value of the unlisted shares. 

The manner in which the said perquisite shall be deducted will be similar to that of deduction of tax on salary (TDS on Salary).

However, as per the recent amendment announced in budget 2020, in case an employee receives the ESOPs from an eligible start up, tax on the ‘perquisite’ shall be deductible on earlier of the following events:

• After the expiry of five years from ESOPs allotment
• On the date of sale of ESOPs
• On the date of exit from the company

At the Time When the Shares are Sold by the Employees

Once the employee exercises the options and gets shares allotted against his name, he has the choice of either holding the share for a while or selling them off and realising some profits off them. The realisation of these profits or gains will attract capital gains tax.

The difference between the sale consideration and the fair market value of the share as on the date of exercise of the option will be the calculation for capital gains taxation. Whether the capital gains obtained are short term capital gains (STCG) or long term capital gains (LTCG) will be determined based on the period of holding of the shares. The period of holding is to be considered from the date of allotment of such shares.

In the Case of Companies whose Shares are Listed

• Where the shares are held for a period less than or equal to 12 months, the resulting gain from the sale of such shares is short term capital gain. Therefore, as per the provisions of Section 111A of the Income Tax Act, 1961, they are to be taxed at a concessional rate of 20%.
• Where the shares are held for a period exceeding 12 months, the resulting gain from the sale of such shares is long term capital gain. Section 112A was introduced in the IT Act and made applicable from April 1, 2018. This section imposes an LTCG tax at the rate of 12.5% without indexation where the gains are in excess of Rs. 1.25 lakh.

In the Case of Companies whose Shares are Unlisted

• Where the shares are held for a period less than or equal to 24 months, the resulting gain from the sale of such shares is short term capital gain. The tax on this STCG will be treated like that of any other income, and the regular income tax slab rates as applicable to the employee shall be applied here.
• Where the shares are held for a period exceeding 24 months, the resulting gain from the sale of such shares is long term capital gain. The tax on this LTCG is chargeable as per Section 112 of the Income Tax Act, at the rate of 12.5% without indexation benefits.

Taxability from the view point of the Employer

There has always been a general sense of ambiguity regarding the deductibility of ESOP expenses in India. It has always been a subject of litigation. In the case of the employer, since the discount provided under ESOP is a general expense, the bone of contention has always been whether to consider it as a general provision under Section 37 of the Income Tax Act, 1961.

Section 37 (1) grants deduction for expenses that are neither personal nor capital expenditure in nature and are not covered under Section 30 to Section 36. 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 most 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.

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