ESOPs granted by holding companies: Indian tax and transfer pricing intricacies

Employee stock option plans (ESOPs) are used as a strategic tool by multinational enterprises (MNEs) to reward and retain employees.

There are several ways in which ESOPs are granted by MNEs. In some cases, the Indian company (I Co) grants an ESOP to its employees, while in others, the foreign holding company (Hold Co) grants an ESOP to the employees of a subsidiary company (i.e., an I Co).

Where a Hold Co grants its shares under an ESOP, the I Co may agree to reimburse the cost of an ESOP – i.e., a discount provided to employees upon the allotment of shares – or the Hold Co may agree to bear the cost by itself, which can lead to peculiar tax and transfer pricing issues that need to be addressed.

One of the critical questions is whether an I Co is allowed to claim an expense for the cost of an ESOP where the ESOP is granted by the Hold Co. India’s income tax law provides that any expenditure laid out exclusively for the purposes of business or a profession shall be allowed as an expense in calculating the taxable business income.

There are judicial precedents wherein it has been held that an I Co should be allowed to claim the cost of an ESOP as an expense. In these judgments, the courts/tribunals noted that the I Co makes payment to the Hold Co and the expense was necessary to retain the employees of the I Co. Accordingly, the I Co should be allowed a deduction for the ESOP cost (see Northern Operating Services Private Limited v Joint Commissioner of Income-tax (2023) and Flipkart India Private Limited v The Assistant Commissioner of Income Tax (2023)).

The situation is much more complex when an ESOP is granted by a Hold Co with no reimbursement from the I Co.

Contractually, the I Co is not required to bear the cost of the ESOP. However, under the Indian Accounting Standards, the I Co is required to recognise the ESOP cost as an expenditure. The same amount is considered an equity contribution by the Hold Co to the I Co. The accounting guidelines adopt a substance-over-form approach and recognise that employees have been allotted the shares by virtue of their services to the I Co.

From a tax standpoint, the question is whether the arrangement between the parties needs to be given importance or the accounting guidelines. There are no judgments in India on similar cases.

One may argue that for determining the business income of a taxpayer, the accounting guidelines adopted by the taxpayer should be followed and the taxpayer should be allowed to claim an expense for the ESOP cost.

In the authors’ view, the commercial arrangement between the parties needs to be given primacy over the accounting guidelines. If the arrangement is that the Hold Co shall bear the expense for the ESOP, the I Co should not be allowed to claim the expense. This position is in line with the aforementioned judicial precedents, wherein the I Co’s reimbursement of the expense was considered important. Accordingly, in cases where an I Co is not obligated to pay any amount to a Hold Co, the I Co should not be entitled to claim the same as an expenditure for tax purposes.

In a related-party set-up, the arrangement between the entities is to be ascertained not only from a written contractual arrangement but also from the conduct of the parties. If the conduct/intent of the parties suggests that the I Co should ultimately bear the cost of an ESOP, by upfront payment or by way of an adjustment from subsequent receivables, it can be argued that the ESOP should be allowed as a business expense for the I Co.

MNE groups across the globe have set up enterprises in India that provide support services to the groups. In such a case, the I Co functions as a captive service provider and is remunerated by the MNE group on a cost plus mark-up basis. Furthermore, the service fees received by the I Co are usually benchmarked by applying the transactional net margin method, as the most appropriate method.

In the above cases, the issue is whether the ESOP cost recognised by the I Co should also be cross-charged by the I Co from its group entity when arriving at the service fees. The question is particularly important where the Hold Co agrees to bear the cost of the ESOP and it is only due to accounting guidelines that the ESOP cost is recognised in the financial statements.

The tax authorities in India would argue that since the cost has been recognised in the financial statements and is operating in nature, the same should be cross-charged by the I Co, along with the arm’s-length mark-up. Otherwise, the tax authorities may propose tax additions.

In the authors’ opinion, the transfer pricing provisions in this situation should not be seen in isolation. The view taken by the taxpayer for the allowability of an ESOP cost as an expense for tax purposes shall have a bearing on the treatment from a transfer pricing perspective.

If the taxpayer has disallowed the ESOP cost since the same has not been incurred by it, then even for transfer pricing purposes, the same should not be included in the cost base. Inclusion in the cost base will lead to double jeopardy for the taxpayer. On one hand, the expense is disallowed, and on the other, the taxpayer shall be required to offer the ESOP cost plus margin as income due to transfer pricing provisions. The tax authorities may still argue that the ESOP cost should be included in the cost base for transfer pricing purposes. In the authors’ view, the claim can be defended before higher forums.

The position is also in sync with judicial precedents, wherein it has been held that unless the expenditure has been incurred by the assessee and claimed as a business expense, it cannot form part of its operating costs for margin computation (see Sprinklr India Private limited v Deputy Commissioner of Income Tax (2022) and i2 Technologies Software Private Limited v The Commissioner of Income-Tax (2017)).

It is pivotal for an MNE group to exercise due caution from a tax and transfer pricing standpoint when issuing an ESOP, especially when a Hold Co issues an ESOP to employees of a subsidiary company in India. Apart from the tax and transfer pricing treatment, it is also important to take a consistent position from an exchange control and goods and services tax standpoint. Also, appropriate disclosures must be made in the financial statements, which will add weight to the taxpayer’s position.

Cases where a Hold Co undertakes to bear the ESOP cost on behalf of an I Co are yet to be tested before a judicial forum. Such a scenario is likely to open another battlefront for which taxpayers need to be prepared.