Employee stock option plans (ESOPs) have gained prominence as a means of remuneration and fostering employee retention. The Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 permit an employer to issue ESOPs directly to employees or through a trust.
The Indian tax authorities have long contested the grant of corporate tax deductions to employers on the basis that expenditure through an ESOP concession is capital and notional in nature. However, numerous judicial pronouncements, including the High Court of Karnataka’s judgment in Biocon (2021) and the High Court of Delhi’s ruling in Lemon Tree Hotels (2015), have allowed taxpayers’ claims for a deduction during ESOPs’ vesting period.
This article explores the challenges employers may face in utilising a trust model.
The accounting aspect
The Institute of Charted Accountants of India’s 2020 revision of its Guidance Note on Accounting for Share-based Payments recognises that an ESOP trust may have different arrangements:
The employer allots shares to a trust when employees exercise options – the employer maintains a notional ESOP pool without issuing shares to employees or the ESOP trust. Upon exercising their option, the employee pays the exercise price to the trust, which passes on the sum to the employer. The employer then issues shares to the trust, which transfers them to the employee. The shares have been issued to the trust at a concessional price for the benefit of the employee and in lieu of services received over the vesting period. Accordingly, the guidance note requires the employer to recognise the ESOP expenses during the vesting period.
The employer provides finance to an ESOP trust at the beginning of the plan – an employer finances a trust at the beginning of a scheme to enable the trustees to subscribe to the company’s shares. The trustee holds the shares in accordance with the scheme. At the end of the vesting period, the shares are transferred to the employees who exercise the option and pay the exercise price. The sums received are used to repay money owed by the trust to the employer.
The employer provides finance to the trust to purchase shares from the open market at the beginning of the plan – this arrangement is similar to (2), but the shares are procured by the trustee from the open market rather than the company.
Despite the differences, the guidance note provides that the employer should book expenditure over the vesting period. This is premised on the simplistic understanding that the trust administers the plan on behalf of the company but may not exactly fit in with the legal form of these arrangements. As such, the choice of arrangement could affect the employer’s tax deduction claim.
The income tax aspect
For income tax purposes, one may have to assess the allowability of an expense to the employer on account of the grant of an ESOP under different arrangements. The deduction claim may be contentious because of:
The time between the allotment of shares by the employer to a trust and by the trust to employees;
Any movement in the market value during the above period; and
A concession granted by the employer to the trust vis-à-vis a concession granted by the trust to the employee.
The guidance note operates on the premise that an ESOP trust is merely an extension of the employer for administration of the scheme. Though the employer may exercise some administrative control over the trust through the trustees, it is legally set up, exists, and holds property for the sole benefit of the employees. From this perspective, the employer’s claim of a tax deduction for a concession granted by a trust to an employee may be diluted.
Tax authorities may argue that from the employer’s standpoint, the shares are allotted for its employees’ benefit at the beginning of the ESOP. Therefore, any concession on that date should be the basis of a deduction claim by the employer. The employer is then out of the picture and the exercise of the option by the employee and subsequent transfer of shares by the trust to employees should not impact the employer. Thus, the tax authority could seek to deny any expenditure booked by the employer as the concession is borne by the trust and not the employer. On this basis, there will be no occasion for the employer to claim a tax deduction based on the forecasted fair market value.
However, a taxpayer can argue that the trust is merely a legally permissible form of implementation of an ESOP. The choice of form should not impact the deduction claim. Furthermore, if a tax authority’s contentions are based on the averment that the trust exists for the benefit of the employees, it should not lose sight of this at the time of issuance of shares. All the steps in an ESOP represent a series of arrangements whereby shares carrying potentially higher value in the future are issued to an ESOP trust solely for the benefit of employees. The accounting rationale for a deduction claim may seem justified. This argument may also present a defence against the applicability of capital gains tax to an ESOP trust upon the transfer of shares to employees.
Claim for an expense deduction: the judicial position
In Biocon, the High Court of Karnataka dealt with a situation where shares were administered through a trust. The company transferred shares to an ESOP trust that were subsequently allotted to employees, subject to the terms and conditions mentioned therein. The company claimed expenditure in its books of accounts equal to the difference of the market price and the allotment price over the vesting period.
The court, while allowing the claim of the company, observed that it is sufficient if the expenditure has been incurred and therefore the discount offered by the employer from market value would also be an expenditure incurred for the purpose of Section 37 of the Income-Tax Act, 1961. Furthermore, the deduction was also cited to be justified as the scheme was in accordance with the Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999.
However, from the facts cited in Biocon, it is not discernible as to which method was being followed by the taxpayer and its ESOP trust to grant options to employees. The tax authorities may therefore look for avenues to distinguish Biocon, especially where the shares are issued to a trust at the initiation of a scheme.
Key takeaways on ESOP issuances through trusts
Practically, there may be advantages for employers, and enhanced certainty for employees, if an ESOP is implemented through a trust. However, given the ensuing tax uncertainties for the employer, caution should be exercised when opting for the trust route.
The Supreme Court is yet to pronounce its verdict on the tax department’s challenge to the judgment in Biocon. Even if the Supreme Court upholds Biocon, taxpayers implementing an ESOP scheme through a trust model may have to endure another round of litigation to justify their claim. Taxpayers could also consider filing representation before the Central Board of Direct Taxes to seek clarity regarding their tax claims.
