Revenue v. Notional: ITAT Upholds ESOP Expenses as Business Deductions under Section 37(1) of the IT Act

Introduction

In the case of Deputy Commissioner of Income-tax v. CBRE South Asia (P.) Ltd.[i], the Income-tax Appellant Tribunal (‘ITAT’) Delhi Bench-B addressed whether expenses incurred under employee stock options (‘ESOPs’) can be deducted under s. 37(1) of the Income-tax Act, 1961 (‘IT Act’). The Assessee, CBRE South Asia (P) Ltd., claimed expenses for ESOPs with supporting invoices from its parent company in the USA.

Brief Facts

• The Assessee, a prominent private limited company, provided real estate consultancy, site management, professional advisory, and project management services. For the assessment year (‘AY’) 2018-19, the Assessee filed its return of income (‘ROI’) on 30.11.2018, declaring a total income of Rs. 2,15,08,30,700.

• During the scrutiny assessment, the assessing officer (‘AO’) questioned the rationale for debiting an expense of Rs. 3,77,40,366 on account of ESOPs and claiming such expenses as a deduction under s. 37(1) of the IT Act.

• The AO was not convinced by the Assessee’s explanation that the parent company’s shares in the USA were allotted as ESOPs to its employees in India. Accordingly, the AO disallowed the deduction, deeming the ESOP expenses to be notional and contingent in nature.

• Seeking relief, the Assessee appealed before the Commissioner of Income-tax (Appeals) [‘CIT(A)’], who provided relief by relying on the judgement of the Hon’ble High Court of Delhi in the case of CIT v. Lemon Tree Hotels Ltd.[ii] Subsequently, the aggrieved Revenue department appealed before the ITAT, contending that ESOP expenses claimed by the Assessee and cross-charged by its parent company in the USA were notional and contingent.

• The Assessee argued that it recorded share-based expenses amounting to Rs. 4,57,97,006 in its profit and loss account based on the fair value of ESOPs on the grant date and amortized over the vesting period. However, in its ROI, the Assessee claimed Rs. 3,77,40,366, representing the actual cost incurred based on the ESOPs actually exercised by its employees and the corresponding amount of invoices by the parent company.

Held

• The ITAT ruled in favour of the Assessee, affirming that ESOP expenses are allowable under s. 37(1) of the IT Act. The ITAT relied on the evidence provided by the Assessee, including supporting invoices from the parent company, clarifying that the expenses were actual, not merely accounting entries. It was also determined that these expenses aligned with the fair value of ESOPs at the grant date and their market prices at the exercise date.

• Furthermore, the ITAT relied on the judgement in ACIT v. Cvent India Pvt. Ltd.[iii], wherein it was held that ESOP expenses are legitimate business expenditures. The ITAT noted the fallacy in the AO’s assessment, which disallowed the expenses by claiming that they were not crystallized and were capital in nature.

• The ITAT observed that the Revenue did not present any evidence to contradict the CIT(A) findings or provide any binding decision supporting their position. Consequently, the ITAT found no reason to interfere with the CIT(A)’s decision and dismissed the Revenue’s appeal. This affirmed that the ESOP expenses incurred and cross-charged by the parent company were indeed allowable as business expenses under s. 37(1) of the IT Act.

Our Analysis 

This decision by the ITAT underscores the importance of proper documentation and substantiation of expenses by companies to avail tax deductions, particularly concerning expenses related to ESOPs. It clarifies that ESOP-related expenses, even when involving cross-border transactions with a parent company, can be considered legitimate business expenses under s. 37(1) of the IT Act. The decision aligns with judicial precedents, promoting a consistent approach to treating ESOP expenses in corporate taxation, thereby providing clarity and reassurance to businesses in structuring their employee compensation plans.

Grounded in established judicial principles and the evidence provided by the Assessee, the ITAT’s ruling confirms that properly substantiated ESOP expenses qualify as deductible business expenses. This decision reiterates previous court rulings and provides consistency in interpreting ESOP-related expenses. This decision supports the view that using ESOPs to incentivize employees is a legitimate business strategy, enhancing company performance and qualifying as an operational expense.

End Notes

[i] [2024] 163 taxmann.com 256 (Delhi - Trib.), [dated: 31.05.2024]

[ii] ITA No. 107/2015, dated 18.08.2015

[iii] ITA No. 523/DEL/2020

Authored by Siddharth Jha, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.