Discount on shares allotted under ESOP constitutes deductible revenue expenditure under Section 37(1).

M/s. Geojit Financial Services Ltd., a company incorporated under the Companies Act, allotted shares to its employees under an Employees Stock Option Plan (ESOP).

The assessee claimed the discount arising on the allotment of ESOP shares as revenue expenditure deductible under Section 37(1) of the Income Tax Act, 1961. The Assessing Officer disallowed the claim, but the Commissioner of Income Tax (Appeals) allowed it.

The Income Tax Appellate Tribunal, Cochin Bench, affirmed the appellate order and dismissed the Revenue’s appeal. The Principal Commissioner of Income Tax challenged the Tribunal’s decision before the Kerala High Court.

Whether the discount allowed on shares allotted under an ESOP constitutes revenue expenditure allowable as a deduction under Section 37(1) of the Income Tax Act, 1961?

Whether, on the facts and circumstances of the case, the Tribunal was correct in affirming the order allowing the assessee’s claim for deduction of the ESOP discount under Section 37(1) of the Income Tax Act?

Section 37(1) of the Income Tax Act permits deduction of expenditure incurred wholly and exclusively for business purposes, and the expression “expenditure” may include a loss.

The Court relied on CIT v. Lemon Tree Hotels (P) Ltd., 2018 SCC OnLine Del 13684, which held that ESOP expenditure is not merely notional merely because the employer issues or allots its own shares rather than purchasing shares from a third party.

It also followed CIT (LTU) v. Biocon Ltd., (2021) 430 ITR 151 (Karnataka), which held that ESOP discount is an ascertained business liability accruing over the vesting period; its later quantification upon exercise of the option does not make it contingent.

The Karnataka High Court further held that the discount represents expenditure incurred to secure employee services and incentives, rather than a short receipt of capital.

The principles in Bharat Movers and Rotork Controls India (P) Ltd. were applied regarding accrued business liabilities, while CIT v. Infosys Technologies Ltd., (2008) 297 ITR 167 (SC) was distinguished as a tax-deduction-at-source case involving different statutory provisions and issues.

The Court held that allotting shares to employees at a price below their market value results in the assessee absorbing the difference between the market value and the issue price.

That difference constitutes an economic loss or expenditure incurred for the business purpose of attracting, retaining, and incentivising employees, and therefore falls within Section 37(1).

The liability arises over the vesting period and is not rendered contingent merely because the precise amount may be determined when the employee exercises the option.

The Revenue’s contention that no deductible expenditure arises in the absence of a purchase of shares from a third party was rejected, since such an approach would ignore the commercial reality of ESOP arrangements and incorrectly characterise the discount as a notional loss.

The Court also found that the ESOP discount was not a diminution or short receipt of capital, but an expenditure incurred in the course of earning business profits.

It held that the discount on shares allotted under the ESOP is revenue expenditure allowable under Section 37(1) of the Income Tax Act, subject to the applicable statutory requirements.

The Court affirmed the order of the Income Tax Appellate Tribunal and dismissed the Revenue’s appeal.