Global Tax Alert | 24 October 2013
Bangalore Tribunal rules on deductibility of employee share reward discount cross-charged by foreign parent company
This Tax Alert summarizes a ruling of the Bangalore Income Tax Appellate Tribunal (Tribunal) in the case of Novo Nordisk India Pvt. Ltd.1 (Taxpayer) on the issue of deductibility of expenditures incurred on providing shares of the Taxpayer's parent company, being a foreign company (FCo), to the Taxpayer's employees under an Employee Share Purchase Scheme (ESPS). The Tribunal held that the ESPS discount cross-charged by FCo was an employee cost, wholly and exclusively incurred for the purpose of the Taxpayer's business and hence, to be allowed as a revenue expenditure, irrespective of the fact that FCo stood to benefit indirectly by such an expenditure.
Under the Indian Tax Laws (ITL), a revenue expenditure which is expended wholly and exclusively for the purpose of taxpayer's business, is allowed as a deduction in computing taxable income.
The Taxpayer is an Indian company engaged in the business of marketing and distributing healthcare products. It is a wholly owned subsidiary of FCo (a Danish company) which was listed on the Copenhagen Stock Exchange.
During tax year 2005-06, FCo floated a global share reward program which it extended to employees of its foreign affiliates (including the Taxpayer) by incorporating a condition that the benefit so granted shall be cross-charged to the respective affiliate if permitted by local rules. In terms of this program, shares were to be allotted to the employees at a discount on the market value and such shares were to be subject to a lock-in period of three years.
Pursuant to FCo's global program, the Taxpayer framed its own ESPS for offering FCo's shares to its employees at a discount on the market value and furnished it to the Tax Authority as per the extant tax rules.2
The Taxpayer paid the amount representing the difference between the market value and the ESPS price to FCo for the shares allotted to the Taxpayer's employees pursuant to the ESPS and claimed a deduction for the same as a revenue expenditure. Reliance, inter alia, was placed on the Mumbai Tribunal ruling in the case of Accenture Ltd.3 (Accenture ruling) where the Mumbai Tribunal had allowed a deduction for a similar cross-charge.
The Tax Authority rejected the claim and disallowed the expenditure which was upheld by the First Appellate Authority. The Taxpayer appealed further to the Tribunal.
Tax Authority's position
The cross-charge of the discount paid by the Taxpayer to FCo represents a capital expenditure since it results in enhancement of FCo's share capital.
Since the ESPS involved the issue of new shares by FCo with a lock-in period of three years, the entire arrangement was in the capital field. Ideally, FCo ought to have borne the discount but it recovered the same from the Taxpayer merely to facilitate a tax deduction for the Taxpayer. There was no business expediency for the Taxpayer to agree to bear such a cost.
Since the cost was born in favor of the parent company, without any business expediency, the payment was subject to a provision under the ITL in terms of which the Tax Authority is entitled to disallow excessive or unreasonable payments made to related parties.
The Accenture ruling is distinguishable from the present facts since in Accenture's case, the shares of the parent company were issued to the taxpayer's employees at the taxpayer's behest whereas, in the present case, the shares were issued and the discount was recovered from the Taxpayer at FCo's behest.
The ESPS was introduced with a view to motivate and encourage the employees. Hence it has to be treated as a form of employee compensation, incurred wholly and exclusively, for the purpose of the Taxpayer's business. Unlike a situation where a company issues its own shares to employees at a discount on the market value, which does not involve actual cash outflow, in the present case, there was an actual cash outflow by way of a cross-charge paid to FCo.
The Tax Authority's contention that the cross-charge was merely to facilitate a tax deduction for the Taxpayer is without any basis, more so since the particulars of the ESPS were furnished beforehand to the Tax Authority, at which stage, no such objection was raised.
Deductibility of the expenditure was not diluted merely because, FCo also stood to benefit in addition to the Taxpayer. Reliance was placed on the Supreme Court's decision in the case of Sasoon J. David & Co. (P) Ltd. 4 and a Karnataka High Court decision in the case of Mysore Kirloskar Ltd.,5 wherein it was held that if expenditure was incurred for promoting the business, it has to be allowed even if a third party stood to benefit from the expenditure.
The Tribunal ruled in the Taxpayer's favor and allowed the deduction for cross-charge of the ESPS discount paid by the Taxpayer, for the following reasons:
- • The shares were issued under the ESPS, at a discounted premium, to compensate the employees for the continuity of their services to the Taxpayer. Such a discount cannot be treated as short capital receipt or a capital expenditure. By virtue of the decision of the Special Bench of the Bangalore Tribunal in the case of Biocon Ltd.,6 it is now settled that an Employee Stock Option Plan (ESOP) discount constitutes a revenue expenditure.
- • FCo had a policy of offering share rewards to its employees to attract the best talent. FCo allowed its subsidiaries/affiliates across the world (including the Taxpayer) to participate in this policy. Pursuant thereto, the Taxpayer contributed the discount pertaining to shares issued to its own employees. There was an actual cash outflow to the extent of the discount. Since these facts were undisputed, the Tax Authority's contention that the expenses belong to FCo and/or such expenditure is capital expenditure is without any basis. As far as the Taxpayer is concerned, the difference paid by the Taxpayer was an employee cost and revenue expenditure incurred wholly for business purpose.
- • It could not be suggested that the amount of the discount borne by the Taxpayer was excessive or unreasonable. The discount was linked to the market price of FCo's shares on the Copenhagen Stock Exchange, which was beyond the control of FCo or the Taxpayer. Therefore, there was no basis to invoke the provisions in the ITL which enable the Tax Authority to disallow excessive or unreasonable payments to related parties.
- • The Taxpayer's case is identical to the Accenture ruling. It cannot be said that the Taxpayer incurred the expenditure at the behest of FCo. The Taxpayer framed its own ESPS to reward its employees based on FCo's global share reward program. That, by itself, will not mean that the reward was at the behest of FCo. In any event, the immediate beneficiary is the Taxpayer, though FCo may also be an indirect beneficiary of the motivated work force of a subsidiary.
- • Business expediency required that the Taxpayer incur such cost in respect of its employees. The fact that FCo may also be indirectly benefited by a motivated workforce of the Taxpayer would not be grounds to disallow an expenditure that is otherwise allowable under the ITL.
Deductibility of a discount given to employees under a share reward program, where a company issues its own shares to its employees, has been a controversial issue. The decision of the Special Bench of the Bangalore Tribunal in the case of Biocon Ltd.7 held that an ESOP discount is an allowable revenue expenditure, in terms of which, the issue is presently decided in the taxpayer's favor.
The issue involved in the present appeal is on a different facet viz., where a subsidiary bears the cross-charge of the parent's share reward program to the extent that it pertains to the subsidiary's employees. As compared to a situation of issuance of its own shares where the company receives a lesser share premium, there is actual cash outflow for the subsidiary in this situation.
The present ruling reiterates the ratio of the earlier Accenture ruling while upholding that such cross-charge paid to a parent company is an allowable revenue expenditure, notwithstanding the fact that it is related to the issue of shares by the parent company and the parent company stands to benefit to the extent of cross- charge paid by subsidiary.
2 Up to tax year 2006-07, the employees were entitled to beneficial tax treatment of the share reward if the share reward scheme complied with guidelines issued by the Central Government and a copy of such scheme was furnished to the Tax Authority.
3 See EY Tax Alert, Mumbai ITAT rules on deductibility of business expenditure, dated 5 August 2010.
4 [118 ITR 261].
5 [166 ITR 836].
6 ITA No.248/Bang/2010. See EY Tax Alert, India proposes amendments to its foreign direct investment policy, dated 19 July 2013.
7 ITA No. 248/Bang/2010. See EY Tax Alert, India proposes amendments to its foreign direct investment policy, dated 19 July 2013.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Private Limited, Mumbai
- • Sudhir Kapadia
+91 22 6192 0900
Ernst & Young Private Limited, Hyderabad
- • Jayesh Sanghvi
+91 40 6736 2078
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
- • Nachiket Deo
+44 20 778 30862
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
- • Gagan Malik
+65 6309 8524
Ernst & Young LLP, Indian Tax Desk, New York
- • Tejas Mody
+1 212 773 4496
EYG no. CM3905