In reviewing the provisions of subsection 37(1), it should be noted that the following four conditions must be met for an expense to be deductible under subsection 37(1) of the Act: The taxpayer established an ESOP program under which the shares were issued at a price below market price. Consequently, the taxpayer claimed the difference between the market price of the shares and the issue price (haircut) as ESOP expenditure under Article 37(1) of the Law. Relying on the decision of the Karnataka High Court in CIT v. Biocon Ltd. [2020] 121 taxmann.com 351/276 Taxman 1/430 ITR 151, the Bangalore Court ruled that the taxpayer was entitled to deduct ESOP expenses if the rights were transferred. The Bangalore Court also pointed out that, since there is a time difference between the “acquisition of the option” and the “exercise of the option”, the period of taxation of ESOP benefits as a condition may also be different. Consequently, the tax authorities were not entitled to consider that the taxpayer should have deducted the withholding tax from the amount of the rebate by assessing it as being established in the hands of the taxpayer in the year in which ESOP was transferred to him. Shares awarded by the employer under the Employee Stock Option Plan (ESOP) are taxable in the hands of employees in respect of the head wage under section 17(2)(vi) of the Income Tax Act 1961 (`the Act`). As far as ESOP is concerned, the bone of contention between the Assessé employer and the tax department is the tax deductibility of ESOP expenses in the hands of the Assessed employer. The employer`s assessor claims it as a tax-deductible operating expense and states that it should be attributed to the employer as a payroll expense. This article deals with this issue through the provisions of the law and the jurisprudence of precedents.
The 2017 bill limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation and amortization) for four years, with the limit falling to 30% of EBIT (excluding EBITDA). In other words, starting in 2022, businesses will deduct depreciation from their profits before calculating their maximum deductible interest payments. Purchase of shares from major shareholders: ESOP can provide a market for the shares of major shareholders and their estates. The use of ESOP to purchase the shares of major shareholders has advantages over direct redemption by the Company. The company`s contribution to the ESOP is tax deductible, so the purchase of shares is done with pre-tax dollars, which helps preserve the company`s cash and net worth. Controlling shareholders receive capital gains on the sale of their shares to an ESOP if they sell only a small portion of their shares. If certain conditions are met, selling shareholders of a limited holding company can defer or avoid capital gains tax on the sale of shares to an ESOP. For a leveraged ESOPs, a deduction of up to 25% of the covered payroll is allowed for contributions used to repay the principal of the ESOP loan. Company C contributions used to pay interest on an ESOP loan are fully deductible (and not limited by covered payroll) if no more than 1/3 of ESOP contributions are allocated to “highly paid employees”. Special regulations for S companies are included in the text above, but can easily be repeated here. The limit for tax-deductible employer contributions is 25% of salary, whether or not the SOP is used. Contributions to 401(k), profit sharing, cash purchase, and stock bonus plans count toward this limit, as do interest payments on an ESOP loan.
Distributions on ESOP shares, regardless of their use, are not considered deposits. The additional annual rules for plan members are the same as in C Corporations. “Expenses that are not expenses of the type described in paragraphs 30 to 36 and that are not capital or personal expenses of the assessor, that are intended or spent entirely and exclusively for the purposes of the business or profession, are included in the calculation of income under the heading `Profits and profits of enterprises or professions`. Companies sponsoring ESOPs can deduct dividends paid on shares held by ESOP, mainly in three ways. First, dividends may be paid in cash to HBOP members, either directly or as payments to ESOP, which are distributed to members within 90 days of the end of the plan year. Second, dividends can be applied to loan payments of a leveraged ESOP (but only dividends on shares purchased with the loan can be used for such payments). Third, dividends voluntarily reinvested by employees in the company`s shares in the ESOP are deductible for the company. Distributions of S companies (the equivalent of dividends) are not tax deductible, but can be used to repay an ESOP loan. An ESOP is often defined as a “corporate finance technique”.
A corporation can make tax-deductible contributions in cash or shares to the ESOP trust. If this contribution is made in shares of the company, the resulting tax deduction increases the cash flow of the company and the additional cash can be used for any purpose of the business. If the contribution is made in cash, ESOP may use the cash to purchase shares of the company itself, existing shareholders or retired or laid-off employees who have received distributions of ESOP shares. Acquisition of assets or general financing of the business with pre-tax dollars: ESOP contributions can be used to protect capital payments for the company`s normal debt, allowing the business to efficiently make tax deductions for capital payments, which can significantly reduce after-tax borrowing costs. In a leveraged ESOP transaction, the business can effectively repay the loan from its pre-tax income, as the company`s payments are treated as employee benefit plan contributions, which are fully tax deductible. With a conventional loan, only the interest of the borrowing company is deductible. Assuming a marginal tax rate of 40%, a business would have to earn about $10 million before taxes to provide funds to amortize the principal of a $6 million loan. A pre-tax income of only $6 million is required to generate funds to amortize the principal of a $6 million ESOP loan. Thus, cash flows relative to acquisition liabilities are significantly increased in a properly structured ESOP.
New leveraged ESOPs, where the company borrows a large amount relative to its EBITDA, may find that their deductible expenses are lower and, therefore, their taxable income may be higher as a result of this change. This change does not affect S companies 100% owned by ESOP as they do not pay taxes. In summary, the special panel considered that the rebate on the issuance of ESOP could not, inter alia, be treated as a capital expenditure and concluded that the obligation to issue shares to employees at a reduced price at a later date in lieu of their services was a permissible deduction under section 37(1) of the Act. The Hon`ble Tribunal also found that the obligation to pay the discounted bonus, which is employee compensation, is directly related to the duration of the services provided by each employee and that the obligation to issue discount stock options during the vesting period exists and that the amount of the deduction must be calculated in accordance with the terms of the ESOP system. Therefore, the refund was deductible over the vesting period. The Special Court also emphasized that the obligation to repay or incur during the vesting period must be adjusted, as the actual reduction can only be determined at market price if employees exercise their options.