Transfer Pricing Implications of Employee Stock Option Plans (ESOP)
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- On September 17, 2024
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Employee Stock Option Plans (ESOPs) have become a popular reward for companies to attract, retain, and incentivise employees. ESOPs provide an opportunity for employees across different group companies to gain equity ownership in the parent entity, aligning their interests with the overall performance and long-term success of the group.
In the Indian context, the arrangement between the parent entity and subsidiary company, as along with the Guidance Note issued by ICAI, has a significant implication on the accounting treatment for ESOPs issued by the foreign parent entity to the employees of an Indian group company. The implementation of Transfer Pricing (TP) also varies depending on the arrangement and accounting treatment adopted by the Indian group company.
Scope
This article primarily focuses on the judicial position from the perspective of an Indian subsidiary company (I Co) whose employees are granted ESOPs of foreign parent entity (F Co). From a transfer pricing perspective, the critical question that arises in the given scenario is whether the proportionate ESOP cost debited to the statement of profit and loss of the Indian group company should be considered as operating cost or non-operating cost.
Technical View
The above question is particularly relevant when using the Transactional Net Margin Method (TNMM) as the most appropriate method to benchmark the international transaction. The inclusion or exclusion of ESOP costs from the operating cost base can significantly impact the calculation of the net operating margin. Accordingly, the transfer pricing implications in this context are evaluated under two scenarios:
Scenario 1: ESOP Expenses Cross-charged by F Co
If ESOP expense is cross-charged by F Co to I Co by issuing a debit note, it may be treated as an actual expense in the hands of I Co, and the proportionate ESOP cost will be recognised as payable to F CO. In such scenario, the expense is actual, and the transaction is entered in concert with F Co pursuant to an arrangement, and therefore, such actual or real expenses may be treated as operating cost in the hands of I Co for the purposes of determining net operating margin.
In this regard, reference is drawn from the judgement of Hon’ble Bangalore Tribunal [1] where the proportionate ESOP cost was allowed as a deduction in the hands of I Co. In this case, the ESOP expenses pertaining to Indian employees were actually cross-charged by F Co and paid by I Co, and such ESOP expenses were treated as operating expenses by I Co. The Hon’ble Tribunal observed that the transaction is on an actual basis and therefore, ESOP cost should be allowed as a deduction in the hands of I Co.
Scenario 2: ESOP Expenses Not Cross-charged by F Co
In this scenario, the proportionate ESOP cost may not be payable to F Co but is debited to the statement of profit and loss of I Co and credited to reserves on account of Ind AS or ICAI Guidelines on ESOPs. Here, it is essential to evaluate the implications from a transfer pricing perspective.
If the ESOP cost is not cross-charged by F Co on actual basis but debited to the statement of profit and loss based on accounting principles or the guidance note, such recognition of costs may considered as a unilateral act of I Co pursuant to a guidance note or accounting standards and therefore, may not be considered as transaction as per the definition provided under section 92F(ii) of the Act. Such cost may be treated as notional in nature, with no obligation of payment to F Co. Accordingly, a view may be taken that costs not borne by I Co may not be considered for purpose of determining its operating margins of I Co. In this regard, reliance may be placed on the judgement of Hon’ble Delhi Tribunal [2] and Hon’ble Bangalore Tribunal [3].
Further, reference can be drawn from judgement of Hon’ble Bangalore Tribunal [4] wherein it is held that ESOP costs are not part of operating costs as no payment was made by I Co under the agreement with F Co. Additionally, as per another judgement of Hon’ble Bangalore Tribunal [5], I Co had no obligation to make any payment to F Co. Accordingly, the proportionate ESOP cost debited to the statement of profit and loss of I Co, as per the requirement of Ind AS, is notional in nature and therefore treated as a non-operating cost for determining arm’s length profitability.
Treatment of ESOP Costs Under Safe Harbour Rules
As per the definition of “Operating Expenses” provided in Rule 10TA(j) of the Income Tax Rules, 1962 (“the Rules”), it specifically includes “costs relating to Employee Stock Option Plan or similar stock-based compensation provided for by the associated enterprises of the assessee to the employees of the assessee.” However, as per Rule 10TD of the Rules, the provision of safe harbour rules is applicable only if I Co has specifically opted for them. Consequently, the definition provided under safe harbour rule is not applicable unless specifically opted for by the taxpayer. Hence, treatment of ESOP costs as operating in nature merely based on the reference to safe harbour rules may not be a prudent approach. For this proposition, reference may be drawn from the judgement of Hon’ble Bangalore Tribunal [6].
Treatment of ESOP Cost in Comparable Companies
In this context, reference is made to the Hon’ble Delhi Tribunal [7], where it was held that comparisons of margins between the taxpayer and the comparable company must be made under identical conditions. ESOP is considered an extraordinary item of expenditure, and therefore, for the purpose of making proper comparison of the margin, one-time ESOP costs incurred by the comparable company cannot be included as part of the operating expenses.
KNAV Comments
From the above analysis, it can be observed that the treatment of a particular expense as operating or non-operating is highly fact-specific. Therefore, a thorough evaluation of the facts from different perspective is critical for determining the appropriate arm’s length profitability. Careful consideration must be given to the specific circumstances surrounding the ESOP arrangement and the accounting treatment adopted, as these factors significantly influence the transfer pricing implications.
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