Employee Stock Options – ESOP | The next big thing under the Income-tax scrutiny

Employee Stock Options or ESOPs are an effective way to remunerate and motivate an employee to achieve higher objectives for an organisation. The aftermath of the pandemic saw a rising wave of ESOP being granted to the Indian employees of foreign multinational companies. In short, the Indian employees of foreign subsidiaries get ESOPs from the foreign parent company as a compensation package. This is quite a common practice for foreign companies to issue ESOPs to the Indian employees of their subsidiary company.

As the employees are employed with the Indian subsidiary company, the discount/cost of ESOP that is initially borne by the foreign company is often passed to the Indian subsidiary company. Accordingly, payment of such costs is made by the Indian subsidiary company to the foreign parent company without any TDS or withholding taxes. This appears quite simple in a logical transaction until this caught the attention of Indian tax authorities.

The tax authorities in India have now started to question the position of no tax deduction on such costs paid by the Indian subsidiary company to the Foreign parent company. In some cases, the tax authorities have disallowed the payment made and questioned if the said transaction can be even treated at allowable cost against income. Further, there is no clarity on the effective percentage of the tax rate that can be applied to the said amount which can range anywhere between 10% – 42%. It is understood that the tax authorities are investigating the said transactions as they are of the assumption that some of the cost pertains to royalty or similar expenses and tax should be deducted on the said amount.

In addition to the Income-tax troubles, transfer pricing authorities have always questioned the nature of such expenditure and have expected a return on such an expenditure incurred by the Indian subsidiary company.

With such a disallowance due to the non-withholding of taxes and transfer pricing, the issue may act as a double whammy for the taxpayers. If such an approach from tax authorities is left ignored or left for courts to settle, would hamper the ease of doing business and could cost important investments to the shining investment destination.

From a technical point of view, let us understand why there would not be taxes withheld on the cost paid by the Indian subsidiary to the foreign subsidiary:

1. The expense pertains to the proportion of the discount provided by the Foreign parent company to the employees of the Indian subsidiary company for the services provided by the employees of the Indian subsidiary company. Such expenditure is booked by the Foreign parent company at an initial stage and the proportionate entitlement is recovered from the Indian subsidiary company. The recovery of expenditure on discount does not lead to a generation of income for the Foreign parent company and therefore prima facie not liable to be taxed in India on a payment to a non-resident.  
2. If the Indian company issues an ESOP of its own company, then such a discount would have no implications from an Indian TDS point of view, as there is no income generation while claiming a discount on ESOP.
3. The employees who are entitled to ESOP are taxed at respective stages, thereby Income- taxes being paid on the same income that is alleged to be disallowed as a cost or discount, leading to dual and sometimes triple tax effects on the same stream of income in different forms.
4. On reviewing the various Articles of the Double Tax Avoidance Agreement (DTAA) entered between India and other countries, no reference has been found to trigger such an Indian expenditure in the category of income for the Foreign parent company. Therefore, such a payment could be treated as a mere allocation of the book expenditure incurred by the Foreign parent company.  
5. On analyzing the provisions of the Indian Income-tax law, no provision has been found to specifically bring the allocation of ESOP cost under the purview of income and further any tax deduction at source under Section 195 of the Income-tax Act. Accordingly, such a payment could be treated as a pure reimbursement in the commercial sense of business.

Considering the above, if you are an Indian subsidiary company, and your employees have been issued ESOP specifically of a Foreign parent company, you may want to undertake the following steps:

i. Review of the ESOP agreement to evaluate tax implications from all angles.

ii. Validate the costs that are booked due to ESOPs from Income-tax, transfer pricing, GST and FEMA point of view.

iii. Obtain an opinion to ascertain your position, review the transaction and detail out legal opinion to make the case strong along with the commercial sense.

iv. In case of scrutiny, get technical representation support where the right legal and technical interpretations are represented before the tax authorities.

Hope you have found this article interesting and informative. In case you need any further information or have any clarification, you can reach us at surajagrawal@transprice.in or akshaykenkre@transprice.in.