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Employee Stock Option Plan (ESOP)
ESOP is compensation for employees, often in the form of employee stock options, linked to the value of the employer’s stock. It is typically awarded in addition to cash-based compensation to align employee interests with those of the company’s shareholders, to attract and retain key personnel.
The treatment of ESOP for financial reporting and tax purposes is complicated. On top of that complexity, how ESOP expenses and deductions are treated can vary depending on where a company pays the compensation. Layering on transfer pricing rules and the views and approaches of tax authorities around the world, the treatment of ESOP in transfer pricing is often challenging. In this Publication, we have tried to resolve these transfer pricing issues faced by MNEs by analyzing the OECD Guidelines, UN TP Manual and Indian & Global TP practices.
Cost Sharing Arrangement
International transaction can be an agreement or arrangement for allocation of the cost / apportionment of the cost /contribution towards cost sharing. A question which often arises for consideration is with regard to inclusion / exclusion of certain costs in the cost pool while charging the fees for such inter-company arrangements.
Normally a cost sharing arrangement (CSA) comprises of various outlays which are required to be shared among the participating entities. One such cost is the cost related to Employee Stock Option Plan (ESOP) relating to employees engaged in rendering services envisaged under a CSA. Whether the costs related to ESOPs, recognized by the companies in their P&L could form part of the cost base in an inter-company cost allocation/sharing arrangement?
OECD Guidelines
Stock options are basically remuneration for the employment services performed by the employees benefiting from the plan. The charge with respect to stock option granted to those individuals would become part of the cost of rendering services to other members of the group that might be charged separately. Where an employee is co-employed by more than one group entity, in such cases, a split charge between the group entities in respect of the stock options to the various co-employers might be appropriate.
UN TP Manual
The ESOP expenses should be included in the cost base for the limited purpose of computing the mark-up, since the additional compensation is given by the overseas AE for the performance of the employees of the Indian taxpayer. This is based on the principle that stock-based compensation is a part of the remuneration structure of the employees; therefore, it is included in the cost base for the purpose of computing the mark-up in the same way as the cash component of remuneration.
Indian Perspective
Here is no specific guidance available in the Indian TP Regulations on the definition of costs/relevant base while computing operating margins. However, Rule 10TA of the Income-tax Rules, 1962, provides a definition of operating expense for the purpose of margin which includes ESOP expenses.
Rule 10TA defines “operating expense” which includes the costs incurred in the previous year by the assessee in relation to the international transaction during its normal operations including 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, reimbursement to associated enterprises of expenses incurred by the associated enterprises on behalf of the assessee, amounts recovered from associated enterprises on account of expenses incurred by the assessee on behalf of those associated enterprises and which relate to normal operations of the assessee and depreciation and amortization expenses relating to the assets used by the assessee.
Global Practice
Given below are the North American, EMEA and Asia Pacific region tax authorities view on ESOP compensation from transfer pricing perspective.
Americas
Under the cost sharing rules of the United States Internal Revenue Service, controlled parties may enter into a cost sharing arrangement (CSA) to share the costs and risks associated with the development of intangibles in proportion to each party’s share of reasonably anticipated benefits (RAB) expected to result from use of these cost-shared intangibles. The cost sharing regulations provide that the results of a CSA are consistent with the arm’s length standard only if, among other requirements, each controlled participant’s share of intangible development costs (IDCs), which includes Share Based Compensation (SBC), is proportionate to its RAB share.
The US Tax Court, held in Altera v. Commissioner (Altera) that the 2003 regulation requiring participants in CSAs to share SBC costs was invalid. In June 2019, a divided panel of the US Court of Appeals for the Ninth Circuit reversed the Tax Court and upheld the 2003 regulation requiring controlled participants to include the cost of SBC in a CSA.In June 2020, the US Supreme Court denied Altera’s petition for a writ of certiorari. In September 2020, the IRS released a new practice unit titled “Cost Sharing Arrangements with Stock Based Compensation focusing on the inclusion of SBC as an IDC under a CSA.
Some jurisdictions, such as Canada and the Netherlands, that do not allow tax deductions for SBC may take an inconsistent approach to ESOP depending on whether ESOP is included in inbound or outbound charges—while SBC in outbound charges may be expected, SBC in inbound charges may be challenged (i.e., a corporate income tax deduction for these charges may be denied).
EMEA
Israel is a notable exception where the inclusion of SBC in the cost base for a cost-plus pricing mechanism was mandated by a High Court decision in 2018 (Kontera Technologies Ltd. v. TA 3 Assessing Officer) and the Israeli Tax Authority issued a circular in 2021 to re-affirm this position (Income Tax Circular No. 1/2021).
Despite the lack of formal guidance in most jurisdictions like Australia, China, Germany, Ireland (Republic), Israel, Italy, Japan, Mexico, Romania, Singapore, South Korea, Sweden, Switzerland and the United Kingdom, the local tax authorities generally expect ESOP expenses to be included in the cost base used to calculate the transfer price for a local routine entity’s activities so long as the ESOP is relevant to the activity and is reflected in the local financial statements. Greater ambiguity exists in places where there are no specific regulations and there is limited practical experience with these matters.
Asia Pacific
Indian courts have held that ESOP compensation expense shall be considered operating and included in the cost base for computation of markup in the following cases,
Tesco Bengaluru (P.) Ltd. vs DCIT (2022) Bangalore ITAT held that the reimbursement of the cost of issue of shares paid by the assessee to its AE as an item of expenditure incurred by the assessee on behalf of its employees and hence should have formed part of the operating cost of the assessee.
Hewlett Packard (India) Software Operation Pvt. Ltd. vs DCIT (2021) Bangalore ITAT has held that the ESOP expenditure incurred is a compensation/incentive to the employee which has direct nexus with his employment. Such compensation to the employees in the form of ESOP are included in salary of the employees under Section 17, therefore, such expenses are incurred for the purpose of business and allowed as expenditure under Section 37 of the Income Tax Act in the hands of the employer.
Accordingly, it shall be considered as part of operating expenses for the purpose of margin computation, being an allowable expenditure eligible for deduction under Section 37.
Radisys India Ltd. vs DCIT (2022) The ESOP expenditure pertaining to issue of shares of the holding company to the employees of the Assessee (i.e., Subsidiary company), cannot be considered as Operating cost in the hands of the assessee, as the payment towards subscription of shares has been directly made by the employees (who have opted for scheme).
But, in the event the expenditure is treated as an operating cost, then the same needs to be considered as operating revenue if the AE has cross charged such ESOP cost to the assessee.
Measurement
In general, tax authorities expect taxpayers to use the local GAAP (local statutory) financial statement for determining routine returns. Thus, a general expectation would be to include the local GAAP measure of ESOP expense when computing routine returns.
However, there is some ambiguity and limited practical experience with tax authority views on ESOP in certain jurisdictions. Additionally, some tax jurisdictions may accept measures other than the local GAAP amount in the cost base. For example, taxpayers in the UK may choose to use the UK tax deduction amount instead of the UK GAAP amount. Regardless of the ESOP cost measure used in the cost base for transfer pricing purposes, companies are generally expected to apply the approach consistently year over year.
Since local GAAP rules may differ across countries, reliance on local GAAP measures for ESOP may still lead to differences in treatment of ESOP in routine returns across jurisdictions. MNCs may follow IFRS or Local GAAP, some may allow companies to choose between two or more accounting standards for their statutory financial statements, some may not require ESOP expense to be recorded on the statutory financials of the local entity, some may have ESOPC expense equal to the tax deduction or recharge amount but not others.
Thus, following local GAAP for ESOP cost may still yield different results for routine return computations depending on whether the ESOP expense is recorded as zero, fair value as of grant date, or another measure. Where ESOP is measured differently for local GAAP and tax accounting purposes, inclusion of the local GAAP expense in the cost base will lead to a mismatch between the cost base used for the routine return and the tax deduction for those costs.
Conclusion
The value and timing of the ESOP expense or deduction depends on the accounting and/or tax treatment of ESOP, while the treatment of ESOP as an expense to be included in the cost base of routine entities depends on the transfer pricing rules and practice of the jurisdiction where employees are granted ESOP. As discussed above jurisdictions differ in their views and approaches on whether and how SBC should be reflected in the cost base of routine entities.
Some Jurisdictions like India have almost settled the issue based on rulings in favour of including the ESOP in the cost base by considering it as an Operating Expense.
These differences in corporate tax determinations around ESOP, such as their deductibility, can lead to significant complexity for MNEs and difficulty in application of consistent transfer pricing policies across jurisdictions. Often, MNEs have to develop tailored approaches for different jurisdictions or sets of jurisdictions.
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Disclaimer
The information in this article is not intended to be a written advice concerning one or more corporate tax matters because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on tax authorities & laws that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser