Employee Stock Option Plans, as a tool to reward & retain key human talent has gained enormous acceptance and adoption worldwide. Enterprises are more than ever interested in adopting non-traditional methods for making payments to their Employees. Hence ESOPs have become the most popular and accepted form of Employee Compensation.
Emergence of share-based payment as an important means of employee compensation has also generated heated debate on the manner of accounting for such payments. Accordingly the lawmakers have chalked down provisions dealing the same primarily under Guidance Note 18- issued by ICAI on Accounting for Employee Share-Based Payments, supported by relevant Sections under Income-tax Act, 1961. Certain judgments have also been given with regard of allowance of ESOP expenses.

COMPENSATION COST: MEANING
In more concrete terms, ESOP expense is known as Compensation Cost. This is because, employee share-based payments generally involve grant of shares or stock options to the employees at a concessional price or a future cash payment based on the increase in the price of the shares from a specified level. The basic objective of such payments is to compensate employees for their services and/or to provide an incentive to the employees for remaining in the employment of the enterprise and for enhanced performance. Compensation Cost is the difference between the value of Company’s Share at the time of Grant and the price at which the Company has offered the Options to the Employee. This difference becomes the Cost to the Company.

COMPENSATION COST = FAIR MARKET VALUE ON GRANT – EXERCISE PRICE

BOOKING OF COMPENSATION COST

Equity-settled Schemes:
In case of Schemes in which the Employee gets the Equity Shares of the Company against Exercise of Options, Compensation Cost is recognised by the Employer on a straight-line basis over the vesting period of the options. The entire expense is calculated at the time of Grant of Options and it is equally divided over a period within which the options will vest with the Employees, as the case may be.

Cash-settled Schemes:
In case of Schemes, where the Employee gets the incremental value of Company’s Shares over a period of time, the Employer has to make a provision equivalent to the amount to be paid to the Employees in the year in which the payment is to be made.

ALLOWANCE OF COMPENSATION COST

• The Employer i.e. the Company for whose Employees the Scheme is being framed, shall book compensation cost in its books of accounts;
• In case the scheme is framed by Holding Company, and it awards benefits to the Employees of its Subsidiary Company(s), then also the compensation cost will be booked by the Holding Company. However, the subsidiary will reimburse the holding company for such expense incurred by the holding company for the employees of the subsidiary company.

TAX TREATMENT
Compensation Cost is an allowable expense under Section 37 of the Income-tax Act, 1961. This is booked as an expense in the Profit & Loss account of the Company and is allowed as a deduction over the period of vesting of options on a straight-line basis.
In case of cash-settled schemes, the expense incurred upon payment of appreciation is booked as a provision in the books of accounts of the company in the year in which payment is to be made.
Let us understand the above-stated concepts with the help of an illustration:

1. For Equity-settled Schemes
   

   Options Granted = 1000 FMV on Grant = Rs. 30/- Exercise Price = Rs. 10/- per option
   Compensation Cost = Rs. 20/- per option
   Vesting Period	Options Vested	Compensation Cost (in Rs.)
   100% at the end of 1st year from the date of grant	1000 options	1,000*(30-10) = 20,000

   Therefore, the total compensation cost of Rs. 20,000/- (1000*(30-10)), has to be booked in the year of vesting, by the company in its P&L A/c of the company.

2. For Cash-settled Schemes
   

   Options Granted = 1000 FMV on Grant = Rs. 30/-
   Vesting Period	Options Vested	FMV on Redemption	Provision to be made* (in Rs.)
   100% options at the end of 1st year from the date of grant	1000 options	Rs. 50/-	1000*(50-30) = 20,000

* It is presumed that the payment of appreciation is being made in year of vesting.

RELATED JUDGEMENTS
In case of CIT vs. LEMON TREE HOTELS LTD, following the Madras High Court in CIT vs. PVP VENTURES LTD (TC(A) No. 1023 of 2005), it was held by Delhi High Court on 4th August, 2015, that expense incurred by the assessee on account of ESOPs is an allowable expense and hence this could be debited to the profit & loss account of the Assessee i.e. the Employer Company.
Also in another case of CIT(A) vs. PEOPLE INTERACTIVE INDIA PRIVATE LTD dated 21st October, 2015, the special bench has held that the discount under ESOP is in the nature of employee cost and hence is deductible during the vesting period w.r.t. to the market price of shares at the time of grant of options to the Employees. The amount of discount claimed as deduction during the vesting period is required to be reversed in relation to the unvested /lapsed options at the appropriate time. However, an adjustment to the income is called for at the time of exercise of option by the amount of difference in the amount of discount calculated with reference the market price at the time of grant of option and the market price at the time of exercise of option.