ESOP Expenditure and Out-of-Court Settlement Compensation for Right to Sue Are Allowable Business Deductions

ORDER

Waseem Ahmed, Accountant Member.- This appeal has been instituted by the Assessee against the order of the Learned Commissioner of Income Tax Appeals (“Ld. CIT (A)”) passed under section 250 of the Income Tax Act, 1961, (“The Act”) dated 04.09.2025.

2. In the memo of appeal, the Assessee has raised 4 grounds along with sub grounds, which we for the sake of brevity are not inclined to reproduce here. Ground No. 1 raised by the assessee is general in nature and does not call for any fresh adjudication. Hence, the same is dismissed as general in nature. Through Ground Number 2 along with sub ground numbers 2.1 to 2.4, the assessee has challenged the validity of the assessment order.

3. The necessary facts are that the assessee, a private company, filed its return of income for the A.Y. 2022-23 declaring a business loss of Rs. 325,84,48,983/- only. The assessee’s case was selected for scrutiny under CASS. Accordingly, notice u/s 143(2) of the Act was issued on 02-06-2022 by the Assessment Unit. Finally, the loss was assessed at Rs. 316,60,44,634/- after making certain additions or disallowances to the total income of the assessee.

4. The aggrieved assessee preferred an appeal before the Ld. CIT(A) and submitted that the notice u/s 143(2) of the Act for assuming jurisdiction to make the assessment was required to be issued by the NFAC. However, in the present case, the notice was issued by the Assessment Unit. Therefore, the assessee contended that the notice u/s 143(2) of the Act was invalid and without jurisdiction. Consequently, the assessment order passed on the basis of such notice was also invalid. However, Ld. CIT(A) rejected the assessee’s argument by observing as under:

5.1 Ground of appeal No.1: In this ground, appellant challenged the Validity of Assessment Order contending specifically that the notice under section 143(2) of the Incometax Act was not issued by the National Faceless Assessment Centre (NaFAC) but by the Assessment Unit (AU). The Appellant claims that this invalidates the entire assessment proceedings. Section 143(2) requires the AO or prescribed authority to issue the scrutiny notice to the assessee. Recent amendments and CBDT notifications have clarified that in faceless regimes, an Assessment Unit duly empowered under relevant notifications by the CBDT acts as the Assessing Officer for such purposes. The Supreme Court emphasized in several cases that procedural irregularities in the identity of the officer do not vitiate proceedings as long as substantive powers are properly delegated. It is further clarified that faceless assessment units, once empowered through statutory notifications, are legally competent and are to be treated as Assessing Officers under section 2(7A). Further, the submission by the Appellant ignores operational realities of digital assessment as established by the Finance Act, 2021 and implementing orders where Assessment Units have been vested with all such powers, including the service of statutory notices. The notice issued by the AU was legally valid, as the AU acted as the prescribed authority under genuine empowerment. The assessment order cannot be annulled on this technical ground. The Ground of Appeal No.1 of the Appellant dismissed.

5. Being aggrieved by the order of Ld. CIT(A), the assessee has filed the present appeal before us and has challenged the findings of the Ld. CIT(A) on the issues raised in the grounds of appeal.

6. The Ld. AR before us reiterated that the section 143(2) notice issued by the assessment unit is invalid and without jurisdiction. Accordingly, the consequent assessment based on the invalid notice u/s 143(2) is also invalid.

7. On the other hand, the Ld. DR before us contended that notice under section 143(2) is required to be issued by the AO or by the prescribed income tax authority. The assessment unit is a prescribed income tax authority. To buttress his argument, the Ld. DR relied on the ruling of the Hon’ble Delhi High Court in Ambience (P.) Ltd. v. Asstt. CIT  (Delhi).

8. We have heard the rival contentions of both the parties and perused the materials on record. The limited issue before us is whether the notice u/s 143(2) of the Act issued by the Assessment Unit is invalid for want of jurisdiction. It is not in dispute that the assessee filed its return for A.Y. 2022-23 and the case was selected for scrutiny under CASS. Thereafter, the Assessment Unit issued a notice u/s 143(2) of the Act on 02.06.2022.

8.1 The contention of the Ld. AR is that only NFAC could have issued such notice, not the Assessment Unit. We are unable to accept this contention. Section 143(2) of the Act permits issuance of notice by the AO or the prescribed income-tax authority. Under the faceless assessment framework, the Assessment Units have been constituted and empowered to perform the functions of the AO. Therefore, merely because the notice was issued by the Assessment Unit instead of NFAC, the notice cannot be treated as without jurisdiction. The Ld. CIT(A) has also recorded that the Assessment Units are legally competent to exercise such powers, including issuance of statutory notices.

8.2 We also find that the Ld. DR has relied upon the decision of the Hon’ble Delhi High Court in Ambience (P.) Ltd. (supra) in support of the validity of notice issued by the prescribed income-tax authority where in it was held as under:

8.3 In view of the above, we find no merit in the contention of the assessee that the notice u/s 143(2) of the Act was without jurisdiction merely because it was issued by the Assessment Unit. Accordingly, we uphold the finding of the Ld. CIT(A) on this issue. Accordingly, the ground of appeal raised by the assessee is hereby dismissed.

8.4 Vide Ground No. 3 along with sub grounds 3.1 to 3.6, the assessee has challenged the order of the Ld. CIT(A) in confirming the disallowance of ESOP expenses.

9. The necessary facts are that the assessee claimed ESOP expenditure of Rs. 7,00,54,349/- for the year under consideration. It submitted that its holding company, M/S Kiranakart Pte. Ltd., issued the ESOPs to employees of assessee. An independent valuer determined the fair value of the ESOPs using the Black-Scholes Option Pricing Model, as prescribed under IND AS 102. The valuer also considered the prices at which the company had issued shares to investors in the funding rounds conducted closest to the respective valuation dates.

9.1 The assessee explained that since the holding company was newly incorporated and there were no comparable listed companies, the valuer adopted suitable assumptions for volatility. According to the assessee, the absence of comparable companies did not materially affect the valuation.

9.2 It was further submitted that the ESOP expenditure was incurred wholly and exclusively for the purpose of business and was therefore allowable as a deduction u/s 37(1) of the Act. The liability was not contingent or notional. The expenditure related to F.Y. 2021-22 and, since the assessee followed the mercantile system of accounting, it was required to be accounted for in that year.

10. However, the AO did not accept the assessee’s explanation. The AO observed that both the assessee and its holding company were newly incorporated and had no past business history, profits, reserves, or surplus to form a reliable basis for valuation. The AO also noted that the valuer had adopted certain figures and assumptions without supporting documentary evidence and that there were no comparable listed companies.

10.1 The AO further observed that the valuation report itself was dated 27.09.2022, i.e., after the end of F.Y. 2021-22. According to the AO, the ESOP liability had therefore neither accrued nor crystallised as on 31.03.2022. The AO also held that the shares had not actually been handed over to the employees and that the options could be terminated in certain circumstances. Therefore, no definite liability had arisen during the year.

10.2 The AO treated the difference between the market value of shares and the price at which the options were offered to employees as a hypothetical and notional loss. The judicial precedents relied upon by the assessee were held to be distinguishable on facts. Accordingly, the AO disallowed the entire ESOP expenditure of Rs. 7,00,54,349/-claimed for deduction u/s 37(1) of the Act and added the same to the total income of the assessee.

11. The aggrieved assessee preferred an appeal before the Ld. CIT(A), who confirmed the finding of the AO by observing as under:

5.2 Ground of appeal No.2: In this ground appellant challenges the disallowance of ESOP Expenditure (INR 7,00,54,349). The Appellant claims deduction for ESOP expenses on the ground that the liability was accrued and recognized under Ind AS 102 for FY 2021-22, with the cost cross-charged by the Singapore parent. The Appellant relies on a valuation report dated 27 September 2022 and contends that service-based vesting justifies accrual. The AO disallowed the expenses based on the following reasoning:

a. The valuation report post-dates the financial year.

b. The company and its parent are start-ups with no historical financial base or contemporaneous documentary evidence.

c. The ESOP expense is hypothetical, notional, and not actually incurred by March 31, 2022.

The Supreme Court in ED Sassoon & Co Ltd v. CIT 26 ITR 27 (SC) held that for an expense to be accrued, the liability must be crystallized and certain by the cutoff date, not merely anticipated. In this case, the expense was recognized after the year-end, based on a post-facto valuation—not on a binding obligation as of March 31, 2022.

In CIT v. Excel Industries Ltd. 358 ITR 295 (SC), the Supreme Court reaffirmed that contingent liabilities cannot be claimed as deduction. The ESOP scheme here makes vesting uncertain, dependent on continued employment, possible forfeiture, and other factors. The actual cost, per the record, was not incurred within the relevant fiscal year.

The Appellant cites Biocon Ltd  (Karnataka HC), but the facts differ materially:

a. In Biocon, options were exercised, and the liability was certain.

Whereas the appellant claimed deduction where ESOP cost was booked based on estimates or post-facto valuations without actual vesting and exercise during the relevant year. The appellant has not demonstrated a certain, unconditional liability as of March 31, 2022. The cost is hypothetical and contingent, not crystallized. The valuation report, issued well after the close of the year, cannot create a deductible expense retroactively. The AO’s disallowance is sustained in full. The Ground of Appeal No.2 of the appellant is dismissed.

12. Being aggrieved by the order of the Ld. CIT(A), the assessee is in appeal before us.

12.1 The Ld. AR before us submitted that the assessee had claimed deduction of ESOP expenditure. Its parent company, Kiranakart Pte. Ltd., Singapore had issued ESOPs to the employees and consultants of the assessee under the Share Option Plan adopted on 19.07.2021. As per the letter dated 25.03.2022, the assessee was required to reimburse the cost of ESOPs granted to its employees and consultants. The reimbursement was on a cost-to-cost basis.

12.2 The Ld. AR submitted that the ESOP scheme was introduced to hire and retain employees and to recognise their contribution to the business. Therefore, the expenditure was incurred wholly and exclusively for the purpose of the assessee’s business. It was neither capital nor personal in nature.

12.3 The Ld. AR further submitted that the liability was not hypothetical or contingent. The assessee was obligated to reimburse the ESOP expenditure to its parent company under the reimbursement arrangement. Therefore, the liability was ascertained.

12.4 The Ld. AR submitted that the AO and the Ld. CIT(A) were not justified in treating the expenditure as hypothetical, contingent and not crystallised. They were also not justified in holding that the assessee had failed to establish a certain and unconditional liability as on 31.03.2022.

12.5 It was further submitted that the ESOP expenditure was duly recognised in the audited financial statements for the year ended 31.03.2022. Merely because the valuation report was prepared after 31.03.2022, the expenditure could not be denied. The valuation report was available before completion of the statutory audit. The audit report for F.Y. 2021-22 was dated 29.09.2022.

12.6 The Ld. AR also submitted that the cross-charge recovery letter specifically provided that the ESOP cost relating to the employees of the assessee would be recovered by the parent company from the assessee on cost-to-cost basis. Thus, the reimbursement liability had crystallised when the ESOP scheme was introduced to the employees of the assessee.

12.7 The Ld. AR placed reliance on the decision in Biocon Ltd. v. Dy. CIT (LTU), Bangalore [2014] 144 ITD 21/[2013] 25 ITR(T) 602 (Bangalore – Trib.), which was subsequently upheld by the Hon’ble Karnataka High Court in CIT v. Biocon Ltd.  430 ITR 151 (Karnataka). It was submitted that ESOP expenditure has been held to be revenue expenditure allowable u/s 37 of the Act and the liability arising during the vesting period is not merely contingent.

12.8 The Ld. AR also relied uponBayer Crop Science Ltd. v. Dy. CIT [2024] 204 ITD 630 (Mumbai – Trib.) and other decisions following Biocon Ltd. in support of the allowability of ESOP expenditure.

12.9 With regard to ESOP expenditure cross-charged by a foreign parent company, the Ld. AR specifically relied upon the following judicial precedents:

12.10 It was submitted that these decisions support the deduction of ESOP expenditure where the parent company grants shares or options to employees of the Indian subsidiary and recovers the corresponding cost from the subsidiary.

12.11 Accordingly, the Ld. AR submitted that the ESOP expenditure cross-charged by the parent company was an expenditure incurred for the assessee’s employees and for the purpose of its business. The same was an ascertained liability and was allowable as a deduction u/s 37 of the Act. The disallowance made by the AO and sustained by the Ld. CIT(A) was therefore liable to be deleted.

13. The Ld. DR, on the contrary, vehemently supported the orders of the lower authorities. He submitted that the ESOP expenditure had not crystallised during the year. The valuation report itself was dated 27.09.2022, after the close of F.Y. 202122. Further, the shares had not been issued to the employees, and the options were subject to vesting conditions and possible forfeiture. Therefore, the liability as on 31.03.2022 was uncertain and contingent. He also submitted that the valuation was based on assumptions without comparable listed companies. Accordingly, the Ld. DR contended that the AO was justified in treating the expenditure as hypothetical and notional and the order of the Ld. CIT(A) should be upheld.

14. We have heard the rival contentions of both the parties and perused the materials available on record. The limited issue before us is whether the ESOP expenditure of Rs.7,00,54,349/- claimed by the assessee is allowable u/s 37(1) of the Act. The undisputed facts are that the holding company of the assessee, M/s Kiranakart Pte. Ltd., Singapore, introduced a Share Option Plan on 19.07.2021 for the employees and consultants of the assessee. The assessee was required to reimburse the ESOP cost relating to its employees to the holding company on a cost-to-cost basis. An independent valuer determined the fair value of the options by applying the Black-Scholes Option Pricing Model. Accordingly, the expenditure was recognised in the audited financial statements for the year ended 31.03.2022.

14.1 The AO disallowed the claim mainly on the ground that the valuation report was dated 27.09.2022. He also observed that the assessee and its holding company were newly incorporated and had no past business history. According to the AO, since the shares had not been handed over to the employees and the options could be terminated, the liability had not crystallised during the year. The Ld. CIT(A) substantially proceeded on the same reasoning and treated the expenditure as hypothetical and contingent.

14.2 We are of the considered view that the approach of the authorities below is not justifiable. The nature of ESOP expenditure must be assessed based on the purpose for which the options are granted. ESOPs are granted to attract, retain and motivate employees and to compensate them for their services. Therefore, the cost attached to such options is employee compensation and it is incurred for carrying on the business.

14.3 We note that the Special Bench of the Tribunal in Biocon Ltd. (supra), held that a discount on ESOP represents deferred employee remuneration. It further held that such expenditure gives rise to an ascertained liability during the vesting period and is allowable as a deduction. The relevant observation of the Hon’ble Special Bench of the Tribunal with respect to allowability of the ESOP for reference is extracted as under:

9.2.6 There is no doubt that the amount of share premium is otherwise a capital receipt and hence not chargeable to tax in the hands of company. The Finance Act, 2012 has inserted clause (viib) of section 56(2) w.e.f. 1.4.2013 providing that: ‘where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares’, then such excess share premium shall be charged to tax under the head ‘Income from other sources’. But for that, the amount of share premium has always been understood and accepted as a capital receipt. If a company issues shares to the public or the existing shareholders at less than the otherwise prevailing premium due to market sentiment or otherwise, such short receipt of premium would be a case of a receipt of a lower amount on capital account. It is so because the object of issuing such shares at a lower price is nowhere directly connected with the earning of income. It is in such like situation that the contention of the Ld. Departmental Representative would properly fit in, thereby debarring the company from claiming any deduction towards discounted premium. It is quite basic that the object of issuing shares can never be lost sight of. Having seen the rationale and modus operandi of the ESOP, it becomes out-and-out clear that when a company undertakes to issue shares to its employees at a discounted premium on a future date, the primary object of this exercise is not to raise share capital but to earn profit by securing the consistent and concentrated efforts of its dedicated employees during the vesting period. Such discount is construed, both by the employees and company, as nothing but a part of package of remuneration. In other words, such discounted premium on shares is a substitute to giving direct incentive in cash for availing the services of the employees. There is no difference in two situations viz., one, when the company issues shares to public at market price and a part of the premium is given to the employees in lieu of their services and two, when the shares are directly issued to employees at a reduced rate. In both the situations, the employees stand compensated for their effort. If under the first situation, the company, say, on receipt of premium amounting to Rs. 100 from issue of shares to public, gives Rs. 60 as incentive to its employees, such incentive of Rs. 60 would be remuneration to employees and hence deductible. In the same way, if the company, instead, issues shares to its employees at a premium of Rs. 40, the discounted premium of Rs. 60, being the difference between Rs. 100 and Rs. 40, is again nothing but a different mode of awarding remuneration to employees for their continued services. In both the cases, the object is to compensate employees to the tune of Rs. 60. It follows that the discount on premium under ESOP is simply one of the modes of compensating the employees for their services and is a part of their remuneration. Thus, the contention of the ld. DR that by issuing shares to employees at a discounted premium, the company got a lower capital receipt, is bereft of an force. The sole object of issuing shares to employees at a discounted premium is to compensate them for the continuity of their services to the company. By no stretch of imagination, we can describe such discount as either a short capital receipt or a capital expenditure. It is nothing but the employees cost incurred by the company. The substance of this transaction is disbursing compensation to the employees for their services, for which the form of issuing shares at a discounted premium is adopted.

9.2.7 Now we espouse the second part of the submission of the ld. DR in this regard. He canvassed a view that an expenditure denotes “paying out or away” and unless the money goes out from the assessee, there can be no expenditure so as to qualify for deduction u/s 37. Subsection (1) of the section provides that any expenditure (not being expenditure in the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”. To put it differently, an expenditure must be laid out or expended wholly and exclusively for the purpose of business so as to be eligible for deduction u/s 37(1). There is absolutely no doubt that section 37(1) talks of granting deduction for an ‘expenditure’, and the Hon’ble Supreme Court in Indian Molasses Co. (P.) Ltd. (supra) has described ‘expenditure’ to mean what is ‘paid out or away’ and is something which has gone irretrievably. However, it is pertinent to note that this section does not restrict paying out of expenditure in cash alone. Section 43 contains the definition of certain terms relevant to income from profits of business or profession covering sections 28 to 41. Section 37 obviously falls under Chapter IV-D. Sub-section (2) of section 43 defines “paid” to mean: “actually paid or incurred according to the method of accounting upon the basis of which the profits or gains are computed under the head ‘profits and gains of business or profession’.” When we read the definition of the word “paid” u/s 43(2) in juxtaposition to section 37(1), the position which emerges is that it is not only paying of expenditure but also incurring of the expenditure which entails deduction u/s 37(1) subject to the fulfilment of other conditions. At this juncture, it is imperative to note that the word ‘expenditure’ has not been defined in the Act. However, sec. 2(h) of the Expenditure Act, 1957 defines ‘expenditure’ as : ‘Any sum of money or money’s worth spent or disbursed or for the spending or disbursing of which a liability has been incurred by an assessee.’ . When section 43(2) of the Act is read in conjunction with section 37(1), the meaning of the term ‘expenditure’ turns out to be the same as is there in the afore quoted part of the definition under section 2(h) of the Expenditure Act, 1957, viz., not only ‘paying out’ but also ‘incurring’. Coming back to our context, it is seen that by undertaking to issue shares at discounted premium, the company does not pay anything to its employees but incurs obligation of issuing shares at a discounted price on a future date in lieu of their services, which is nothing but an expenditure u/s 37(1) of the Act.

9.2.8 Though discount on premium is nothing but an expenditure u/s 37(1), it is worth noting that the Hon’ble Supreme Court in the case of CIT v. Woodward Governor India (P.) Ltd. [2009] 312ITR 254  has gone to the extent of covering “loss” in certain circumstances within the purview of “expenditure” as used in section in 37(1). In that case, the assessee incurred additional liability due to exchange rate fluctuation on a revenue account. The Assessing Officer did not allow deduction u/s 37. When the matter finally reached the Hon’ble Supreme Court, their Lordships noticed that the word “expenditure” has not been defined in the Act. They held that : “the word “expenditure” is, therefore, required to be understood in the context in which it is used. Section 37 enjoins that any expenditure not being expenditure of the nature described in sections 30 to 36 laid out or expended wholly and exclusively for the purposes of the business should be allowed in computing the income chargeable under the head “profits and gains of business or profession”. In sections 30 to 36 the expression “expenditure incurred”, as well as allowance and depreciation, has also been used. For example depreciation and allowances are dealt with in section 32, therefore, the parliament has used expression “any expenditure” in section 37 to cover both. Therefore, the expression “expenditure” as used in section 37 made in the circumstances of a particular case, covers an amount which is really a “loss” even though the said amount has not gone out from the pocket of the assessee’. From the above enunciation of law by the Hon’ble Summit Court, there remains no doubt whatsoever that the term ‘expenditure’in certain circumstances can also encompass ‘loss’even though no amount is actually paid out. Ex consequenti, the alternative argument of the ld. DR that discount on shares is ‘loss’and hence can’t be covered u/s 37(1), also does not hold water in the light of the above judgment. In view of the above discussion, we, with utmost respect, are unable to concur with the view taken in Ranbaxy Laboratories Ltd. (supra).

B. Is discount a Contingent liability ?

9.3.1 The Ld. Departmental Representative supported the impugned order by contending that the entitlement to ESOP depends upon the fulfilment of several conditions laid down under the scheme. It is only when all such conditions are fulfilled and the employees render services during the vesting period that the question of any ascertained liability can arise. He submitted that during the entire vesting period, it is only a contingent liability and no deduction is admissible under the provisions of the Act for a contingent liability. The options so granted may lapse during the vesting period itself by reason of termination of employment or some of the employees may not choose to exercise the option even after rendering the services during the vesting period. It was, therefore, argued that the discount is nothing but a contingent liability during the vesting period not calling for any deduction. In the opposition, the Ld. AR submitted that the amount of discount claimed by the assessee as deduction is not a contingent liability but an ascertained liability. He stated that in the ESOP 2000, there is a vesting period of four years, which means that the options to the extent of 25% of the total grant would vest with the eligible employees at the end of first year after rendering unhindered service for one year and it would go on till the completion of four years.

9.3.2 It is a trite law and there can be no quarrel over the settled legal position that deduction is permissible in respect of an ascertained liability and not a contingent liability. Section 31 of the Indian Contract Act, 1872 defines “contingent contract” as “a contract to do or not do something, if some event, collateral to such contract does not happen”. We need to determine as to whether the liability arising on the assessee-company for issuing shares at a discounted premium can be characterized as a contingent liability in the light of the definition of contingent contract. From the stand point of the company, the options under ESOP 2000 vest with the employees at the rate of 25% only on putting in service for one year by the employees. Unless such service is rendered, the employees do not qualify for such options. In other words, rendering of service for one year is sine qua non for becoming eligible to avail the benefit under the scheme. Once the service is rendered for one year, it becomes obligatory on the part of the company to honor its commitment of allowing the vesting of 25% of the option. It is at the end of the first year that the company incurs liability of fulfilling its promise of allowing proportionate discount, which liability would be actually discharged at the end of the fourth year when the options are exercised by the employees. Now the question arises as to whether the liability at the end of each year can be construed as a contingent one?

9.3.3 The Hon’ble Supreme Court in Bharat Earth Movers v. CIT [2000] 245 ITR 428  dealt with the deductibility or otherwise of provision for liability towards encashment of earned leave. In that case, the company floated beneficial scheme for its employees for encashment of leave. The earned leave could be accumulated up to certain days. The assessee created provision of Rs. 62.25 lakh for encashment of accrued leave and claimed deduction for the same. The Assessing Officer held it to be a contingent liability and hence not a permissible deduction. When the matter finally came up before the Hon’ble Supreme Court, it was held that the provision for meeting the liability for encashment of earned leave by the employee was an admissible deduction. In holding so, the Hon’ble Apex Court observed that : “the law is settled : if a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. What should be certain is the incurring of the liability. It should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied the liability is not a contingent one. The liability is in praesenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain.” From the above enunciation of law by the Hon’ble Supreme Court, it is manifest that a definite business liability arising in an accounting year qualifies for deduction even though the liability may have to be quantified and discharged at a future date. We consider it our earnest duty to mention that the legislature has inserted clause (f) to section 43B by providing that “any sum payable by the assessee as an employer in lieu of any leave at the credit of his employee” shall be allowed as deduction in computing the income of the previous year in which such sum is actually paid. With this legislative amendment, the application of the ratio decidendi in the case of Bharat Earth Movers (supra) to the provision for leave encashment has been nullified. However, the principle laid down in the said judgment is absolutely intact that a liability definitely incurred by an assessee is deductible notwithstanding the fact that its quantification may take place in a later year. The mere fact that the quantification is not precisely possible at the time of incurring the liability would not make an ascertained liability a contingent.

9.3.4 Almost to the similar effect, there is another judgment of the Hon’ble Supreme Court in the case of Rotork Controls India (P.) Ltd. v. CIT [2009] 314 ITR 62 . In that case, the assessee-company was engaged in selling certain products. At the time of sale, the company provided a standard warranty that in the event of certain part becoming defective within 12 months from the date of commissioning or 18 months from the date of dispatch, whichever is earlier, the company would rectify or replace the defective parts free of charge. This warranty was given under certain conditions stipulated in the warranty clause. The assessee made a provision for warranty at Rs. 5.18 lakh towards the warranty claim likely to arise on the sales effected by the assessee. The Assessing Officer disallowed the same on the ground that the liability was merely a contingent liability and hence not allowable as deduction u/s 37 of the Act. When the matter finally came up before the Hon’ble Supreme court, it entitled the assessee to deduction on the “accrual” concept by holding that a provision is recognized when : “(a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources will be required to settle the obligation : and (c) a reliable estimate can be made of the amount of the obligation”. Resultantly, the provision was held to be deductible.

9.3.5 When we consider the facts of the present case in the backdrop of the ratio laid down by the Hon’ble Supreme Court in Bharat Earth Movers (supra) and Rotork Controls India (P.) Ltd. (supra), it becomes vivid that the mandate of these cases is applicable with full force to the deductibility of the discount on incurring of liability on the rendition of service by the employees. The factum of the employees becoming entitled to exercise options at the end of the vesting period and it is only then that the actual amount of discount would be determined, is akin to the quantification of the precise liability taking place at a future date, thereby not disturbing the otherwise liability which stood incurred at the end of the each year on availing the services.

9.3.6 As regards the contention of the ld. DR about the contingent liability arising on account of the options lapsing during the vesting period or the employees not choosing to exercise the option, we find that normally it is provided in the schemes of ESOP that the vested options that lapse due to non-exercise and/or unvested options that get cancelled due to resignation of the employees or otherwise, would be available for grant at a future date or would be available for being re-granted at a future date. Ifwe consider it at micro level qua each individual employee, it may sound contingent, but if view it at macro level qua the group of employees as a whole, it loses the tag of ‘contingent’ because such lapsing options are up for grabs to the other eligible employees. In any case, if some of the options remain unvested or are not exercised, the discount hitherto claimed as deduction is required to be reversed and offered for taxation in such later year. We, therefore, hold that the discount in relation to options vesting during the year cannot be held as a contingent liability.

14.4 The Hon’ble Karnataka High Court in Biocon Ltd. (supra) upheld the view taken by the Hon’ble Special Bench of the Tribunal as discussed above.

14.5 Further, we note that the reasoning of the Ld. CIT(A) that the ratio laid down in Biocon Ltd (supra) is distinguishable because the options in the present case had not been fully vested or exercised also cannot be accepted. The very concept of allowing ESOP expenditure is based upon accrual of employee compensation during the vesting period. The liability arises over the period when the employee renders the required service. Actual exercise of the option or subsequent allotment of shares is the discharge of that liability. It is not the event which first creates the liability. The Special Bench in Biocon Ltd (supra) has specifically recognised this distinction.

14.6 The principle laid down by the Hon’ble Supreme Court in Bharat Earth Movers v. CIT 245 ITR 428 (SC), also supports this view. Once a business liability has definitely arisen, deduction cannot be denied merely because the liability is to be discharged or finally quantified at a future date. What is necessary is that the liability should be capable of being estimated with reasonable certainty. The relevant finding of the Hon’ble Supreme Court reads as under:

The law is settled: if a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. What should be certain is the incurring of the liability. It should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied, the liability is not a contingent one. The liability is in praesenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain.

14.7 Furthermore, in the present case, there is an additional feature. The foreign holding company granted the options to the assessee’s employees and consultants. The letter dated 25.03.2022 required the assessee to reimburse the corresponding ESOP cost to its holding company on a cost-to-cost basis. Thus, the expenditure does not represent a mere book entry made voluntarily by the assessee. It represents the cost of employee compensation borne by the holding company for employees working for the assessee and recoverable from the assessee.

14.8 The fact that the shares will be ultimately issued by the foreign holding company does not change the character of the expenditure. What is relevant is whose employees received the benefit and for whose business their services were rendered. The several benches of the Tribunals have accepted deduction of ESOP expenditure where a foreign holding company grants options or shares to employees of its Indian subsidiary and the corresponding cost is cross-charged to the subsidiary.

14.9 We now consider the objection regarding the date of the valuation report. The report was prepared on 27.09.2022, whereas the relevant financial year ended on 31.03.2022. In our view, the date on which the valuation exercise is completed cannot by itself determine the year of accrual of expenditure. What is relevant is the date with reference to which the options have been valued and the period to which the expenditure relates. The assessee has also pointed out that the valuation was available before completion of the statutory audit and the audit report itself was dated 29.09.2022. The material placed before us also explains that the date of submission of a valuation report is distinct from the valuation date and that a post-year-end report does not, by itself, invalidate recognition of expenditure relating to the relevant period.

14.10 We also find no sufficient basis to reject the claim merely because comparable listed companies were not used to determine volatility. The assessee and its holding company were in their initial year of operations. The valuer determined the fair value of the stock options by applying the Black-Scholes Option Pricing Model. While carrying out the valuation, the valuer also considered the prices at which the company had issued shares to investors in the funding rounds closest to the respective valuation dates. The absence of a comparable listed company, by itself, cannot make the entire valuation imaginary. If the AO had any specific objection to an assumption or input used by the valuer, the same could have been examined on its own merits. However, the entire ESOP expenditure cannot be treated as non-existent merely because comparable companies are unavailable.

14.11 There is a clear difference between the possibility that an option may lapse in future and the recognition of ESOP expenditure during the vesting period. Under an ESOP scheme, an employee is required to render services during the vesting period to become entitled to the options. It is possible that some employees may leave the company before completing the required period. In such cases, their options may not vest and may ultimately lapse. However, this possibility by itself does not make the entire ESOP liability contingent from the beginning.

14.12 The ESOP expenditure is recognised over the vesting period because the employees render services to the company during that period. As the services are received, the corresponding expenditure is recognised. If an employee subsequently leaves the company and the options do not vest, the expenditure already recognised in respect of those unvested options can be reversed or appropriately adjusted. Thus, the possibility of some options lapsing or being forfeited is taken care of through subsequent adjustment. It does not justify treating the entire ESOP expenditure as a contingent liability during the vesting period.

14.13 Considering the facts in their entirety, we are of the opinion that the expenditure represents employee compensation incurred for the assessee’s business. The liability cannot be regarded as hypothetical merely because the options were to vest or be exercised subsequently. The subsequent date of the valuation report also does not alter the year to which the expenditure relates. The claim is therefore required to be considered that ESOP expenditure is allowable u/s 37(1) of the Act over the relevant vesting period. Accordingly, we set aside the finding of the Ld. CIT(A) and direct the AO to allow the ESOP expenditure of Rs. 7,00,54,349/-, being the amount attributable to the year under consideration. Needless to say, if any of the options subsequently lapse or remain unvested, the corresponding adjustment shall be made in accordance with law. Hence, the ground of appeal raised by the assessee is hereby allowed.

15. Vide Ground No. 4, the assessee has challenged the order of the Ld. CIT(A) in confirming the disallowance of payment made towards extinguishment of the right to sue on account of non-deduction of TDS.

17. The necessary facts are that during the year, the assessee company made a payment of Rs. 7,45,00,001/- to a person named Shri Anish Nikhil Nanda. It claimed that the said person was about to file a suit against the assessee company for alleged damage caused to him. To protect its reputation, the assessee company reached an out-of-court settlement and paid Rs. 7,45,00,001/-, and the said person, in lieu thereof, extinguished his right to file a suit.

17.1 The assessee further claimed that the amount paid for extinguishment of the right is a capital receipt for the recipient, Shri Anish Nikhil Nanda. Once the amount paid is not taxable in the hands of the recipient, no liability arises for deduction of tax at source in the hands of the assessee company. To buttress its contention, the assessee company placed reliance on several judicial rulings of the Tribunal and Hon’ble High Courts.

17.2 However, the AO did not accept the assessee’s argument. The AO held that the assessee failed to produce documentary evidence explaining the nature of the alleged damage, the basis for determining the compensation of Rs. 7.45 crore, and its connection with the assessee’s business. The AO also noted that the assessee was in its first year of operations, and it was not clear what damage had been caused to warrant such a substantial payment.

17.3 The AO further rejected the assessee’s claim that the amount was a capital receipt in the hands of the recipient and, therefore, no TDS was required. The AO held that the assessee could not itself decide the taxability of the amount in the hands of the recipient. Accordingly, for failure to deduct TDS, the AO disallowed 30% of the payment, amounting to Rs. 2,23,50,000/-, u/s 40(a)(ia) of the Act.

18. The aggrieved assessee preferred an appeal before the Ld. CIT(A) and reiterated that the amount paid to Shri Anish Nikhil Nanda is a capital receipt. Therefore, the provision of section 195 of the Act is not applicable to the said payment. Accordingly, the disallowances made by invoking section 40(a)(ia) deserve to be deleted. However, the Ld. CIT(A) confirmed the disallowances made by the AO by observing as under:

5.3 Ground of Appeal no.3: In this ground Appellant challenged the Disallowance of Amount Paid for Extinguishment of Right to Sue. The Appellant claims deduction for the payment made to Mr. Ansh Nikhil Nanda as compensation for extinguishing his “right to sue,” asserting that it is a capital receipt not liable to tax in the hands of the recipient, and thus, not subject to TDS under section 195.However, the AO disallowed 30% of the payment for failure to deduct TDS, citing the following reasons:

In the case of GE India Technology Centre Pvt Ltd v. CIT 327 ITR 456 (SC), Hon’ble Supreme Court held that TDS obligation exists if there is any doubt over taxability or if the Revenue reasonably establishes the payment has income character for the recipient. The Appellant failed to seek determination under section 195(2) or provide irrefutable evidence of capital nature. Revenue was right to presume liability in absence of clear documentary proof.

The Appellant cites ITO v. Vinay P. Karve , but in that case, the recipient’s circumstances (criminal fraud, police complaint) were fully documented, and the payment was supported by evident contractual breach and settlement. Absent similar legal and factual foundation, such precedent does not apply.

Similarly, in CITv. J. Dalmia [149 ITR 215] (Delhi HC), compensation was held as capital only where awarded through arbitration, on concrete facts. Here, the record lacks court documents, arbitration award, or credible third-party confirmation.

In the absence of robust documentary evidence of capital nature and settlement basis, and since the Appellant did not seek a lower/nil deduction certificate or section 195(2) order, the AO’s presumption and disallowance under section 40(a)(ia) is justified and no interference in the order of AO is required. The ground of Appeal No.3 of the Appellant is dismissed.

19. The assessee, being aggrieved and dissatisfied with the order passed by the learned Commissioner of Income Tax (Appeals) [‘Ld. CIT(A)], has preferred the present appeal before us, challenging the findings and conclusions recorded by the Ld. CIT(A) and seeking appropriate relief in respect of the issues raised in the grounds of appeal.

19.1 The Ld. AR before us contended that the assessee had paid compensation of Rs.7,45,00,001/- to Shri Ansh Nikhil Nanda for extinguishment of his right to sue the company. The payment was a capital receipt in the hands of the recipient and was not chargeable to tax. Accordingly, the Ld. AR submitted that the assessee was not required to deduct tax at source from such payment. The Ld. AR also submitted that the Act contains no provision for deducting tax on payment of compensation for extinguishment of a right. The lower authorities have not specified under which section the assessee was required to deduct TDS, if any.

20. The Ld. DR, on the other hand, vehemently supported the findings of the lower authorities. He submitted that the disallowance made by the AO was justified on the facts of the case and in accordance with law. He further contended that the assessee had not brought any material on record warranting interference with the findings of the lower authorities. He, therefore, prayed that the order of the Ld. CIT(A) be upheld and the grounds raised by the assessee be dismissed.

21. We have heard rival contentions of both sides and perused the materials on record. The assessee paid Rs.7,45,00,001/- to Shri Anish Nikhil Nanda under an out-of-court settlement. The payment was made to settle the proposed filing of a suit against the assessee and to protect its reputation. In consideration of the payment, the recipient gave up his right to sue the assessee.

21.1 The AO disallowed 30% of the payment u/s 40(a)(ia) of the Act mainly on the ground that tax was not deducted at source. The Ld. CIT(A) confirmed the same. However, we find that neither the AO nor the Ld. CIT(A) has identified the specific provision of Chapter XVII-B under which tax was required to be deducted from the impugned payment.

21.2 In our considered view, this aspect goes to the root of the matter. Disallowance u/s 40(a)(ia) of the Act can be made only when the payment is of a nature on which tax was deductible under Chapter XVII-B of the Act. Compensation paid for giving up a right to sue is not a payment for carrying out any work, commission or brokerage, or professional or technical services. Thus, sections 194C, 194H and 194J of the Act do not apply merely because compensation has been paid. The material placed before us also does not show that the payment was in the nature of a non-compete fee falling within section 28(va) of the Act.

21.3 Thus, the basic condition for invoking section 40(a)(ia) of the Act has not been established. The Revenue cannot first presume a liability to deduct tax and thereafter make a disallowance without showing the provision under which such tax was deductible. The Ld. CIT(A), therefore, was not justified in confirming the disallowance merely because the assessee had not obtained a lower or nil deduction certificate.

21.4 We also find support from the decision in Satyam Food Specialities (P.) Ltd. v. Dy. CIT  68 SOT 449 (Jaipur – Trib.). In that case, compensation received for relinquishment of the right to sue was held to be a capital receipt and not taxable u/s 28(va) of the Act. The Tribunal observed that relinquishment of the right to sue was neither a capital asset nor taxable u/s 28 of the Act.

21.5 Accordingly, we hold that no tax was deductible at source on the impugned payment in the facts before us. Consequently, the disallowance of Rs. 2,23,50,000/-made u/s 40(a)(ia) of the Act cannot be sustained. Therefore, we hereby set aside the finding of the Ld. CIT(A) and direct the AO to delete the addition made by him. Hence, the ground raised by the assessee is allowed.

21.6 Before parting, we consider it appropriate to deal with the applicability of section 195 of the Act to the payment in question. Before the Ld. CIT(A), the assessee referred to section 195 of the Act. The Ld. CIT(A) has also referred to section 195(2) of the Act.

21.7 In this regard, we note that section 195(1) of the Act does not require deduction of tax merely because a payment is made to a non-resident. The obligation to deduct tax arises only when the amount paid to the non-resident is chargeable to tax in India. Therefore, even if section 195 of the Act is assumed to be applicable in the present case, it was first necessary to establish whether the amount paid by the assessee was taxable in India in the hands of the recipient.

21.8 For this purpose, the nature of the payment was required to be examined. It was necessary to determine whether the payment was taxable in India as royalty, fees for technical services, business income attributable to a permanent establishment in India, capital gains, or under any other applicable provision of the Act read with the applicable DTAA, if any.

21.9 In the present case, neither the AO nor the Ld. CIT(A) has recorded any finding that the amount received by the recipient was chargeable to tax in India. They have also not identified any provision under which such amount was taxable in India. In the absence of such a finding, liability to deduct tax u/s 195(1) of the Act cannot be presumed merely because the payment was made to a non-resident. If the amount is not chargeable to tax in India, there can be no obligation to deduct tax u/s 195(1) of the Act.

21.10 Further, if the recipient was a resident, section 195 of the Act would have no application. In that case, the requirement to deduct tax could arise only under the TDS provisions applicable to payments made to residents. However, neither the AO nor the Ld. CIT(A) has identified any such provision under which tax was required to be deducted on the payment in question.

21.11 Thus, whether the recipient is treated as a resident or a non-resident, the disallowance cannot be sustained on the basis adopted by the lower authorities. If the recipient is a resident, section 195 of the Act has no application. If the recipient is a non-resident, liability u/s 195(1) of the Act arises only when the amount is chargeable to tax in India. No such finding has been recorded in the present case.

21.12 Without prejudice to the above, we also notice an apparent inconsistency in the approach adopted by the AO. Though the AO expressed doubt regarding the genuineness or allowability of the expenditure itself, he ultimately disallowed only 30% of the expenditure on the ground of non-deduction of tax at source, without specifying the particular TDS provision under which tax was required to be deducted. The very fact that the AO proceeded to make only a proportionate disallowance for nondeduction of tax, instead of disallowing the expenditure on the ground on which its genuineness was doubted, indicates that the expenditure was not ultimately rejected in its entirety. Accordingly, for the reasons stated above, the disallowance on account of non-deduction of tax at source cannot be sustained and the same is deleted. Accordingly, Ground No. 4 raised by the assessee is allowed.

22. In the result, the appeal filed by the assessee is partly allowed.

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