ESOP costs in transfer pricing: Attribution, value, and taxation

Before examining the transfer pricing controversy, it is necessary to understand the litigation on whether ESOP costs are deductible at all under Section 37 of the Income-tax Act, 1961 (now Section 34 of the Income-tax Act, 2025).

In Biocon Ltd. v DCIT,² the Karnataka High Court held that the ESOP discount, i.e., the difference between the market price and the exercise price of the option, is not a purely notional or illusory expense. The Court reasoned that ESOPs are a form of employee compensation, and the discount represents consideration paid for services rendered over the vesting period. The consideration is real, even if the settlement is equity-based rather than cash-based.

Biocon matters to the transfer pricing debate for one important reason: it forecloses the argument that ESOP costs are inherently fictional. They are not. The question that transfer pricing law asks, however, is different and narrower. It is not whether ESOP costs are real, but whether they are real for the Indian entity specifically, i.e., whether the Indian entity has actually incurred or borne them.

These are distinct questions and conflating them has been a recurring source of confusion in assessment and some tribunal orders.

The Revenue’s position rests on three interlocking arguments.

First, the ESOP benefit flows to employees who render services for the Indian entity. The economic value created by those employees accrues primarily to the Indian subsidiary, not to the parent. Excluding the cost associated with incentivising those employees may therefore understate the true cost of the functions performed in India and reduce the profits attributed to the Indian entity.

Second, Ind-AS 102 itself requires ESOP costs to be recorded as an expense of the entity whose employees hold the options. On this view, accounting standards reflect economic reality. If the Indian entity is required to recognise the cost, that recognition should carry through into transfer pricing computation.

Third, excluding ESOP costs from the operating base of a cost-plus entity creates a structural opportunity for base erosion. A mark-up applied to a reduced cost pool produces lower reported profits in India and hence, lower taxes are paid in India.

Three decisions have materially shaped the judicial position on ESOP costs in transfer pricing, aligning with the taxpayers’ contentions. Read together, they establish a consistent principle: inclusion in the operating cost base requires actual economic incurrence by the tested party, not merely accounting recognition.

• Amazon Development Centre (India) Pvt. Ltd. v CIT³

  The Bangalore bench of the Income Tax Appellate Tribunal examined a revisionary order passed by the Commissioner of Income Tax directing the inclusion of ESOP costs in Amazon India’s operating base. The Tribunal reversed the direction.

  The Tribunal’s reasoning rested on two findings. First, there was no evidence that Amazon India had reimbursed the ESOP expenditure to its offshore parent. Second, the accounting recognition of ESOP costs arose solely from the mandatory requirements of Ind-AS 102 rather than from any economic transaction between the Indian entity and the parent.

  Critically, the Tribunal rejected the argument that safe harbour treatment of ESOP costs could be extrapolated to cases where the taxpayer had not opted for the safe harbour regime. Safe harbour rules create a separate, elective framework. They do not define arm’s length principles for general transfer pricing cases which are excluded from safe harbour rules.

• i2 Technologies Software (P.) Ltd. v CIT⁴

  The Bangalore bench reached a similar conclusion, reiterating that ESOP costs do not form part of the operating cost base where the Indian entity has not economically incurred the expenditure. The decision reinforces the distinction between accounting recognition and actual cost bearing for transfer pricing purposes.

• DCIT v Mitsubishi Corporation India Pvt. Ltd.⁵

  Though this decision did not specifically concern ESOP expenditure, the Delhi bench of the Tribunal laid down an important principle with direct application to this controversy. Under TNMM, only costs actually incurred or borne by the tested party can ordinarily form part of its operating cost base for transfer pricing purposes. Notional expenses, hypothetical allocations, and costs incurred by third parties without corresponding reimbursement or economic outflow by the tested party cannot be imported into the tested party’s accounts merely for transfer pricing adjustments. This principle, stated in the context of a broader TNMM dispute, provides doctrinal support for the ESOP-specific decisions.

The divergence between the Revenue’s position and the emerging judicial position reflects a genuine conceptual disagreement, not merely a procedural dispute. The table below sets out the split.

The table reveals that the accounting position and the transfer pricing position are not coextensive. A cost can be real in the hands of the group, required to be recognised under accounting principles, and still fall outside the tested party’s operating cost base for transfer pricing purposes if the tested party has not economically borne it. These frameworks serve different purposes and do not map onto each other.

The underlying tension is one of attribution: value is created by Indian employees, the benefit is granted by the foreign parent, and the cost is often borne by neither party in India. Transfer pricing law has yet to fully reconcile this triangular relationship.

The judicial trend consistently supports exclusion of ESOP costs from the operating cost base of an Indian entity where: (a) the Indian entity has not reimbursed the parent for the cost; (b) no actual cash outflow or economic obligation has arisen for the Indian entity; and (c) the accounting recognition is driven by Ind-AS 102 mandates rather than by any inter-company transaction.

That said, this is not settled law. The Revenue continues to raise the issue in assessments, and the absence of a High Court ruling squarely on the transfer pricing-specific question means the risk is live. Amazon and i2 Technologies Tribunal-level orders and do not bind other benches. A taxpayer relying on this position should expect challenge and should ensure its documentation is robust.

Multinational groups with Indian operations should assess their ESOP arrangements against the following considerations.

• Documentation

  The foundation of a defensible position is contemporaneous documentation establishing that the Indian entity has not reimbursed the parent and has not assumed any obligation to do so. Groups should ensure that stock option plans, reimbursement arrangements, and inter-company agreements are aligned. Inconsistencies across these documents are frequently relied on by tax authorities to assert that the Indian entity has effectively borne the ESOP cost.

  Inter-company agreements should clearly delineate who bears the economic cost of the ESOP arrangement. If the Indian entity is a cost-plus entity, the agreement should specify whether ESOP costs are included or excluded from the cost base on which the mark-up is applied and why.

• Consistency across filings

  The position taken in the transfer pricing documentation should be consistent with the treatment in the financial statements and the tax return. Inconsistency across these filings is a red flag in assessments and weakens the overall position. A common example: treating ESOP costs as operating expenses in the financial statements while excluding them from the transfer pricing study without explanation exposes the taxpayer to the inference that the exclusion was an afterthought rather than a principled position.

• Reimbursement arrangements

  Where the Indian entity does reimburse the parent for ESOP costs, the analysis changes materially. Reimbursement establishes economic incurrence, which removes the primary basis for exclusion.

  Groups often adopt reimbursement arrangements for commercial or accounting reasons without fully evaluating the transfer pricing consequences. Once the Indian entity contractually assumes or reimburses the ESOP cost, the argument that the cost has not been economically incurred becomes substantially weaker.

  Groups considering formalising reimbursement should model the transfer pricing impact before doing so, as it will increase the Indian entity’s cost base and, depending on the mark-up applied, may increase the profit attributed to India. To illustrate:

Scenario A: ESOP Cost Included in Operating Cost Base

Scenario B: ESOP Cost Excluded from Operating Cost Base

The treatment of ESOP costs in transfer pricing sits at the intersection of accounting standards, tax law, and economic attribution, and none of these frameworks produce the same answer. Ind-AS 102 requires recognition of ESOP costs in the financial statements. Section 37 (and its successor) permits deduction under the tax laws of India. Transfer pricing law asks a third and different question: has the Indian entity actually borne the cost?

The emerging judicial answer is that accounting recognition alone does not constitute economic incurrence. Where the Indian entity has neither reimbursed the parent nor assumed any obligation to do so, ESOP costs recorded due to Ind-AS 102 should not automatically enter the operating cost base for transfer pricing purposes.

That position, while supported by consistent Tribunal jurisprudence, has not been confirmed at the High Court level. Given the Revenue’s continued challenges in assessments and the absence of a binding High Court ruling, the controversy is likely to receive appellate consideration in the near future.

Until the law is settled at the appellate level, the Tribunal position provides qualified but meaningful protection for taxpayers who have maintained contemporaneous documentation of the economic substance of their arrangements. Reliance on the Tribunal trend without supporting documentation leaves the exclusion position exposed. Multinational groups should structure and document their ESOP arrangements to withstand scrutiny from tax authorities and potential judicial challenge.