Tax implications of Severance Pay

Many who are being sacked are being provided additional compensation in the form of severance pay, voluntary retirement compensation

The first seven months of 2022 have witnessed another round of mass layoffs. An employee is a key component of any given company, be it well-established firms or months-old startups. There are many reasons for the layoffs: cost-cutting, non-performance and pandemic hit global disruptions.

Well-known corporations are not left behind in laying off their staff and workers. For instance, Microsoft Corporation, a global software giant has become the first major tech company to lay off its staff of about 1,800 or 1% of its 1,80,000 total headcount in all of its offices and product lines. Lido learning, an ed-tech startup has laid off 200 employees. Few more to add to the list, homegrown Vedantu - 624, Unacademy - 600, Cars24 - 600 and in its entirety, the Indian Startup ecosystem has laid off more than 11,000 and staring at another 50,000 job losses in near future.

On July 20, Ford, one of the major global automobile giants, ceased operations in its Chennai plant and directed ‘Chennai Ford Employees Union’ to conclude the ‘Severance Negotiations’ before August 10, failing which it will be forced to launch its own ‘last offer’ termed Voluntary Separation Scheme.

Severance Pay and taxability

Many such sacked are being provided additional compensation in the form of severance pay, voluntary retirement compensation, retrenchment compensation, and gratuity or bearing one or the other names. Those sacked are not aware whether such receipts are subject to income tax. And, what is their current legal position among others? Can they avail tax exemptions for the same or not? Since they are ‘one-time-transactions’ non-recurring in nature, they were held as ‘Capital Receipts’ and excluded from the tax bracket till March 2019 or disputed by both the Tax Department as well as aggrieved employees.

Severance pay received by an employee from an employer is taxed in the hands of the employee as Profits-In-Lieu under the head Salaries under Section 17 (3) (i) of the Income Tax Act, 1961. In certain cases, appellate authorities held that these receipts were of a ‘capital nature’ and could not be taxed. In certain cases, due to the absence of the employer & employee relationship, held them as not taxable under the head Salaries. The legal position has changed with effect from April 1, 2019, induced by the Union Budget 2018 which specifically provides that any compensation received or receivable, whether revenue or capital, in connection with the termination or the modification of the terms and conditions of any contract relating to its business, shall be taxable as business income under Section 28(ii).

Similarly, to tackle tax evasion under the guise of severance pay, the same given by any person other than the employer, say, the third party, shall also be taxed under the head ‘Other Sources’ under Section 56(2) of the 1961 Act.

Still one can avail of tax exemption

If the compensation or severance pay is in accordance with the provisions of the Industrial Disputes Act, 1947, and if the concerned employee was not working in a managerial or administrative or supervisory capacity with wages exceeding Rs 10,000, then they can avail an exemption up to Rs 5 lakhs as provided under Section 10(10B) of the 1961 Act.

If it is received under Voluntary Retirement Scheme, then it is exempt from tax subject to certain conditions stipulated under Section 10 (10C): maximum compensation should be within Rs 5 lakhs, he or she should be an employee of an authority established under the Central or State laws, Public Sector Undertakings, University, etc. and, finally, the receipts should comply Rule 2BA of the Income Tax Rules, 1962. This exemption shall be allowed to claim only in the assessment year in which the compensation is received.

Currently, there is no specific relief available for those employees who were sacked with compensation due to pandemic hit businesses, however, an individual is eligible to claim relief under Section 89 of the 1961 Act in respect of compensation received by him or her in connection with the termination of his employment as salary paid in arrears or in advance provided a continuous rendering of service for three years or more and the unexpired portion of his term of employment is three years or more.

Before what about the question of ‘capital receipt’? In November 2021, the Income Tax Appellate Tribunal’s Bombay Bench in Ajay B Ghose v. DCIT-CPC IT No. 1720 /Mum/2021 relying on certain merits of the case held that severance pay is to be regarded as ‘capital receipt’ and not taxable in the hands of the taxpayer.

Further, it is very much opted to state here that since the outbreak of the pandemic approximately 23,500 employees have lost their jobs. In light of this, I would like to suggest to the Ministry of Finance to bring a unique ‘Tax-Holidays Scheme’ of three to five financial years, exclusively for those who are in receipt of ‘Severance Pay’ to provide a much-needed breathing space.

One ought to not forget that the same salaried employees contributed significantly to the exchequer compared to any other type of taxpayer when their time was good.

(The writer is the founder and chief executive officer of Shree Tax Chambers)