Laid off? Seek advice before claiming tax exemption on severance pay

You can claim only if the payout is voluntary and you have documentary proof to this effect

A large number of employees have received the pink slip in recent days from big tech companies, start-ups, and so on. Usually, ex-employees receive a severance pay at the time of such layoffs in addition to gratuity, leave encashment, and provident fund. Currently, there is no unanimity among tax experts on whether severance pay is taxable.  

Ankit Jain, partner, Ved Jain & Associates, says, “The taxation of severance pay is still under dispute. Tax authorities and courts have divergent views on the matter.”

View 1: It’s taxable

One set of experts believes severance pay is taxable. Maneet Pal Singh, partner, IP Pasricha & Co says, “Severance pay received by an employee from an employer is taxable in the hands of the former under the head ‘Salaries’ under Section 17(3)(i) of the Income-Tax (I-T) Act.”

This set believes the employer must deduct tax at source. Sumit Mangal, partner, Luthra & Luthra Law Offices India, says, “Since severance pay is taxable as salary, the employer is required to withhold appropriate tax while making such a payment to the employee.”

View 2: It isn’t taxable

Another set believes severance pay isn't taxable for two reasons. Jayashree Parihar, counsel, PSL Advocates & Solicitors says, “Severance pay is not taxable since it is considered a voluntary payment and is a capital receipt.”

According to these experts, due to the absence of any implied obligation to pay, severance pay can’t be considered compensation under Section 17(3)(i) of the I-T Act.  Further, they believe, this payment is a capital receipt and not a revenue receipt, and hence not subject to tax. 

In past disputes, the tax authorities have argued that severance pay is taxable as ‘profits in lieu of salary’. Jain says, “However, the Gujarat High Court and the Mumbai Tax Tribunal have held that since the payment of severance pay is a voluntary exercise and not part of the terms of employment, it is a capital receipt which can’t be taxed.”

What is undisputed

There is no dispute regarding severance pay (or any other compensation on termination) given by any person other than the employer. That amount is taxable under the head ‘Other Sources’ under Section 56(2) of the I-T Act. Payments under sections 10(10B) and 10(10C) of the I-T Act are exempt.

Remedial measure in 2018 budget

The government, through the 2018 Union Budget and other consequent notifications, tried to rectify the above dilemma. Pallav Pradyumn Narang, Partner, CNK says, “The law has been suitably modified by the addition of Clause (xi) of Section 56 to subject such incomes to tax with effect from April 1, 2019.”

Abhinay Sharma, managing partner, ASL Partners, explains how such payments were to be taxed after this modification. “Any compensation, whether revenue or capital, in connection with the termination or modification of the terms and conditions of any contract relating to its business, is taxable as business income under Section 28(ii),” he says 

Dispute continues

The dispute, however, has not been resolved yet. Parihar informs that in a recent decision by Income Tax Appellate (ITAT) Tribunal Mumbai in the case of Ajay B Ghose v. DCIT-CPC, Bengaluru, in 2021, noted that severance payment is completely voluntary. For it to be considered compensation, there would need to be an implied obligation to make payment. Since there was no obligation on the employer’s part, either express or implied, the ITAT ruled it to be exempt from taxation. 

What should you do?

If you have received severance pay, don’t decide on your own whether to pay tax on it or not. Instead, seek professional advice.

If you claim exemption, ensure there is no express or implied obligation on the employer’s part to make such a payment. And make sure the documents clearly specify the payment is being made voluntarily.

Jain says, “Since the exemption hasn’t been confirmed by the Supreme Court yet, the employee may not be able to get any relief before two levels of appeal.” Hence, he suggests weighing the pros and cons carefully before deciding to claim exemption.

How VRS amount is taxed

• If compensation is received under a voluntary retirement scheme (VRS), then it is exempt from taxation under Section 10(10C) of the Income-Tax Act
• Lower of the actual compensation amount received or Rs 5 lakh is exempted under this section
• The scheme must satisfy the conditions prescribed in Rule 2BA: Completion of 10 years of service or 40 years of age; amount received should not exceed three months’ salary for each completed years of service, or salary at retirement multiplied by remaining months of service left; and vacancy caused by VRS must not be filled up
• Tax exemption for amount received under VRS can be claimed by an employee only once in his lifetime