Thousands of employees have been laid off by their respective employers this year. Recently, Twitter sacked the majority of its over 200 employees in India as part of mass layoffs across the globe. FE reported earlier that more than 12,000 employees were laid off by startups in India this year. Top companies like Meta, Google and Amazon have also been in the news for layoffs.
While laying off an employee before the end of the contracted period, companies generally provide compensation in the form of severance pay. This payment helps the employee to live through the time before which he gains another employment. However, it is important to understand that severance pay is not tax-free. There are certain Income Tax rules that provide for the taxation of severance pay received by a laid-off employee.
“Severance pay is in the nature of compensation provided by the employer to the employees in the event of termination of the employment contract of such employees. It would be taxable as ‘Profits in lieu of salary’ u/s 17(3) of the Income Tax Act, 1961 as severance pay usually would be in the nature of ex-gratia payment within the ambit of Section 17(3)(i) of the IT Act which provides for taxation of any amount of any compensation due to or received by an employee from his employer or former employer at or in connection with the termination of his employment or the modification of the terms and conditions relating thereto,” says Dr. Suresh Surana, Founder, RSM India.
“Accordingly, such severance pay would be taxable under the head ‘Salary’ as per the marginal rates applicable to the employee,” he adds.
Laid off under Voluntary Retirement Scheme
According to Gopal Bohra, Partner, N.A. Shah Associates, severance pay would not attract taxes if s/he has been laid off under any voluntary retirement scheme.
“Severance payment received by an employee from the employer is taxable as salary under the provision of Section 17(3) of the Act. However, if the employer under the scheme of voluntary retirement pays the severance payment it will be exempt subject to maximum of Rs. 5,00,000 under section 10(10C) of the Income Tax Act,” says Bohra.
“An employee who rendered continuous service for three years or more before termination of his employment and unexpired portion of his term of employment is three years or more is eligible to claim relief under section 89 of the I T Act read with Rule 21A of the I T Rules. The employer while making payment of severance payment will deduct TDS in accordance with the provision of section 192 of the Act,” he adds.
Severance pay from Third party
According to Dr Surana, in case the severance pay is received from any third party, who is not the employer, such amount received would be subjected to tax as ‘Income from other sources’ as there is no employer-employee relationship.
How tax on severance pay is calculated
Tax experts say that severance pay is included under the head salary and is taxable as per marginal slab rates applicable to the employee. Such tax rates would be further enhanced by Health and education cess @ 4% and surcharge, if any.
Some tax experts say that severance pay is one of the most disputed part of individual taxation, which is yet to be fully settled by judicial interpretation.
“Severance pays received by an employee from an employer is taxed in the hands of the employee. It is one of the most disputed parts of individual taxation. Severance pay is often given voluntarily by the companies during the layoff. Sometimes it’s considered as exempt income but this issue is still not settled by judicial interpretation. Ideally, severance pay should be considered as profit in lieu of salary and it should be taxed under the head salary,” says Sujit Bangar, Founder, Taxbuddy.com.