Laid off? You have to pay tax on severance pay

Published: June 1, 2020 12:30 AM

Additional compensation/ severance pay given by employer is taxed as ‘profits in lieu of salary’. But gratuity, retrenchment compensation or VRS is tax exempt in certain cases

With reduction in revenues due to Covid-19, many businesses are offering pink slips to employees.

By Shailesh Kumar

With reduction in revenues due to Covid-19, many businesses are offering pink slips to employees. Employers often seek to compensate such employees with some additional compensation in the form of severance pay, voluntary retirement compensation, retrenchment compensation, gratuity for past services, etc. These receipts/ compensation have tax consequences for the employees.

Tax on additional compensation
Any additional compensation/ severance pay received by an employee from employer is taxed as ‘Profits in lieu of salary’ under Section 17(3) of Income Tax Act. Therefore, any compensation due to or received by a person from his employer in connection with termination of his employment is taxable as salary in the hands of the employee at the applicable slab rates. The tax treatment is the same if you receive ex gratia payment on account of shutting down of company or lay-offs.

When compensation is given by any person other than employer (i.e. employer-employee relation does not exist between payer & payee) in connection with the termination of employment, as per Section 56 such compensation, due or received, is taxable under head ‘other sources’.

Tax exemption for VRS
Section 10(10C) grants exemption from taxation, if compensation is received under Voluntary Retirement Scheme (VRS) framed in accordance with prescribed guidelines. The exemption is capped at Rs 5 lakh and is available to employees of an authority established under the Central or State Act, local authority, university, IITs, Central or state government, notified institute of management, or notified institute of importance throughout India or any state, Public Sector Undertaking, a co-operative society or even any other private company.

However, this exemption is for employees who have completed 10 years of service or completed 40 years of age; (b) vacancy caused by voluntary retirement must not be filled up (c) retiring employee is not employed in a concern belonging to the same management (d) amount receivable under VRS does not exceed three months’ salary for each completed year of service, or salary at retirement multiplied by remaining months of service left. This exemption can be taken only once.

Exemption for retrenchment compensation
If retrenchment compensation is received by a ‘workman’ defined under Industrial Disputes Act, then it is exempt up to Rs 5 lakh as per Section 10(10B). However, employees working in a managerial or administrative capacity or employed in supervisory capacity, drawing monthly wages exceeding Rs 10,000 do not get this tax exemption benefit.

Tax exemption on gratuity
Gratuity for employees of State/ Central government or local authority, is fully tax exempt. For non-government employees, the maximum tax-exempt gratuity amount is lower of amount received, Rs 20 lakh or 15 days salary based on last drawn salary for each completed year of service, or part thereof in excess of six months.

The writer is director, Nangia Andersen Consulting. Inputs from Vasudha Arora

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