Opinion

Pradip Kapasi, CA

ABY Limited is a large engineering manufacturing company. The company regularly comes across cases of new employees joining the company and employees leaving the organisation. Different situations arise in connection with joining and leaving of the employees which involve tax considerations. These situations some of which have different combinations, as informed by the company, are as under:

Situation i)

A new employee joins the company by leaving his previous job. The Querist company reimburses the notice pay paid by the new employee to his previous employer. The payment is made by the Querist after his joining the organisation on the production of proof of payment. This is not mentioned in the letter of appointment but it is an understanding between the company and the recruitee.

The Querist desires an opinion on the tax treatment of the amount of notice pay reimbursed by the company in the hands of the employee? How the same will be reflected in the Form No. 16 to be issued to the employee?

Situation ii)

An existing employee leaves the Querist company. When an employee leaves the organisation he gives three months notice to the company. He has to serve the company for the full notice period or in the alternative compensate the company by payment of an amount what is known as the Notice pay. The unutilized Privilege Leave is paid to the employee or is allowed to be adjusted against the Notice pay. The following alternatives are available to the employee.

1. He serves the full notice period. He has not to pay any Notice pay. He is paid for the Privilege Leave due to him. He works for the period of eleven months which includes Notice Period of three months.

2. He does not serve the full notice period but instead works for ten months. He pays one month’s Notice pay to the Querist. He is allowed to adjust the shortfall in the notice period of two months against the Privilege Leave (one month for the year and one month accumulated leave) and the company pays the dues to him net of notice period. He works for ten months including for the notice period (part) of one month out of notice period of 3 months and one month’s notice pay, payable by him, is adjusted against his Privilege Leave.

3. He works for eight months only. Does not serve during the notice period and enjoys one month of Privilege Leave. He receives the payment for nine months including for one month of Privilege Leave. He pays the entire shortfall in notice pay for three months by cheque.

The Querist has sought advise on the tax treatment in the hands of the employee in each of the above (two situations) and also advice on how the same will be reflected in Form No. 16 of the employee and about the liability of the Querist to deduct tax at source. The Querist has also requested for suggestion on any related matter of importance.

I had the benefit of discussing the facts of the case with the Tax Manager of the Querist who supplemented the information and helped in formulating the exact issues for opinion. I place my appreciation on records of his help.

REPLY

In Situation One, the employee has paid an amount to his previous employer for quitting the service during the notice period. It is the damages paid by him for disrespecting the terms of his appointment whereunder he was required to serve during the notice period. His present employer, the company reimburses the notice pay, paid by him to his previous employer, after his joining the organisation on the production of proof of payment. This is as per the understanding between the company and him though not mentioned in the letter of appointment.

The issue from the company’s view point is whether the said payment is includible in the salary of the employee or not. The liability to pay the notice pay admittedly is that of the employee and the company was under no obligation to pay the same. Attention of the querist is drawn to the provisions of s. 15 and s. 17 wherein any payment made by an employer which was otherwise payable by an employee under his obligation is taxable under the head ‘Salary’ and in the circumstances, the reimbursement of such payment will be taxable in the hands of the employee. Secondly, the reimbursement is made to the employee by the company as per the terms of his employment, though not recorded in the letter of appointment, and by this count the same become taxable in the hands of the employee, as a salary u/s. 15 and alternatively as the perquisite or profit in lieu of salary u/s. 17(1)(iv) of the Income-tax Act. A useful reference may be made to the decision in the case of I.E.L.Ltd. vs. CIT, 204 ITR 386 (Cal.). In this view of the matter the querist company is advised to deduct tax at source on such reimbursement by treating the same as taxable under the head Salary, in the hands of the employee. The related issue can be whether the payment by the employee to his previous employer is deductible in computing his income or not. Attention is here is invited to the provisions of s. 16 of the Act which prescribes for the admissible deductions in computing the income under the head Salary. A bare reading of the same will clarify that the payment of the nature under the question is not admissible as the deduction. The employee may, if so advised, resort to the real income theory and establish that the said payment was deductible in computing his income from the previous employer, under the head Salary. This may involve the detailed process of reasoning leaving the outcome uncertain. In the circumstances the company is advised to deduct the tax at source on reimbursement and the employee may claim the refund thereof.

The Situation Two has three different possibilities. Each of these are considered hereafter;

1. In this alternative, the employee is paid for encashment of his Privilege Leave in addition to his regular salary on which tax is deducted at source. This payment of the Privilege Leave, subject to the exemption u/s 10(10AA), is considered as the perquisite or profit in lieu of salary and is made specifically taxable vide s. 17(1)(iv) introduced by the Finance Act, 1984 w.r.e. from 1-4-1978. In this view of the matter the querist company is advised to deduct tax at source on such payment of Privilege Leave by treating the same as taxable under the head Salary, in the hands of the employee. The employee here works for the entire notice period and therefore is not required to make any payment to the company. The period for which he works is included in his regular period of service for which the payment is made by the company by way of salary which is taxable as the regular salary under the head ‘Salary’ and the tax on the same is deducted by the company.
    

2. This alternative is in fact a combination of the two alternatives a) and c) wherein the dues payable by the company to the employee towards Privilege Leave of two months is adjusted against the part of the Notice Pay of two months and the employee serves for the part of the notice period; i.e., one month. In this alternative, no payment is made to the employee towards the Privilege Leave for which he was otherwise entitled to. He in turn does not pay the Notice Pay which he was otherwise liable to pay for not serving two months. He serves for the balance Notice period of one month for which he is paid the regular salary. (i) The period for which he works is included in his regular period of service for which the payment is made by the company by way of salary in addition to the regular salary. Such salary subject to the exemption u/s 10(10AA), is taxable as the regular salary under the head ‘Salary’ and the company is advised to deduct tax thereon.
   
   (ii) As regards, the adjustment of dues, on a careful analysis of the adjustment of dues, it is clear that the employee’s entitlement for the Privilege Leave pay is independent of his liability to pay for not serving the company. These are two different aspects of his terms of employment. The right to receive payment towards Privilege Leave has accrued and arisen and the same is taxable in the hands of the employee in the year of receipt. The point that requires to be further examined is whether the employee, in the circumstances, be said to have received any payment at all. Again, on a careful analysis of the facts it is reasonable to treat the appropriation/cancellation by the parties of their respective obligations as the acts of actual if not constructive payments and in that view of the matter the tax treatment of each event has to be independently considered. So considered the payment or constructive payment of the Privilege Leave represents the perquisite or profit in lieu of salary which is specifically taxable vide s. 17(1)(iv). Attention at the same time is invited to the decision of the House of Lords in the case of Reade vs. Brearely, 17 TC 687 wherein it had been held that when a payment which was never to be made could not be taxed. In that case, the assessee, a priest, headmaster of the school was not to receive any salary due to his membership of a congregation dedicated to the education, entered in to an agreement for receipt of salary to suit the rules of employment and simultaneously donated the said rights to the congregation. It was held that the payment was a fiction which was never to be made and therefore was not taxable. The applicability of this decision to the facts of the Querist is debatable and the Querist company is advised to deduct tax at source on Privilege Leave by treating the same as taxable under the head Salary, in the hands of the employee. The employee may, if so advised, resort to the real income theory and establish that the said payment was deductible in computing his income, under the head Salary and claim refund of the taxes deducted by the company.
    

3. Like in alternative a), the employee is paid for encashment of his Privilege Leave in addition to his regular salary on which tax is deducted at source. This payment of the Privilege Leave is considered as the perquisite or profit in lieu of salary and is subject to the exemption u/s. 10(10AA), made specifically taxable vide s. 17(1)(iv). In this view of the matter the Querist company is advised to deduct tax at source on such payment of Privilege Leave by treating the same as taxable under the head Salary, in the hands of the employee. The second limb of this alternative involves the payment by the employee of the notice pay to the company for the period of notice or any shortfall thereof. The issue that arises is whether the payment by the employee to the company is deductible in computing his income or not. Attention here is again invited to the provisions of s. 16 of the Act which prescribes for the admissible deductions in computing the income under the head Salary. A bare reading of the same will clarify that the payment of the nature under the question is not admissible as the deduction. The employee may, as advised in the first alternative, if so counselled, resort to the real income theory and establish that the said payment was deductible in computing his income, under the head Salary. In the circumstances the company is advised to deduct the tax at source without reducing the income under the head Salary by the amount of notice pay and the employee may claim the refund thereof.