Severance Pay And Taxes: Is It Taxable And Do You Need To Pay Advance Tax?

When an employee’s services are terminated for reasons beyond their control, such as restructuring or layoffs, they may sometimes be paid compensation. This is commonly referred to as ‘severance pay’.

According to tax experts, ‘severance pay’ is not a formal legal term under Indian tax law. This expression is commonly used to describe payments made by an employer to an employee when the latter is allowed to leave the organisation or the terms of employment are significantly changed.

“In practice, it can include retrenchment compensation, voluntary retirement payments, salary in lieu of notice, or ex gratia amounts paid at the time of separation. For tax purposes, most such payments are generally treated as part of employment-related income,” says Shubham Jain, Director, SVAS Business Advisors.

Is Severance Pay Taxable?

Severance payments are treated as taxable in most cases because they are linked to the employer-employee relationship. However, the type of payment and availability of exemptions – if any – determine the actual tax treatment.

“Some components - such as retrenchment compensation, voluntary retirement compensation, gratuity, or leave encashment - may qualify for partial tax relief, provided the relevant conditions under the tax rules are satisfied,” says Jain, adding, “A large severance payout in a single year can increase a person’s overall income for that year and may push them into a higher tax bracket. In some cases, relief mechanisms are available to reduce the tax impact of receiving a lump-sum amount in one year. From an advance tax perspective, the position usually depends on whether the employer has already deducted the appropriate tax at source.”

Advance Tax On Severance Pay

Typically, salaried individuals receiving severance pay do not need to pay advance tax separately if the employer has already deducted the appropriate tax at source while making the payment. “Employers are required to estimate the employee’s total salary income for the year and deduct tax accordingly. However, advance tax may become relevant if the tax deducted by the employer is insufficient or if the individual has other significant sources of income during the year,” says Jain.

How To Report Severance Pay On A Tax Return

Severance pay should be reported as part of salary income in the income tax return (ITR). The details are typically reflected in the salary schedule of the return, often under the category of payments received in connection with termination of employment.

“Taxpayers should rely on Form 16 issued by the employer while preparing the return. If any part of the payment qualifies for exemption, only the remaining taxable portion should be included in salary income,” says Jain.

Advance Tax Rules For Salaried Individuals Receiving Severance Or Ex-Gratia Payments

For employees, the primary responsibility for tax deduction rests with the employer, who is expected to deduct tax on the employee’s estimated total salary income for the year, including any severance or ex gratia payments.

“If the tax deduction has been done correctly, the employee generally does not have to pay advance tax on that income. However, if the deduction is inadequate or the individual has other taxable income that is not subject to tax deduction, advance tax may need to be paid during the year in the usual instalments,” informs Jain.

What Happens If The Employer Does Not Deduct TDS On Severance Pay?

The employer may face consequences under the income tax law, including interest and penalties, if it fails to deduct the required tax on a taxable severance payment.

The employee, however, remains responsible for reporting the income and paying the applicable tax while filing his income tax return. “If the tax has not been deducted at source, the individual may have to pay the tax directly before filing the return. In some situations, the employer may avoid further consequences if the employee has already declared the income and paid the due tax,” says Jain.