Summary of this article
Severance pay taxed as salary under “profits in lieu of salary” rules
No special tax rate; normal slab rates apply to severance income
Section 89(1) relief can reduce tax on lump sum payouts
Exemptions apply only if structured components like gratuity, VRS included
Layoffs have been in the news since Oracle, an American multinational technology company, laid off thousands of employees by mailing them at six am. Though it is not verified, some reports suggest that employees will get six months' salary as severance pay. In this story, we look at how severance pay is taxed.
Severance Pay Taxed As Salary
Severance pay for any company during a layoff, just like Oracle, is taxed as “profits in lieu of salary” and taxed under income under the head salary and taxed at the normal slab rate applicable to the taxpayer. “However, if the package includes components such as gratuity or leave encashment, that part of income shall be adjusted for the amount till which it is exempt from taxation under the respective laws, but they should be separately mentioned in the package,” says Ritika Nayyar, partner, Singhania & Co.
There is no special lower tax rate merely because the payment arises from a layoff. It is taxed like a regular salary.
An exemption up to Rs 5 lakh is available under Section 10(10C), but only where the payment is made under a valid voluntary retirement scheme that satisfies prescribed conditions. “In most layoff situations, this benefit is not available unless the scheme is properly structured to meet those conditions. One should not go merely by the label. Actually, the structure of the scheme is what matters,” says Vishal Gehrana, advocate on record associated with Karanjawala & Co.
Relief under Section 89 (1) can be claimed where severance compensation leads to a higher tax incidence due to bunching of income in a single year. “The relief mechanism spreads the income notionally over preceding years to mitigate rate escalation. Filing of Form 10E is mandatory before claiming such relief. Courts have generally upheld its applicability to compensation falling within “profits in lieu of salary,” subject to factual satisfaction,” says B. Shravanth Shanker, managing partner, B. Shanker Advocates.
Spread Payments To Ease Tax Burden
“There is no special exemption available just because the income is severance. It is taxed like a salary, so only general tax-saving options can be used. Deductions under Sections 80C, 80D, and 80CCD may be claimed within their limits. These include investments such as provident funds, insurance, pension contributions, and health insurance,” says Gehrana. These will, of course, apply only under the old tax regime.
“However, in situations like these, the Act provides various reliefs, such as a retrenchment exemption up to Rs 5 lakh, a voluntary retirement scheme exemption up to Rs 5 lakh, a gratuity exemption up to Rs 10/20 lakh (depending on your organisation coverage), a leave encashment exemption up to Rs 25 lakh, etc.,” says Nayyar. Additionally, one also has the option of taking relief under section 89(1) as well. One can calculate various scenarios and opt for the one that gives maximum relief, provided no double benefit is claimed on the same income.
If the employer agrees, spreading the payment over more than one financial year may reduce the tax burden. However, this depends on mutual agreement and is not a legal entitlement.
“A practical caution must be kept in mind. Employers usually deduct tax at source on such payments, but that is only a provisional deduction. The final tax liability is determined when the return is filed, where relief under Section 89(1) or eligible deductions can still be claimed,” says Gehrana.
As the old saying goes, one should not judge a book by its cover. In taxation of severance, what the payment is called matters far less than how it is structured and what it represents in substance.
“Proper tax planning must align with the substance of the employment termination terms,” says Shanker.
