Recovery of notice pay has become a bone of contention between the GST authorities and the industry and the litigation has its origins in the negative list regime of Service tax and has now crept into the GST. Let us examine the various enactments, which may enable us to take an informed decision on the GST levy.
Indian Contract Act, 1872
Employment contracts are made under the Indian Contract Act, 1872. A contract of employment is a bilateral agreement for the exchange of service and remuneration over a period of time. Like any other valid contract, it must satisfy all the essential ingredients viz. offer, acceptance, consideration, competent parties, legal object and free consent etc. Such employment contract in the form of an appointment letter or agreement usually provides for the notice pay recovery.
Section 2(d) of the Indian Contract Act, 1872 defines the consideration as under: “When, at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration for the promise”.
Section 74 of the Indian Contract Act, 1872 Compensation for breach of contract where penalty stipulated for— When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.
Notice pay is nothing but the amount stipulated in the employment contract for breach in serving the stipulated notice period. Since notice pay is a sum mutually agreed by the parties for breach of contract, it can be regarded as a consideration flowing from the employment contract itself read with Sec. 74 of the Indian Contract Act, 1872 and not under any other separate contract wherein employer has agreed to refrain from doing any act against the concerned employee. Once notice pay recovery is stipulated in the contract, an employer can only sue for recovery of such amount but cannot enforce mandatory serving of the notice period. Once it is concluded that an employer cannot enforce mandatory serving of the notice period such employer cannot be said to have refrain from an act of suing the employee for mandatory serving against the notice pay recovery. In such scenario notice pay recovered cannot be said to be a consideration against agreeing to the obligation or to refrain from an act, or to tolerate an act.
From Section 74 ibid, it is explicitly clear that, the amount a party (‘receiver’) is eligible to receive upon the breaking of a contract is in the nature of compensation for breach. The term breach implies an act on part of the one breaching the contract (‘the defaulter’), the breach doesn’t therefore implies that the receiver is doing an act or tolerating an act. There is no supply element when the receiver is getting compensated owing to an act of the defaulter.
It is pertinent to note that the term consideration as discussed in section 2(d) of the said act does not cover liquidated damages within its ambit. This further strengthens the fact that as per Indian contract act which is the parent act for law relating contracts also does not treat liquidated damages as a consideration and therefore liquidated damages are neither paid for any promise to do an act nor for abstaining from a promise.
It must be noted, the damages or liquidated damages means a compensation payable by the seller/supplier for the loss or injury suffered by the recipient on account of non-performance or delay in performance or deficiency. The payment of damages is a condition of contract. In case of notice pay recoveries, there is no agreement by the employer to causing loss or damage by leaving early for a consideration. The expression ‘to tolerate an act’ relates to situations where a person commissions another person to do or commit a particular act for a consideration. There is a clear distinction between the damages or compensation payable for breach of contract or delay in performance as compared to payment of a consideration for forbearance or tolerating an act or not performing an act. The payment of damages is a condition of contract and not a consideration for any service in the nature of forbearance or tolerating an act. Here, it is important to appreciate that there is a difference between a transaction which is a “condition to a supply” and a transaction which is a “consideration for a supply”.
Income Tax Act, 1961
Section 15 of the Income Tax Act, 1961 specifies the following kinds of income on which income tax is to be charged:
a. any salary due from an employer or a former employer to an assessee in the previous year, whether paid or not
b. any salary paid or allowed to him in the previous year by or on behalf of an employer or a former employer though not due or before it became due to him
c. any arrears of salary paid or allowed to him in the previous year by or on behalf of an employer or a former employer, if not charged to income-tax for any earlier previous year Such income is chargeable to income tax under the head ‘Salaries’.
As per Section 16 of the Act, the income chargeable under the head “Salaries” shall be computed after making the following deductions:
a. a deduction in respect of any allowance in the nature of an entertainment allowance specifically granted by an employer to the assessee who is in receipt of a salary from the Government, a sum equal to one fifth of his salary (exclusive of any allowance, benefit or other perquisite) or five thousand rupees, whichever is less
b. a deduction of any sum paid by the assessee on account of a tax on employment within the meaning of Article 276(2) of the Constitution, leviable by or under any law.
Hence, salary received by an employee from his employer is subject to income tax as per the provisions of the Act. However when an employer deducts certain amount from his employee’s salary if the employee leaves his employment without serving the notice period mentioned in the employment agreement / appointment letter, the issue is whether deductions made from the salary of employee who has not served notice period can be treated as income and subjected to tax. In all such cases, the income under the head of salaries is reduced to the extent of recoveries made by the employer and the Form 16 is issued accordingly. In such a case, the TDS deductions are also done under the salary income head only. All these facts lead to the conclusion that the notice pay consideration is nothing but salary income and not service income.
Finance Act, 1994
Major amendment were made in Service Tax laws by way of introduction of negative list based taxation with effect from 1st July 2012. All the services were covered under the definition of service and were taxable, except the services listed in Negative list or services exempted vide mega exemption notification. As per Section 65B (44) of Finance Act, 1994, “Service” means any activity carried out by a person for another for consideration, and includes a declared service, but shall not include the provision of service by an employee to the employer in the course of or in relation to his employment. In other words, the service provided by employee to employer in course of employment is excluded from service tax levy. However there is no such exclusion or exemption to the services provided by employer to employee. The same is also not covered in the exclusion limb of the service definition either and covers declared services in the definition of service.
Section 66E (e) of Finance Act 1994 provides that: ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’ is a declared service. When an employee resigns from service, either adequate notice for such resignation is to be served or he needs to pay equivalent salary for the notice period to the company or employer recovers the same from his dues. Service tax is leviable on service being ‘any activity’ for a consideration. Though the employer is receiving / recovering a consideration, there is no activity done by such employer to the employee in exchange for consideration of notice period recovery. So one can argue that the fundamental premise of ‘activity for a consideration’ itself is not satisfied, in which case the Service tax levy may not be applicable.
The Honorable Madras High Court, in the case of GE &TD India Ltd Vs DCCE, Chennai 2020(1) TMI 1096, held that the employer cannot be said to have rendered any service per se much less a taxable service. The Court also said that the employer merely facilitated the exit of the employee by imposing a cost on him for the sudden exit. The definition in Section 66E of the Finance Act does not apply in this scenario as the employer has not tolerated any act of the employee but has permitted the sudden exit while being compensated by the employee.
Similarly CESTAT, Ahmedabad in the matter of HCL Learning Systems Vs CCE, Noida 2019(12) TMI 558 held that notice pay recovery is out of the salary already paid and is not covered under the provisions of service tax. Hence the notice pay recovery is out of service tax ambit.
With the advent of GST law, the position has been altered again and controversy started brewing under the same clause wherein tolerating an act has been thrust on notice pay. Notice pay recovery is a consideration paid by employee to employer for non-performance of terms of contract of employment. Therefore this becomes a taxable service falling under the head “Agreeing to tolerate an act” under SAC Code 999794 with applicable GST rate of 18%. If in appointment letter, it is stated that Notice pay will be recovered with GST, then it will be recovered from employee, otherwise it will be deemed that, GST is inclusive as per Rule 35 of CGST Rules, 2017 and the GST component will be borne by company itself.
As per Section 7 of CGST Act, 2017, the expression “supply” includes among other things all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business and also services by an employee to the employer in the course of or in relation to his employment. Clause 5(e) of schedule (II) to Section 7 of CGST Act, 2017 states that “The following shall be treated as supply of services, namely: – (e) Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act;”. Whether any activity or transaction in question can be said to be covered under clause 5(e) of Schedule II to section 7 then it seeks to declare agreeing to the obligation to refrain from an act or tolerate an act or a situation or to do an act, as declared supply of services.
The said clause 5(e) has the following ingredients: –
· one party is under obligation, as agreed, to refrain from an act;
· one party is under obligation, as agreed, to tolerate an act or situation;
· one party is under obligation, as agreed, to do an act; all against consideration.
Section 2(31)(b) of CGST Act 2017 defines consideration in relation to supply of goods and services or both and includes the monetary value of any act or forbearance. The word “Service” defined under Section 2(104) of the CGST Act, 2017 means anything other than goods, money and securities. It is pertinent to understand before levy, whether the receipt or deduction of salary in lieu of notice period by an employee can be said to be consideration for an act of forbearance and whether the act of accepting the resignation without contractual period of notice from an employee can be said to be an act of toleration. The employee opting to resign by paying amount equivalent to month of salary in lieu of notice, has acted in accordance with the contract and that being the case no question of any forbearance or tolerance does arise. Further, as per the agreement, the resignation by the employee is not subject to any acceptance or approval and employee is free to tender his resignation, make payment of notice period salary to leave. Hence, there is neither any activity nor any passive role played by the employer. It must be noted here, that there is no consideration within the meaning of Sec.2(31)(b) of the CGST Act, 2017 flowing from an act of forbearance in as much as there is no breach of contract, as a question of any consideration for forbearance would arise in case of breach of contract.
More over, there is no service provider and service recipient in case of notice pay recovery as the employment contract is for rendering of services by the employee to the employer as per the conditions of the contract in line with the objectives of the company. But no where in the agreement, there are express terms to state that on the resignation of the employee there is a service being provided by one to the other in terms of tolerating an act, as no employer takes an employee just to collect the notice pay recoveries but to serve the organization. In the unfortunate event of resignation by an employee, the employer is recovering the liquidated damages for breach of employment contract in order to compensate for the loss suffered at his end or in the other scenario, the employer pays to the employee for the notice period so that he can leave the organisation early and thereby he can avoid further damage to the organization. In either of these events, there is no service provider and service recipient to define so that a taxable supply can be imagined and the same can be subjected to tax under GST laws.
From the above, it can be concluded that the notice pay recovery cannot be a taxable supply even under GST as there is no service provider and service recipient and there is no rendition of taxable supply in the whole, much less the declared service of tolerating an act. The Income tax law, which governs the income is treating such considerations under the head of Salaries and not under the head of service income, then the same cannot be subjected to GST treating it as consideration for taxable supplies. Similarly the Contract act is considering the recovery as liquidated damages for breach of contract, which at the most can be a transaction in money much less a service income. Hence notice pay recovery cannot be subject to GST and the decisions under service tax laws should help in litigation.