Notice pay recoveries! The most common phenomenon in any Organisation. Certainly, one of the debatable topics when it comes to taxability under the GST Law. While the arguments are either way, here are 3 reasons why notice pay recovery should not be taxable under GST.
According to Section 7 of the CGST Act, 2017, any transaction should pass through the following tests to be regarded as a supply:
- Should qualify as goods / services
- The transaction should be made or agreed to be made
- There should be an element of consideration for the supply
- It should be carried out in the course and furtherance of business
For a transaction to qualify as supply, it is pertinent that all of the above conditions are satisfied. Each of the character when carefully analysed in the backdrop of notice pay recovery suggests that the same does not qualify as a “Supply” and hence is not covered in the ambit of GST. The detailed reasons for the same are listed below:
Reason 1: Not a voluntary act:
- A contract of employment is a contract between the employer and an employee where the employee promises to provide employment services to an employer in return for a consideration i.e. “salary”. Further, in most cases, the contract of employment also provides for recoveries on account of breach of such contract.
- It is important to understand that the essential purpose of the contract is for employment service and not to recover notice pay which arises only as a condition of breach of contract or when the contract comes to an end. Needless to say, the clause containing the notice pay recovery in the contract of employment does not extend an option to the employee whether or not to perform. It sure does protect the employer in case of early cessation of service by the employee.
- The term “made or agreed to be made” used in the definition of “supply” suggests a certain degree of voluntary act of the service provider. At this juncture it is worth noting a ruling under the Australian GST Law, in the case of “Shaw vs. Director of Housing and State of Tasmania (Nos. 2), 2001 TASSC 2”, where in it was held that the obligation of a judgment debtor(employee) to pay a judgment sum(notice pay recovery), extinguished by the act of payment, did not constitute a supply because it did not depend upon any voluntary action on the part of the judgment creditor(employer). Thus, there cannot be a supply constituted by a release of an obligation that occurs independently of the act of the releaser.
- Borrowing the analogy of the said judgement, it can be inferred that, the act of notice pay recovery is only an extinguishment of the obligation of the employee which does not constitute an independent/voluntary act by the employer.
- Therefore, the act of notice pay recovery arises as a condition of breach and is not a contract in itself to qualify as a supply.
Reason 2: Does not constitute toleration of an act by the employer – Employer is not the supplier:
- A supplier may be said to be making a supply by “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”, only when there is a specific performance obligation to do so, to honour the contract.
- Given that the ‘act of toleration of breach’ by the employer is not at a voluntary act, the condition of breach indicated in the contract, in no stretch of imagination can be inferred to mean toleration of an act. Notice pay recovery is a compensation for injury and not a benefit arising to the employer.
- Contracts containing non-compete clauses, contracts imposing trade restraint, contracts imposing restraint on the geographical operations are certain examples which are executed with an intention of creating performance obligation between the parties to the contract qualify as services under the category “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”.
- The employee at his own choice seeks to not serve the period of notice pay. The promise made by the employee in the contract of employment to serve the notice period is repudiated which subsequently leads to a breach of contract requiring a remedy.
- The remedy in the form of liquidated damages already envisaged in the contract becomes enforceable and thereby the recovery of notice pay serves as a cure for such damage. Accordingly, it can be said that there is no supply as such effected by the employer on recovering a pre-agreed sum for breaching the contract of employment. Where there is no supply extended, the question of employer qualifying as a supplier does not arise.
Reason 3: Damage vs consideration:
- Damage in its general connotation means money compensation for loss or injury caused by the wrongful act of the other. Notice pay recovery is a damage arising out of breach of the contract of employment which curtails the time period of the employer to find a competent and suitable replacement. It also hampers the smooth administration of the work which was hitherto carried out by the employee.
- Damages are never an alternative mode of performance. It is not the voluntary act of the employer to recover the notice pay damages for injury caused by the employee.
- The definition of the word “Consideration” used in Section 2(31) of the CGST Act, 2017 is defined as under:
“Consideration in relation to supply of goods or services or both includes ——-”
It becomes necessary to evaluate the meaning of the word “in relation to” used in the aforesaid definition. In the case of ‘Doypack Systems Pvt. Ltd. v. Union India & Ors.,  2 S.C.C. 299’ the Supreme Court has categorically held that the phrase “in relation to” is equivalent to the phrases “concerning with” and “pertaining to”. Therefore, the phrase “In relation to” used in the definition of the term “consideration” suggests a connection with the act of supply.
Therefore, it can be deduced that any consideration should have a direct nexus to the voluntary act of supply.
- The notice pay recovery always emanates when a contract of employment has ended. The purpose of the contract was only to sign up an employee on roles of the Organisation in return for the employment service offered by the employee and not to recover notice pay. Therefore, in the context of the contract of employment notice pay recoveries does not attain the character of a consideration for the very reason that they are not linked to any voluntary act of the supplier.
- At this juncture is it pertinent to note the ruling in the case of “M/s Bhayana Builders (P) Ltd & Others vs. CST Delhi, & Others”, where in it was emphatically held that the architecture of the Law is such that the consideration should always flow from the service recipient to the service provider and should accrue to the benefit of the latter. Applying the analogy of the ruling and the explanations above, it can be inferred that notice pay recovery neither is a consideration, nor does it is flow at the discretion of the service provider (employee in the contract of employment) Further that, there is no benefit accruing to the employer, moreover he has suffered from the sudden exit of the employee.
- It is also relevant to note that the Honourable CESTAT Chennai in the case of Commissioner of Service Tax vs. Repco Home Finance Limited STA No.511 of 2011 LB-2018 dated 08.07.2020 has distinguished “damages as a condition of contract and consideration”. In the said ruling the CESTAT held that the foreclosure charges are imposed by the banks in order to protect the loss of interest on account of foreclosure of the loan by the customers. Mere mentioning of foreclosure charges does not give the customers any option to perform or not perform. The Honourable CESTAT on analysis of various concepts under The Indian Contract Act, 1872 and the distinction drawn between damage and consideration under the Australian GST Law, has ruled that the foreclosure charges are in the nature of damages and not consideration.
Rulings under the erstwhile Service Tax regime:
Even under the Service Tax regime, in the following cases it was ruled that notice pay recoveries are in the course of employment and therefore, not covered under the provisions of Service Tax:
Conclusion: Notice pay recoveries are nothing but liquidated damages arising out of breach of the employment contract. It becomes absolutely necessary to understand the concept of supply and discern the difference between consideration and damages to analyse any tax liability under GST. Although the said transaction is not liable to GST in the backdrop of the reasons explained above, the Revenue may not appreciate the same. The revenue authorities have started including every other transaction undertaken by the business under the purview of GST without appreciating of the test of supply. Being mindful of the reasons explained supra and the adopting the direction of thoughts on the same transaction under the erstwhile Service Tax regime the taxability of this matter can certainly be contested before the higher judicial forums.
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