1. Appointment letter usually provides that an employee must serve a notice period upon giving a notice to resign from the employment. This is to provide adequate time to the employer to ensure proper handover of the tasks of the resigning employee. However such appointment letter also provides that resigning employee can pay a certain amount (“notice pay”) in lieu of his obligation to serve the notice period. Department is of the view that service tax and now GST is applicable on such recovery of notice pay and hence the employer must pay GST on such recovered amount. Judicial precedents are not yet available which can put an end to the controversy. Hence it is apt to understand the nuances of the given transaction before taking a final position. Present article desires to do that.
2. Is notice pay recovery a consideration against agreeing to the obligation to refrain from an act, or to tolerate an act or a situation and hence a supply of service under Entry 5(e) of Schedule II to the CGST Act, 2017 ?
Is notice pay recovery a compensation stipulated in the employment contract payable by employee for not serving the notice period and hence an adjustment against the salary payable not taxable under GST ?
3. Let us explore in greater detail.
4. To appreciate the issue one has to consider the employment contract as well as various labour laws as applicable to the employee in question.
5. 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. Such employment contract in the form of an appointment letter usually provides for the notice pay recovery.
6. Another important aspect to be considered is the applicable labour law. As an illustration an employee engaged in a corporate office located in Gujarat is governed by the Bombay Shops and Establishments Act, 1948 as adopted by Gujarat. This is because commercial establishment as defined u/s 2(4) of the said Act means any establishment which carries on any business, trade or profession but does not include a factory, shop, residential hotel, restaurant, eating house, theatre or other place of public amusement or entertainment. Term employee defined u/s 2(6) means a person wholly or principally employed, whether directly or through any agency and whether for wages or other consideration, in or in connection with any establishment. It must also be noted that the said Act does not contain any provision providing for recovery of notice pay for the unserved period. In contrast Section 30(2) of the Delhi Shops & Establishment Act, 1954 provides that no employee who has put in three months’ of continuous service can terminate his employment unless he has given to his employer a written notice of at least one month. In case he fails to give such one months’ notice, he will be released from his employment on payment of an amount equal to one month’s pay. Hence we can see that the Bombay Shops and Establishments Act, 1948 does not expressly provide for any payment in lieu of notice period whereas Delhi Shops & Establishment Act, 1954 provides for payment equal to one month’s salary.
7. With the above background arguments for not taxing such notice pay recovery in case of an employee covered under the Bombay Shops and Establishments Act, 1948 can be as under:
a) As noted above the Bombay Shops and Establishments Act, 1948 does not expressly provide for any obligation to pay one month’s salary on failure to serve the notice period in order to release from employment. In absence of such statutory requirement, the conduct of employer and employee shall be governed by the employment contract. Such employment contracts are made under the Indian Contract Act, 1872. It is worthwhile to reproduce Sec. 74 of the said Act as under:
“74. Compensation for breach of contract where penalty stipulated for.—1 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 conclude 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 to refrain from an act, or to tolerate an act
b) Entry No. 1 of Schedule III to the CGST Act, 2017 provides that services by an employee to the employer in the course of or in relation to his employment shall not be regarded as supply of goods or supply of services. Notice pay recovery is nothing but a deduction from the salary payable to the resigning employee. It is not a separate consideration flowing from any independent contract. Hence it should be covered within the referred entry.
c) In the context of Income Tax an issue with respect to claim of deduction for notice pay came up before Hon. Ahmedabad Tribunal in the case of Nandinho Rebello v. Deputy Commissioner of Income-tax  80 taxmann.com 297 (Ahmedabad – Trib.). In this case the appellant had claimed deduction of notice pay recovered by his employer from his salary income. Department denied the deduction on the ground that the same is not allowed the head “salary” since salary is charged on due basis and permissible deductions stipulated u/s 16(2) does not contain notice pay recovery. Hon. Tribunal allowed the appeal and held as under:
“Therefore, notice pay of total Rs.2,76,744/-was claimed in the return of income as deduction which was recovered from the salary by assessee’s previous employers as mentioned above. The ld. CIT(A) was of the view that no such deduction is available under Section 16 of the Act and the salary income is taxable on due basis or on paid basis. After considering the facts as quoted above, we find that employers have made deduction from the salary which was paid to the assessee during the year under consideration because of leaving the services as per agreement made by the assessee and the respective employer. We find that this is a case of recovery of the salary which is already made to the assessee for which we have not to refer Section 16 of the Act as mentioned by the ld. CIT(A). It is pertinent to note that the assessee has actually received the salary from his previous employers after deducting the notice period as per the job agreement with them. Therefore, in our considered view, the actual salary received by the assessee is only taxable and therefore, we allow this ground of appeal of the assessee.”
Above ruling clearly supports the view that notice pay recovery is nothing but an adjustment of salary and hence does not tantamount to any supply which is chargeable to GST.
8. All the above arguments supports the view that notice pay recovery may not be subjected to GST. Early judicial pronouncement however on the issue will go a long way in avoiding the litigation.