Amount received by a prospective employee as compensation for denial of employment is capital receipt

Facts of the case

• The assessee received payment from M/s. ACEE Enterprises (‘ACEE’) against an Employment Agreement entered into between him and ACEE on 10th January, 2007.
• In terms of the said Employment Agreement, the Assessee was to be employed as Chief Executive Officer (‘CEO’) and the employment was to commence from 1st July, 2007.
• According to agreement, either party at its option could terminate the employment by giving six months’ notice to the other party in writing. In case the notice period was less than six months, then compensation equivalent to the shortfall of the notice period was payable by the party concerned.
• On 1st May, 2007 a letter was written by ACEE to the Assessee informing him that there was a sudden change in business plan of the Company and that the company shall not be able to take him on board from 1st July, 2007 as per employment contract. In reply assessee proposed to receive at least one year compensation by the company to cover up the financial loss incurred by the assessee.
• On 25th August 2007, ACEE announced a payment of Rs.1,95,00,000/- to the Assessee subject to income tax compliances as a one-time payment to you for non-commencement of employment as proposed.
• The Assessing Officer (AO) noticed a credit entry of Rs.1,70,90,650/- Before the AO, the Assessee pointed out that the tax of Rs.22,09,350/- had been  deducted at source by a letter dated 7th December, 2010. The Assessee offered an explanation as to why he had not offered the above sum to tax or claimed refund of the TDS.

• The AO rejected the Assessee’s explanation on the ground that under Section 17 (3) (iii) of the Act the receipt by the Assessee of a sum from any person prior to his joining with such person was taxable. The AO also drew an adverse inference as regards failure to disclose that TDS had been deducted by ACEE, in particular since the Assessee had not brought a claim in the return regarding such TDS. The AO concluded that the payment was taxable under the head ‘salary’. The addition of Rs.1.95 crores was added to the returned income and penalty proceedings were also directed to be initiated.

Contention of Revenue

That the condition of a pre-existing relationship of employer and employee was done away with by the use of the words “by any Assessee from any person” introduced by the Finance Act, 2001 with effect from 1st April, 2002 .

 HELD by CIT(A)

The CIT (A), after analysing the documents on record, came to the conclusion that there was no master and servant relationship between the Appellant and ACEE. No payment had been made by ACEE to the Appellant from the date on which the contract was signed till the date when the offer of employment was withdrawn. The CIT(A) concluded that the payment was made by the prospective employer as compensation towards breach of promise and not for any services rendered or to be rendered. Such payment could not be taxed under Section 17(3)(iii).

HELD by ITAT

On the first issue, the ITAT concurred with the CIT(A) that prior to the coming into existence of any relationship of employer and employee between the Assessee and ACEE, the offer on the basis of which the  employment agreement was drawn up had itself come to an end. This was a case where a prospective employee i.e. the Assessee had been compensated for denial of opportunity to be employed by the prospective employer. Therefore, the amount paid could not be said to be in lieu of the salary and a benefit of employment. On the second issue the ITAT observed that the finding of the CIT (A) that the receipt of Rs.1.95 crore was taxable as capital receipt has been upheld by it and therefore the second ground also had to be rejected.

 HELD by HIGH COURT

• The Employment Agreement itself mentions that the employment shall commence ‘latest by 1st July, 2007’. Although it further states that the employee “shall endeavour to join the company as early as possible”, the intention and expectation of the parties was that the employment would commence not earlier than 1st July 2007. This becomes evident from a reading of the letter dated 1st May 2007 written by ACEE to the Assessee in which it stated that that it would not be possible to take the Assessee “on board from 1st July, 2007 as per employment contract.” That the employment did not commence from the date of the Employment Agreement is further evident from the fact that ACEE stated in its letter dated 25th August 2007 that it was making the payment of Rs. 1.95 crores as “a one-time payment to you for non-commencement of employment as proposed.”

• The Court is unable to accept the interpretation sought to be placed on the plain language of Section 17 (3) (iii) of the Act by the Revenue. The words “from any person” occurring therein have to be read together with the following words in sub-clause (A): “before his joining any employment with that person”. In other words, Section 17 (3) (iii) (A) pre-supposes the existence of an employment, i.e., a relationship of employee and employer between the Assessee and the person who makes the payment of “any amount” in terms of Section 17 (3) (iii) of the Act. Likewise, Section 17 (3) (iii) (B) also pre-supposes the existence of the relationship of employer and employee between the person who makes the payment of the amount and the Assessee. It envisages the amount being received by the Assessee “after cessation of his employment”. Therefore, the words in Section 17 (3) (iii) cannot be read disjunctively to overlook the essential facet of the provision, viz., the existence of ‘employment’ i.e. a relationship of employer and employee between the person who makes the payment of the amount and the Assessee.

• The Court accordingly concurs with the concurrent view of the CIT (A) and the ITAT that this was a case where there was no commencement of the employment and that the offer by ACEE to the Assessee was withdrawn even prior to the commencement of such employment. The amount  received  by the Assessee was a capital receipt and could not be taxed under the head ‘profits in lieu of salary’. The other plea of the Revenue that the said amount should be taxed under some other head of income, including ‘income from other sources’, is also unsustainable. The decision in CIT v. Rani Shankar Mishra (2010) 320 ITR 542 (Del) held in similar circumstances that where an amount was received by a prospective employee ‘as compensation for denial of employment,’ such amount was not in the nature of profits in lieu of salary. It was a capital receipt that could not be taxed as income under any other head.