Mr. X was employed with a leading global manufacturing company Global Inc, in their Indian subsidiary, Global India. Due to global restructuring, Global Inc decided to close its operations in India, resulting in the termination of employees including Mr. X. As part of its retrenchment offer, Global India offered severance payment  to Mr. X under a mutual severance agreement. Global India did not withhold taxes on the severance amount paid to Mr. X, and the tax officer disallowed the entire severance payment expenditure, for failure to withhold tax on ‘salary’.
Was the tax officer correct in disallowing the entire severance payment expenditure?
The Sharda Sinha case:
In CIT v. Sharda Sinha (ITA No. 471/2003) the taxpayer was a journalist by profession and was appointed as the foreign correspondent of a German news magazine, in India. The German publisher had paid a lump-sum amount upon termination as sign of compensation for performance of authorship/professional services for a continuous period of 23 years. In a letter written by the publisher, the publisher had acknowledged that the compensation was being paid “due to the loss of his workplace and in consideration of his longtime association”. The Delhi HC held that the sum paid to the taxpayer was “to compensate for the abrupt loss of a source of income and that the termination of the contract had fatally injured the taxpayer’s only source of income for the last 20 years”. Accordingly, the lump-sum severance amount received was held to not be taxed in the hands of the taxpayer since the severance amount was in the nature of a ‘capital receipt’.
In light of this, the important question that arises is whether Global India could rely on this ruling to justify that it was not required to withhold tax on the severance amount paid to Mr X. On close examination of the facts, it appears that the taxpayer in Sharda Sinha was not in ‘employment’ with the foreign company, but was a professional rendering service in India i.e. the taxpayer did not earn any income under the head of “salaries”, but under the head of “business and profession”.
As per Section 192 of the Income Tax Act, 1961 (“IT Act”), any payment made to an employee, which falls under the head of income of “salaries” will be liable to tax withholding and the employer is obliged to withhold such tax and remit the same to the credit of the government exchequer. This would mean that if the severance payment paid to Mr. X qualifies as “salaries”, Global India would indeed have failed to fulfil its obligations.
Now, the definition of “salaries” under IT Act is fairly comprehensive, including inter alia ‘profits in lieu of salary’. Under Finance Act, 2001(with effect from April 1, 2002 i.e. Assessment Year (AY) 2002 -03 and subsequent years), profits in lieu of salary also include “any amount due to or received, whether in lump-sum or otherwise, by a taxpayer from any person after the cessation of his employment with that person”. The term “cessation” has not been defined; but in common parlance, the term would mean ‘ending’, ‘termination’ etc. Thus, payments made at the time of termination of employment too should qualify as “salary” under IT Act.
Interestingly, the Delhi HC in CIT v. Deepak Verma (2010) 194 TAXMAN 265, held that severance payments made by an employer would not be treated as ‘profits in lieu of salary’ and hence, not taxable for AY 2001-02. Pertinently, however, the Delhi HC in that case observed that the “salary” definition at that relevant time was not adequate to cover severance payments. The court specifically pointed out that the amendments vide Finance Act, 2002 with effect from April 1, 2002 will however bring within the tax net severance payments as well. The Delhi HC observed that in fact, the Legislature wanted such type of payments to be treated as income in the hands of employees/ persons and to tax them. In fact, it was for the same reason that the said amendment was inserted in the IT Act.
In summary, though severance payments were not taxable prior to AY 2002-03, under the extant law, such payments are liable to tax as income from salaries. So, since under the law an employer is obliged to withhold tax on salaries paid to its employees, Global India may have failed in its obligation.
Importantly, failure to withhold taxes has manifold consequences. The person who was liable to withhold tax (payer) may be treated as an “assessee (taxpayer)-in-default”, which may result in such person being liable to interest on taxes not withheld and potentially, penalty. Another consequence is the disallowance of the payment as an expense to the payer. The IT Act provides that where no tax has been withheld on sums paid to a resident, thirty percent of such sum will be disallowed.
So, in the instant case, since Global India had not withheld tax on a sum which qualifies as ‘salary’, the tax officer was correct to have disallowed the said expense, although he ought to disallow only 30% of the sum so paid.