Stipulation of the notice period in an employment contract is common these days, particularly where attrition levels are relatively high. Specific clauses inserted in the agreement provide that in lieu of serving the notice period, an amount equivalent to the salary for a certain number of months will be recoverable by the employer from the employee.
In the erstwhile service tax regime, employers received notices demanding payment of service tax on the amount received as notice pay from employees. The tax department’s view in such cases was that employers have tolerated a breach of contract by the employee, which amounts to a declared service as per provisions of the Finance Act. On the other hand, assessees contended that tolerating the act of the employee did not amount to performing an activity for consideration and thus should not be liable to service tax.
The Central Board of Excise and Customs’ Education Guide provides that: “The concept ‘activity for a consideration’ involves an element of contractual relationship wherein the person doing an activity does so at the desire of the person for whom the activity is done in exchange for a consideration.” It also provides that imposition of a fine or penalty for violation of a provision of law does not amount to consideration for the activity of breaking the law and accordingly does not attract levy of service tax.
Thus, based on the explanations provided in the Education Guide, it can be argued that in order to construe something as an activity for consideration, a certain level of reciprocity is required. Likewise, penal action would not attract the levy of service tax.
Schedule II of the Central Goods and Services Tax Act provides that “agreeing to the obligation to refrain from an act, or to tolerate an act” is a supply of service. Further, the scope of consideration has been expanded to include the monetary value of any act or forbearance. Thus, the tax department may demand GST on notice pay, contending that it is consideration for the act of forbearance to sue.
Looking at the position in other countries, under the EU’s value-added tax regime the obligation to refrain from an act or to tolerate an act or situation amounts to a supply of service.
In the case of Société Thermale, the European Court of Justice held that a hotelier’s retention of a client’s deposit as a fixed cancellation charge as compensation for the loss suffered had no direct connection with the supply of any service for consideration and so was not subject to tax. Thus, it can be said that an amount received in the form of “compensation” does not attract the levy of VAT in the EU.
Also to be considered is whether notice pay can be equated to liquidated damages. Liquidated damages are generally understood as an amount paid to compensate for a loss of earnings. It has been observed that these are not consideration for supplies and outside the scope of VAT in the EU.
Another question is whether the notice pay amount can be treated as a consideration to ensure no further legal action in relation to the employment contract will arise.
Consideration under Australia’s GST Act has been defined to include any payment made for any act or forbearance in respect of supply of goods or service. GST Ruling 2001/4 issued by the Australian Tax Office clarified that damages – the most common form of remedy arising out of a termination or breach of contract – cannot be characterized as a supply made by the aggrieved party.
Likewise, in New Zealand’s GST Act consideration in relation to the supply of goods and services has been defined as including forbearance in respect of the supply of any goods or services. In the case of Databank Systems Limited, the High Court in New Zealand observed that to supply means to furnish or provide and requires some action by the supplier. Based on the decision and definition, forbearance to sue appears to be capable of being a supply of service within the GST definition in New Zealand.
On a comparative analysis, the EU, Australia and New Zealand have divergent interpretations on the aspect of damages for an act of toleration or forbearance to sue. It will be interesting to see what view the tax department will take in India, whether litigation under the erstwhile regime will continue or the department will follow the interpretations adopted in the EU and Australia.
L Badri Narayanan is a partner and Disha Jain is a principal associate at Lakshmikumaran & Sridharan.
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