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Should Service Tax be Calculated on Notice Period Recovery?

Recently, we received a question from an organization known to us.

Should we be calculating Service Tax on notice period recovery when we run final settlement for resigned employees?

In case you are wondering how on earth there can be any service tax implication on payroll processing, let us examine the background to this question.

As per Section 65B (44) of the Finance Act, 1994, which provides the legal basis for levy of service tax, the term “service” means “any activity carried out by a person for another for consideration, and includes a declared service.”

There are two key factors which determine the inclusion of a transaction (between 2 parties) for levy of service tax – a consideration or payment and a service activity. In case of notice period recovery, there is a payment from the employee to the employer. If that payment is construed to be a consideration, the question that begs is: “What service does an employer deliver in case of notice period recovery? If the employer is not delivering any service, how can this fall under the service tax ambit?”

You may have noticed the term “declared service” in the definition of the term “service” as per Section 65B (44) of the Finance Act, 1994, stated above. Some tax managers are of the view that though there is no explicit service rendered by an employer to an employee in the context of notice period recovery, an employer can be deemed to have rendered a “declared service” and hence the issue of service tax is relevant.

What is a declared service?

Section 66E of the Finance Act, 1994, states that “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” shall be a declared service. For example, if an organization agrees not to offer a competing product/service in a marketplace and in turn, receives a non-compete fee from another organization, the organization which agrees not to compete shall be said to have delivered a “declared service” and the non-compete fee it receives shall be subject to service tax.

Some tax managers say that an organization, by agreeing to relieve an employee from its rolls without demanding any notice period, can be said to be delivering a declared service and the notice period recovery amount is the consideration it receives in return.

If one concurs with the above view, payroll managers should calculate service tax on the notice period recovery amounts at the time of running final settlements and arrange for the remittance of the service tax.

Our take

We are of the opinion that notice period recovery should not be subjected to service tax. Section 65B (44) of the Finance Act, 1994, which defines the term “service,” explicitly excludes “provision of service by an employee to the employer in the course of or in relation to his employment.” The notice period recovery is a part of an employment contract between an employer and an employee which is outside the purview of service tax applicability. The payment is on account of an employee not meeting certain conditions related to the employment contract. We opine that notice period recovery is in the nature of a penalty/fine and hence cannot be looked at as a consideration for any service. Application of the definition of declared service in the context of an employment contract is not appropriate.

There does not seem to be any circular from the Service Tax Department or case law on this. We have not come across any demand raised by the Service Tax department in this regard. Some organizations seem to be of the view that in order to play it safe it is better to deduct and remit service tax on notice period recovery. In order to put an end to needless speculation, it would be good if the Service Tax Department comes out with a communication clearly specifying its stance on this.

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5 Comments

  1. Chandu October 10, 2015

    I saw notices being issued by service tax department to pay service tax on notice pay recovery. The Department thinks that it is very much taxable.

    reply
    • gautham October 11, 2015

      Do you know under what sections the notices were raised?

      reply
      • Bikrant Kumar December 19, 2015

        Notice by DGCEI has been issued under section 66E(e) of the Finance Act, 1994.

        reply
  2. BALAKRISHNAN November 17, 2015

    The CERA team have now started raising this issue in their audit para. Some of the companies from Southern parts of India starting received SCN based on the audit para. dt. 17th Nov. 2015.

    reply
    • gautham November 19, 2015

      If you can, kindly elaborate on your comment with regard to the basis of the show cause notices and let us know what the audit para dt 17-Nov-2015 refers to.

      reply

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