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Layoffs in startups and tech companies are making headlines everyday. Most companies handing out pink slips are also giving 2-3 months of severance pay to affected employees. Tax laws in India allow tax exemption on such compensation under certain conditions, but the scope is limited.

As per section 17(3) of the Income Tax Act, any payment received by a taxpayer due to the termination of her employment is considered as profits in lieu of salary. Such profits attract tax in the same manner as salary is taxed. This means that the employer may even deduct TDS on the severance pay.

When is exemption allowed?

One way in which you may get tax relief on the severance package is when it is paid under voluntary retirement scheme (VRS), according to Section 10(10C) of the Income Tax Act. The section allows one-time exemption to employees on the proceeds received on voluntary retirement or separation.

The term voluntary separation is not defined by the IT Act but can be understood from the two conditions applicable to qualify for exemption under Section 10(10C). “This section applies to an employee who has completed 10 years of service or completed 40 years of age. So, a person closer to retirement (above 40 years of age) may claim this exemption irrespective of the number of years served with the employer, which may be understood as voluntary retirement. But it is also applicable to a person (below 40 years of age) who has completed 10 years of service, which may be understood as voluntary separation," said Neeraj Agarwala , Partner, Nangia Andersen India.

Exemption allowed under section 10(10C) is lesser of the amount received or 5 lakh.

Note that the ‘voluntary retirement’ phrase does not mean that you can’t take up employment again. “It only provides that the retiring employee shall not be employed in another company or concern belonging to the same management as the previous employer," said Agarwala.

So, can an employee who is being laid off ask the employer to pay compensation under VRS so as to get tax exemption? The answer is no. “VRS scheme is drafted by the employer and exemption under section 10(10C) is only applicable if prescribed conditions are fulfilled. One of these conditions is that the scheme should be for all employees. All severance pay is not VRS, and the decision is with the employer," said Agarwala.

Section 89 too gives tax relief when due to the lumpsum severance payout, the total income is assessed at a rate higher than that it would otherwise have been assessed. “The relief will be granted based on the average tax rate of the previous three years and vary depending on the compensation received," explained Agarwala. “The condition is that compensation is paid after continuous service of not less than three years and the unexpired portion of his term of employment is also not less than three years." To claim this benefit, the employee should submit a declaration in Form 10E to the employer. However, tax breaks under section 10(10C) and Section 89 are mutually exclusive and cannot both be claimed.

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