Income Tax on Retrenchment Compensation Amount

What is Retrenchment?

There are times when an organization or a company is forced to close down its operations due to various reasons such as – Lack of sufficient funds to continue the operation in its existing shape and form, Death of the proprietor, inability to survive in the competitive environment, Bad Management, Major failure of products, Professional Incompatibility between the founding members of the Organization, Major changes in market trends making a company obsolete, Inability to pay its major debtors and many more such reasons.

Whatever be the reason for closure, the Indian Industrial Disputes Act of 1947, stipulates that the workers who have been working in such organization are adequately compensated to take care of their immediate future. This is where retrenchment of workers comes into picture.

Hence when an organization asks to leave the organization, she / he can’t be asked to walk out, just waving hands! They are supposed to be compensated for the same. The amount of compensation is decided by the management of the organization, in a justifiable manner, within the guidelines stipulated under Indian Income Tax Laws, under various sections. What we are trying to explain is how the Indian Income Tax Laws, treat such compensations received.

Here is how it works

Retrenchment compensations are classified under the Indian Income Tax Act as Retrenchment Compensation u/s 10 (Sub Section 10B). However it has a lot of conditions, which needs to be met in order to qualify for the compensation. Let us understand those conditions, as well as what is the amount that is exempt from Income Tax of India, under retrenchment compensation.

Any compensation received by a person due to the Retrenchment shall be exempt to the extent as stipulated underneath.

  • a.     an amount calculated in accordance with the provisions of Section 25F(b) of the Industrial Disputes Act, 1947

OR

  • b.     Such amount, not being more than Rs. 5,00,000 as the Central Government has specified in this matter, if the management has not filed for insolvency / bankruptcy to the Board for Industrial & Financial Reconstruction (in Short it is called as BIFR).

OR

  • c.      The amount received whichever is the least.

In simple terms all the amounts upto Rs 5 Lacs received as Retrenchment Compensation is fully exempt from Income Tax of India.

Compensations in excess of the above mentioned limits is taxable as salary or profit in lieu of salary which is however eligible for relief under Section 89(1) read along with Indian Income Tax Rule 21A.

The Section 25F(b) of Industrial Disputes Act provides for payment of retrenchment compensation equivalent to 15 days average pay for every completed year of continuous service or any part thereof in excess of six months.

For this purpose, average pay will be calculated as explained underneath.

  • a.     if the person is getting monthly salary, then on the basis of the salary of last three calendar months

OR

  • b.     If the person is getting weekly wages, then on the basis of wages of last four completed weeks

OR

  • c.      If the person is getting daily wages, then on the basis of wages of last twelve full working days.

Under the Industrial Disputes Act, for this purpose salary or wages mean all remuneration capable of being expressed in terms of money, which would be payable to a person in respect of the his employment or work done in such employment, including the value of benefits mentioned in the Explanation to such Act.

Compensation received by a person at the time of the closing down of the Organization in which she / he is employed is treated as compensation received at the time of his retrenchment. If ownership or management of the undertaking in which the person is employed is transferred and he takes up employment with the transferee, the consideration received by him at the time of transfer of ownership or management will also qualify for the aforesaid tax exemption if it meets criteria cited underneath.

  • a.     If the service of the person has been interrupted by such transfers of the managements.

OR

  • b.     If the terms and conditions of service applicable to the employee after such transfer are in any way less favorable to the person, than those that were applicable to him immediately before the transfer of the management

OR

  • c.      If the new employer under the terms of such transfer, is legally not liable to pay to the retrenched employee in the event of her / his retrenchment, Retrenchment compensation on the basis that her / his service had been continuous and had not been interrupted by the transfer.

In simple words what this condition means is, if the new management has entered into agreement of the old management that only the old management is liable to pay the retrenchment compensations.

A Simple Example

Ms / Mr. Z is an employee working with M/s. ABC Limited. She / he is retrenched from service by the management and paid a compensation of Rs. 460000 under the Industrial Disputes Act, 1947. The receipt of Rs. 460000 will be exempt from tax.

However it must be noted that the exemption is applicable only once. That is if such a retrenchment compensation is deposited in banks (Which will generate interest amount) or deployed in other investments such as Shares, Stocks, Mutual Funds and deposits with large Corporates, and if any profit is derived out of such investment, they are liable for Income Tax, as per the prevalent rules.

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