Taxability of Ex-gratia / Retrenchment Compensation Paid Under Government-Supported Schemes – Statutory Framework, Judicial Interpretation and Admissibility of New Claim

The taxability of ex-gratia compensation paid to employees of public sector undertakings pursuant to Government-supported restructuring or downsizing schemes has been a recurring subject of litigation. The controversy primarily revolves around whether such receipts constitute taxable income, are exempt under sections 10(10B) or 10(10C) of the Income-tax Act, 1961, or are capital receipts outside the charging provisions altogether. The issue must be examined strictly in light of the statutory provisions and authoritative judicial pronouncements.

Statutory Charging Framework

Under section 4 of the Income-tax Act, tax is chargeable on “total income” of the assessee. The scope of total income is defined under section 2(45), read with section 5, which brings to tax only those receipts which are in the nature of income, unless specifically exempted.

It is a settled principle that capital receipts are not taxable unless expressly brought to tax by a charging provision. Compensation received for loss of employment or impairment of a source of income has consistently been recognised by courts as capital in nature, unless it represents remuneration for services rendered or profits in lieu of salary.

Section 10(10B) – Retrenchment Compensation

Section 10(10B) provides exemption in respect of any compensation received by a workman at the time of retrenchment under:

(i)    the Industrial Disputes Act, 1947, or

(ii)   any other Act, rule, scheme or order,

subject to the limits specified therein.

Significantly, the second proviso to section 10(10B) extends the benefit of exemption to compensation received under any scheme approved by the Central Government, thereby recognising that retrenchment compensation paid pursuant to Government policy decisions deserves favourable tax treatment.

Thus, where separation from service occurs due to downsizing, restructuring, closure or revival measures undertaken by the Government or public sector undertakings with Government approval, the compensation paid partakes the character of retrenchment compensation, irrespective of the label assigned to the scheme.

Section 10(10C) – Voluntary Retirement Scheme (VRS)

Section 10(10C) grants exemption up to ₹5,00,000 in respect of amounts received by an employee at the time of voluntary retirement or termination of service, subject to the scheme satisfying the conditions prescribed under Rule 2BA of the Income-tax Rules, 1962.

The exemption under section 10(10C) is:

(i)    optional,

(ii)   conditional,

(iii)  quantitatively capped, and

(iv)  applicable only where retirement is genuinely voluntary.

Courts have repeatedly held that section 10(10C) cannot be mechanically applied merely because a scheme uses the expression “VRS”. The true nature of the scheme, the surrounding circumstances, and the degree of volition available to the employee are determinative.

Capital Receipt Doctrine – Judicial Interpretation

The ITAT Chandigarh Benches have consistently held that ex-gratia paid through Government budgetary support pursuant to restructuring or downsizing schemes is a capital receipt not chargeable to tax.

In Dayal Singh v. ITO (2024) 169 taxmann.com 539 (Chd.), the Tribunal held that compensation paid under a Government-approved scheme for rationalisation of manpower was compensatory for loss of employment and future earning capacity and was therefore capital in nature.

In Suresh Pal Chauhan v. ITO (ITA Nos. 598 & 622/Chd/2022, order dated 01.04.2023), the Tribunal observed that where ex-gratia is paid out of Government support and not linked to any service conditions, it cannot be taxed as income.

The same principle was reiterated in Rajeshwar Sharma v. ITO (ITA No. 870/2018) and Sarabjit Singh v. ITO (ITA No. 764/2018 – Ranbaxy employee case), where compensation paid upon separation due to restructuring was held to be capital receipt and not taxable as salary or profits in lieu of salary under section 17(3).

In Martin Ekta v. ITO (ITA No. 281/2023), the Tribunal once again affirmed that compensation received under Government-supported separation schemes does not fall within the ambit of taxable income.

High Court Authority – Substance Over Nomenclature

The Madras High Court in Hindustan Photo Film Workers’ Cooperative Welfare Centre v. CIT held that compensation paid under a scheme framed due to financial distress and restructuring, even if described as voluntary retirement, was in substance retrenchment compensation. Consequently, the provisions of section 10(10B) were held applicable.

This principle reinforces the settled law that substance prevails over form in taxation.

Admissibility of New / Corrected Claim

An important and well-settled legal position is that a legitimate claim cannot be denied merely because it was not claimed in the return of income or was claimed under an incorrect provision.

The Delhi High Court in CIT v. Jai Parabolic Springs Ltd. [2011] 336 ITR 42 (Delhi) held that appellate authorities are empowered to consider and allow a claim not made in the return, provided the necessary facts are already on record. The Court clarified that there is no statutory bar on granting such relief and that the purpose of assessment is to compute correct tax liability in accordance with law.

This view is in consonance with the Supreme Court decisions in:

(a)   CIT v. Jute Corporation of India Ltd. (187 ITR 688), and

(b)   National Thermal Power Co. Ltd. v. CIT (229 ITR 383),

as well as the Bombay High Court ruling in CIT v. Pruthvi Brokers & Shareholders Pvt. Ltd. (349 ITR 336).

Accordingly, even where an assessee has initially claimed exemption under section 10(10C), or failed to claim exemption altogether, the correct claim—whether under section 10(10B) or on the footing that the receipt is a capital receipt not chargeable to tax—can validly be raised at the rectification, appellate, or Tribunal stage.

Consolidated Legal Position

On a cumulative reading of sections 4, 5, 10(10B), 10(10C), and the consistent judicial interpretation thereof, the settled legal position is that:

Compensation or ex-gratia paid through Government budgetary support pursuant to restructuring or downsizing of public sector undertakings is capital in nature and not chargeable to tax. Even otherwise, where such compensation is paid under a Government-approved retrenchment scheme, it qualifies for exemption under section 10(10B). Further, a lawful claim cannot be denied merely because it was not made correctly or at the appropriate stage, in view of binding judicial precedents including the Delhi High Court judgment in Jai Parabolic Springs Ltd.

Disclaimer
This note is intended for professional and academic use and is based on statutory provisions and judicial precedents prevailing as on date. It should not be construed as legal advice for any specific case.