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Companies may have to shell out service tax on retention bonuses
December, 14th 2015

Employers could become liable to pay service tax on retention bonuses taken back from workers or money paid in lieu of notice period. Companies routinely offer sign-on bonuses and other retention packages that are contingent on employees staying for a stipulated period of time. If they leave, this money has to be paid back. Some collect a security deposit that the worker forfeits if he or she wants to quit before the term is over.

Such practices, especially prevalent in the information technology and IT enabled services (ITeS) industries, have prompted the Directorate General of Central Excise Intelligence to ask officials to look at them closely.

The move is based on the logic that by letting an employee leave ahead of time, the employer is providing a service and the consideration exchanged ought to be taxed.
"A directive has been issued to alert field officials on an all-India basis on this modus operandi," an official with the agency told ET. Tax experts cautioned against too sweeping an interpretation of the law.

In many industries, employers offer cash linked to a certain period of service with some of the payments being front-loaded. Over the years, such bonuses have become a widely accepted method of retaining talent in many industries.

"A directive has been issued to alert field officials on an all-India basis on this modus operandi," an official with the agency told ET. Tax experts cautioned against too sweeping an interpretation of the law.

In many industries, employers offer cash linked to a certain period of service with some of the payments being front-loaded. Over the years, such bonuses have become a widely accepted method of retaining talent in many industries.

Some companies, particularly in the IT and ITeS space, ask employees to sign indemnity bonds. This obliges them to return the money if they do not complete the stipulated term. "Recovery of an amount, in terms of forfeiture of security deposit or other payments, from employee for leaving the organisation as stated above is a common phenomenon in business organisations," the official said. To be sure, contracts will have to be examined individually to ascertain facts.

This directive comes after the agency discovered that workers quitting from a Bengaluru-based company were forfeiting security deposits to leave before the term of the bond or notice period was over. The agency reckoned this was taxable under law.

According to section 66E of the Finance Act, 1994, agreeing to the "obligation to refrain from an act, or to tolerate an act or a situation, or to do an act" constitutes a service. This covers the return or forfeiture of money ahead of the stipulated notice or bond period, the official said.

These services are being provided by the employers to its employees and consideration in terms of forfeiof security deposit or other payments is being received by the employers in lieu of these services. Hence, employers are liable to service tax for providing these services," the official said.

The effects of such a move will be strong felt, according to experts.

"Such a wide interpretation of this provision could have a huge impact on companies, as it is very common for employers to make recoveries/adjustments from employee compensation on various grounds (such as breach of employment terms, causing damage to company assets, penalties for violating company policies)," said Siddharth Mehta, partner, indirect tax, KPMG in India.

Thus, it is imperative the ambit of service tax is appropriately clarified by the government with respect to such transactions, to avoid undue hardship to industry."

A literal interpretation of the expression, "obligation to refrain from an act, or to tolerate an act," could lead to unwarranted ramifications, with even penalties under contracts for supply of goods, outof-court settlements etc. becoming liable to service tax, Mehta added.

Experts advised caution with regard to documentation. "It is pertinent that corporates examine each of their transactions with their employees. This is because normally one does not envisage that corporates render services to employees. Also, there are transactions which are not truly services but are declared under law as services," said Anita Rastogi, partner, indirect tax, PwC.

ET View: Tax Terrorism Indeed

Hare-brained tax demands must end. The intelligence wing must not come calling on companies when there is lack of clarity in the law. It is harassment. The problem about India's service tax regime is that law and rules have undergone many changes, and varying interpretations have only fuelled disputes. So to collect more revenues, the need is to make the law simple and keep exemptions to the minimum. This will also raise the share of revenues from service tax as a proportion of GDP, which is minuscule now.

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