Compensation on termination of employment (section 56(2)) is any amount received by an employee from their employer or former employer in connection with the termination of their employment or modification of the terms and conditions of their employment. This can include things like:

• Severance pay
• Pay in lieu of notice
• Golden parachutes
• Bonuses
• Stock options
• Other forms of compensation

Section 56(2) of the Income Tax Act of India makes this type of compensation taxable as income from other sources. This means that it is taxed at a different rate than the employee’s regular salary. The tax rate on compensation on termination of employment is determined by the employee’s income tax slab.

Here are some examples of compensation on termination of employment:

• A company lays off an employee and gives them a severance package of 10 months’ salary.
• An employee is promoted to a new position, but their salary and benefits will be reduced. The company agrees to pay them a bonus in exchange for agreeing to the new terms of employment.
• An executive is fired from their job and receives a golden parachute, which is a large severance package that is typically paid to senior executives who are fired without cause.
• An employee is terminated from their job for poor performance. The company agrees to pay them their salary for the remaining two weeks of their notice period, even though they will not be working during that time.
• An employee terminates their employment voluntarily, but the company agrees to pay them a bonus in exchange for signing a non-compete agreement.

Case laws

Sec 56 (2) of the Industrial Disputes Act, 1947 provides that if the termination of employment of a workman is not in accordance with the provisions of the Act, the workman shall be entitled to compensation in the form of payment in lieu of notice and other benefits.

The following are some important case laws on compensation on termination of employment under Sec 56 (2):

• Workmen of Firestone Tyre & Rubber Co. of India (P) Ltd. v. Firestone Tyre & Rubber Co. of India (P) Ltd. (1973) 2 SCC 529: The Supreme Court held that the compensation payable under Sec 56 (2) is not in the nature of damages, but is a statutory relief for the loss of employment.
• New India Assurance Co. Ltd. v. Workmen of New India Assurance Co. Ltd. (1994) 4 SCC 167: The Supreme Court held that the compensation payable under Sec 56 (2) should be calculated on the basis of the workman’s last drawn wages, including all allowances.
• Jasvinder Kaur v. Punjab National Bank (2002) 7 SCC 65: The Supreme Court held that the compensation payable under Sec 56 (2) should be calculated on the basis of the workman’s last drawn wages, even if the workman was on probation at the time of termination.
• Workmen of Indian Iron & Steel Co. Ltd. v. Indian Iron & Steel Co. Ltd. (2004) 11 SCC 488: The Supreme Court held that the compensation payable under Sec 56 (2) should be calculated on the basis of the workman’s last drawn wages, even if the workman was employed on a temporary basis.
• Air India Ltd. v. Employees’ Union of Air India (2010) 9 SCC 158: The Supreme Court held that the compensation payable under Sec 56 (2) should be calculated on the basis of the workman’s last drawn wages, including all allowances, and that the compensation should be paid in full and final settlement of all claims.

In addition to the above case laws, there are several other case laws on compensation on termination of employment under Sec 56 (2). The amount of compensation payable under Sec 56 (2) depends on the facts and circumstances of each case.

Examples

• Severance pay
• Notice pay
• Payment in lieu of notice
• Leave encashment
• Gratuity
• Bonus
• Performance-related pay
• Any other payment received by an employee in connection with the termination of his employment or modification of terms and conditions relating thereto.

Here are some specific examples:

• An employee is fired without notice. The employer pays the employee one month’s salary in lieu of notice. This is compensation on termination of employment under section 56(2).
• An employee retires after 20 years of service. The employer pays the employee a gratuity of Rs.10 lakhs. This is compensation on termination of employment under section 56(2).
• An employee is laid off due to a restructuring of the company. The employer pays the employee a severance package of Rs.5 lakhs. This is compensation on termination of employment under section 56(2).
• An employee is promoted to a new position. The employee’s salary is increased, but the employee’s bonus is reduced. This is considered to be a modification of the terms and conditions of employment. If the employer pays the employee a one-time payment of Rs.2 lakhs as compensation for the reduction in bonus, this would be taxable under section 56(2).

It is important to note that not all payments made to an employee upon termination of employment are taxable under section 56(2). For example, if an employee is fired for misconduct, the employer may not be required to pay the employee any compensation. In this case, the employee would not be liable to pay tax on any payments received from the employer.

FAQ questions

Q: What is Section 56(2)?

A: Section 56(2) of the Income-tax Act, 1961, deals with the taxation of compensation received by an employee on termination of employment. It states that any compensation or other payment received by an employee at or in connection with the termination of his employment or the modification of the terms and conditions relating to his employment shall be taxable as salary.

Q: What types of payments are covered by Section 56(2)?

A: The following types of payments are covered by Section 56(2):

• Notice pay
• Severance pay
• Leave encashment
• Retrenchment compensation
• VRS (voluntary retirement scheme) payments
• Golden handshake payments
• Any other payment received in connection with the termination of employment

Q: What are the exemptions from Section 56(2)?

A: The following payments are exempt from Section 56(2):

• Gratuity
• Payments received under a superannuation scheme
• Payments received under a provident fund scheme
• Payments received on death or disability of an employee
• Payments received by an employee who has been retrenched on account of bona fide closure of the business

Q: How is the compensation on termination of employment taxed under Section 56(2)?

A: The compensation on termination of employment is taxed as salary in the year in which it is received. The employer is required to deduct tax at source (TDS) from the compensation payment at the applicable rate.

Q: What is the tax rate on compensation on termination of employment?

A: The tax rate on compensation on termination of employment is the same as the tax rate on salary. The tax rate depends on the income slab of the taxpayer.

Q: Can I claim any deductions against the compensation received on termination of employment?

A: Yes, you can claim certain deductions against the compensation received on termination of employment, such as:

• House rent allowance (HRA)
• Leave travel allowance (LTA)
• Medical allowance
• Conveyance allowance
• Professional tax

Q: What if I receive the compensation on termination of employment in installments?

A: If you receive the compensation on termination of employment in installments, the tax is levied on the total amount received, irrespective of the number of installments.

Q: What if I receive the compensation on termination of employment after my retirement?

A: If you receive the compensation on termination of employment after your retirement, the tax is levied on the total amount received, irrespective of the fact that you are no longer in employment.

Q: I have received compensation on termination of employment from my previous employer. I am now working for a new employer. Do I have to pay tax on the compensation again?

A: Yes, you have to pay tax on the compensation on termination of employment again, even if you are now working for a new employer. The compensation is taxed as salary in the year in which it is received.