This article seeks to examine the meaning of the word ‘tolerate’ in s. 66E of the Finance Act, 1994 and what it entails. It seeks to understand the purpose of the provision and the areas of its applicability; it seeks to understand the implication it has to an employee who wishes to terminate his employment contract with his employer without serving his statutorily required notice period for any reason. The paper tries to understand whether the non-serving of the notice period is the equivalent of ‘tolerating an act’ as explained in the Finance Act and if so, whether this also means that the recovery extracted by the employer for the notice period not served by the employee upon termination of services is to tolerate and thus is a ‘declared service’. If these conditions are satisfied, the employer is liable towards service tax towards the recovery he receives from the employee. This paper thus, seeks to understand this conundrum and to examine the viewpoint of critics regarding this.
Employment Agreement –
The employer-employee relationships have always been, in a constant state of evolution. As the nature of such relationships evolve and change, so does the nature of disputes that arise as a result of diverging interests which the employer and employees seek to protect in their interaction with each other and the society in general. Several laws and legislations have been drafted to create an appropriate framework to address these concerns with an objective to reasonably balance the interests of employers and employees. Such employment laws have a broad ambit and include within their scope all areas of the employer-employee relationship and are not merely restricted to contractual issues and/or workplace discrimination.
All laws together govern the agreement between the employer and the employee while putting forward the interests of each and also ensuring a protection mechanism to fall back on in case of breach of such duty by one of the parties. One such measure is the service tax applicability on the employment agreement when an employee decides to move on form the employment.
Notice and Notice period –
An employee is required to intimate the company with a formal resignation well in advance and serve a ‘notice period’ of at least two to three months before quitting his employment. Thus, the resignation will amount to a notice and the period served post such a notification is a mandatory serving of a notice period. This period is necessary so the company is able to find someone with at least equal ability to replace the employee that is leaving.
In case the employee does not serve the mandated notice period, the employer can recover a ‘short notice period recovery’ as per the company’s policy or the terms of employment. What needs to be considered is whether service tax has to be collected by the employer from the employee for the short period served. The concept of ‘service’ and ‘declared service’ needs to be examined for this purpose.
Declared Service u/s- 66E
As per Section 65B (44) of the Finance Act, 1994, which provides the legal basis for levy of service tax, the term “service” means “any activity carried out by a person for another for a consideration, and includes a declared service.” Thus, inputs in the form of labour, capital, investment etc. are converted into two kinds of outputs- either goods produced i.e. tangible outputs or services i.e. intangible goods which are the result of the inputs. For example, the manufacturer of a computer device has produced a good for the consumer whereas a doctor who diagnoses his patient’s disease and prescribes medicines for it has provided the patient (or the consumer) with a service.
Section 66E of the Finance Act, 1994, states that “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” shall be a declared service. For example, if an organization agrees not to offer a competing product/service in a marketplace and in turn, receives a non-compete fee from another organization, the organization which agrees not to compete shall be said to have delivered a “declared service” and the non-compete fee it receives shall be subject to service tax. When an advocate agrees to not appear for the opposite party at court, he agrees to refrain from doing an act which could have earned him some monetary benefit. When this refrain is for a consideration, it is an activity carried out by a person (the advocate) for another for a consideration. The act itself fits the definition of a declared service by virtue of refraining from doing something. Thus, it is a declared service under the definition as per S. 66E of the Finance Act.
Deduction on account of quality issues is a form of tolerating an act. When in an exchange of goods or services between two parties a certain quality of product or service has to be maintained and the price received is in proportion to that, the requirements are expected to be strictly followed. Thus, if the producer falters in such a production the consumer may expect to receive a consideration for tolerating such defects. So when quality issues arise and the consumer makes deductions or penalties for tolerating such a flaw, they are qualified as a declared service i.e. tolerating an act for a consideration.
Employee’s failure to serve notice period –
An employee may have any number of reasons for not serving the notice period. However, if the policy of the employer or the employment agreement mentions so, the consequences will have to be met by them.
Companies may collect a compensation from the resigning employee for ‘tolerating’ the early termination of the employment agreement without serving the notice period in pursuance of the wordings of the provision on declared service.
Thus, the question is whether service tax can be made applicable on the amount collected as short notice period recovery. If the short notice period recovery is allowed to be seen as the extraction of a consideration for allowing the employee to terminate his services early in the pursuance of tolerating an act, then it can be seen as a declared service, making it liable towards a service tax. However, if not seen as a declared service under the definition according to the Finance Act, then it does not fit the definition of a service either and thus, is not liable towards taxation as a service. This examination is required to be done by the service tax authority which will then give a final tax treatment of a short notice recovery period.
A declared service has been stated to mean the ‘tolerating’ of any act among other things. Since a service is any activity for a consideration and includes a declared service, such tolerating can be a service if it is in exchange of some consideration. According to the definition given by the Act, ‘tolerating’ an act signifies the foregoing of a benefit by the receiver in exchange for a consideration that compensates the act that is being tolerated. For example, when delivery date has been set and the person making the delivery delays it, but the receiver allows such a delay for a certain amount as delivery charges, it is tolerating an act for a certain consideration i.e. the delay charges. Thus, it is the declared service of tolerating for which the receiver is extracting a certain amount as taxation from the the other party.
When an employer tolerates the early termination of an employment agreement, it is with the extraction of the short notice period recovery. This may be seen as the consideration for the declared service by the employer to the employee.
If seen as a service, the employer may extract the service tax from the employee as a part of the recovery or they may pay the service tax from their own pockets after collecting the consideration. For example, if an employee whose salary is Rs. 1,00,000 per month terminates his employment and instead of serving the required notice period of three months, serves only one month, then the short notice recovery is of (1,00,000*2 months) Rs. 2,00,000. This may be extracted as a part of the recovery in which case it will be calculated on an inclusive basis( as per S. 67(2) pf the Act) and the amount will be 2,00,000*14/114 i.e. Rs 24561.40 as service tax at the rate of 14%. They may also pay it out of their own pockets instead of extracting it out of the employee’s short period payment in which case service tax to be paid will 2,00,000*14/100 i.e. Rs. 28,000 which they will pay out of their own pockets and not extract it as inclusive of the short period recovery.
However, there is no explicit law stating the treatment of the non-serving of notice period and whether it is a service or not and whether it may be taxed or not. Though, there isn’t really a service provided to the employee by the employer, there is a consideration being extracted by them for the non-following of a certain rule. Whether this consideration is to be treated as being for a service is a matter of interpretation at the moment since there is neither any legislation nor any case law that determines it beyond doubt.
Some critics are of the opinion that the early termination of the agreement should not be considered as a service since Section 65B (44) of the Finance Act, 1994, which defines the term “service,” explicitly excludes “provision of service by an employee to the employer in the course of or in relation to his employment.” The notice period recovery is a part of an employment contract between an employer and an employee which is outside the purview of service tax applicability. The payment is on account of an employee not meeting certain conditions related to the employment contract. The notice period recovery thus, is in the nature of a penalty/fine and may not be looked at as a consideration for any service. Application of the definition of declared service in the context of an employment contract thus, seems out of order since the premise of ‘consideration in exchange for tolerance which is seen as a declared service’ may be a flawed interpretation of the Statute.
Thus, a clear notification from the service tax authorities though not notified yet may be in order for uniformity of application of service tax liability in employer-employee agreements. It would give clarity on whether the act of the employer is an act of “tolerance”, if so whether it amounts to a declared service as well as whether the employer is liable to pay an amount of service tax to the government on such a service.
SushanthKaranth, ‘Service Tax Applicability on Short Notice Recovery’, http://taxguru.in/service-tax/service-tax-applicability-short-notice-recovery.html (February 6th, 2015)
Gautham, “Should Service Tax be Calculated on Short Notice Period Recovery?”, https://www.hinote.in/should-service-tax-be-calculated-on-notice-period-recovery, (June 11th, 2015)
 Supra (Footnote 2).
 Supra (Footnote 4).
3rd yr B.A.LL.B (Hons),
Hidhayathullah National Law University, Raipur.
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