Employments agreements usually contain contractual clauses that enable employees to terminate the employment agreement with their employer by either serving what is called a notice period, or in the alternative, paying a sum (usually pre-determined sum) to the employer to dispense with the requirement of serving a notice period.

When an employee chooses to bring the contractual relationship with his employer by serving the notice period, the contract stands terminated at the end of the notice period, and on the contrary, where the employee chooses not to serve the notice period or short serve the notice period, and instead, decides to pay the employer, the contract gets terminated forthwith.

An interesting situation would arise if the Service Tax Department ("Department") contends that the employer had provided a service to its employee in view of Section 66E of the Finance Act, 1994 by "tolerating an act of its employee" who terminates the contract by letting him go off without serving his/ her notice period for an agreed sum.

The answer to the above question assumes significance in the light of the fact that if service tax becomes leviable on such service, it could prove to be a cost to the employers unless they decide to collect the same from their employees. Service tax experts across the country have been grappling with this question, and it is this question this article seeks to examine in the light of the applicable law.

The applicable law

As per the charging section under the service tax laws, which is Section 66B of the Finance Act, 1994 (hereinafter "the Act"), service tax shall be levied on all services, other than those specified in the negative list, which are provided or agreed to be provided in the taxable territory.

The term service has been defined under the Act as "any activity carried out by a person for another for consideration, and includes a declared service...." in Section 65B(44) of the Act.

Section 66E of the Act sets out a list of services which shall constitute declared services under the law. Under the list of activities declared to be taxable services, the activity of "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act; is declared to be a service (See Section 66E (e)).

Thus to levy service tax, there should be a rendition of service in terms of the above definition set out in Section 65B (44) of the Act, and a transaction could be the one declared to be a service under Section 66E of the Act-subject, of course, to the element of consideration. A transaction/activity can be said to be one of a service if and only if the impugned service satisfies the twin conditions of existence of an activity for a consideration, and performance of reciprocal promises.

In this background, I now propose to examine, if the "understanding to terminate" between the employer and employee involves an activity for consideration. Now, an activity could either be active or passive, in the sense that, it may either require parties to a contract to carry out an act, or refrain from doing an act. As stated hereinabove, Section 66E of the Finance Act, 1994 declares the activity of "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act as a service for the purposes of the service tax law.

The purport of the phrase "agreeing to refrain from an act" is useful to bring to tax an agreement of non-compete in as much as the same requires one refraining from act. But, what holds key to our question is the purport of the expression "agreeing to the obligation to refrain from an act on which the Department may seek to rely on. The purport of this expression does not appear to be have been subject to judicial scrutiny, and hence, the number of activities this expression may take into its sweep is debatable.

Take now, for instance, an agreement for supply of goods specifying a penalty of an "x" amount should there be a delay in the supply of goods to the purchaser. The amount paid to the purchaser by the seller in the event of late supply is in the form of penalty/liquidated damages. Now, could the amount paid by the seller be subject to tax on the ground that the buyer/purchase had "tolerated an act"? The answer to this question is to be in the affirmative, in my opinion, because the purchased had tolerated the belated supply of goods.

In our case, like in the case illustrated above, there is an inherent understanding to the effect that the employer shall let the "employee let go of" by permitting him to terminate the contract in lieu of a sum at the time of the entering of the agreement. The employer, while entering into the agreement, gives the right to terminate the contract forthwith where the sum agreed to is paid by him. Given this, could it be said that employer had "tolerated an act" of employee? Could this be called an activity of an employer? In my opinion, yes. Further, since the employer pays a pre-determined sum and exercises his right to terminate the contract forthwith, the test of consideration is satisfied, too.

Taxability of Compensatory damages:-

It is often argued that the legislature may not intend to tax compensation in as much s damages represent a genuine pre-estimate of the amount of the loss suffered and are only aimed at making good the loss suffered by the party wronged, and hence, involve no activity either active or passive on part of the party that compensates. But, the legal tenability of this proposition is in heavy doubt in view of the expression that declares "an agreement to tolerate an act" (certainly for consideration) a service.

Under Rule 6 of the Service Tax (Valuation Rules), only "accidental damages not relatable to the provisions of service" are excluded, meaning it may not be open to contend that the legislature does not intend to tax compensatory amounts/damages, for there is no service involved.

Further, what supports the view that legislature's may not intend to exempt compensatory damages from the levy of service tax is a recent change to the mega exemption notification list that only excludes damages payable to the government, and not damages payable to other non-government entities. This express exemption may make us re-consider our view that compensatory damages may not be taxable at all.

The position under the UK Law:-

It's more than often that Indian practitioners examine the taxability of the relevant transaction under the UK VAT law before reaching a proper conclusion. In the instant case, too, the UK law does shed some light.

Under the UK VAT law, there is no supply for VAT purposes (the law taxes a supply) of "the right to terminate" or other such service where a contract originally contains a clause allowing the parties to terminate the contract early in lieu of compensation for perceived losses arising from termination. However, there will be a supply where no such rights exists and agreements have been separately entered into terminate the contracts. However, the applicability of the position under the UK law would be in doubt as the Indian law employs the phrase "an agreement to tolerate or refrain from an act", which is very much present in our case: the employer agrees to tolerate a premature termination.

The decision of the VAT tribunal in Lloyds Bank Plc (LON/95/2525) is a case in point. In this case, the Llyods sought an early termination of a lease it had, which did not provide for such early cancellation. Lloyds and its landlord therefore agreed a variation to the lease, letting Lloyds terminate the contract for a sum to be paid. The Tribunal in this case ruled that there was a supply by the landlord of granting and exercising an option to terminate the lease in return for a payment, and disagreed with one of its earlier decisions where it ruled that there would be no supply for VAT purposes in case the original contract had a clause permitting early termination.

The law under the UK VAT does provide us an insight into what can actually be the consequence of a clause permitting early termination. The UK Vat does not consider a case like ours to be taxable. However, under the Indian service tax law, owing to one specific phrase, which is "agreement to tolerate an act", it becomes extremely difficult to reach a conclusion on whether or not service tax is payable.

Conclusion

The question whether service tax can be levied in the instant case is a complex one, and is something that service tax experts are likely to continue grappling with. In my opinion, given the understanding between the employer and the employee to let go of the employee for an agreed sum, the likelihood of service tax becoming leviable is extremely high. However, attempts to levy service tax would face strong opposition, and unless the Central Board of Excise and Customs clarifies the applicability of service tax in the instant case, it's not before long that the instant issue would attain clarity.