Changing jobs without serving the notice period can result in an unexpected income tax implication if the old employer recovers salary during a notice period

Salaried employee can end up paying income tax on 14 months salary on job switch: Relief urged in Budget 2025 Let us examine this common yet overlooked issue and explore why it deserves attention in Budget 2025

Naveen Wadhwa

Vice-President, Taxmann

Tarun Kumar Madaan

Chartered accountant

When an employee changes jobs, he faces two agonies: the culture at the new office and the additional tax he needs to pay. Changing jobs without serving the notice period can result in an unexpected income tax implication if the old employer recovers salary during a notice period. Let us examine this common yet overlooked issue and explore why it deserves attention in Budget 2025.

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Why employer may recover salary during notice period
Imagine an employee who decides to leave his current job but cannot fulfil the entire notice period. According to the employment agreement, the employer deducts a portion of the employee's salary as a penalty for the short notice. The new employer can also compensate the employee with an additional salary or bonus to the employee for not serving the notice period. The additional compensation received will increase the employee's tax liability. Both situations carry distinct income tax implications that need to be carefully considered.

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How employee can pay double tax on salary on switching jobs
If the employer deducts an amount from the employee's salary for an unserved notice period, the entire gross salary (before giving any deduction benefit) is considered taxable income.

On the other hand, if the new employer repays the amount deducted due to the non-serving notice period to the employee, this payment is added to the employee's taxable income. This could create a situation where he is effectively taxed on 14 months' salary in a year instead of 12.

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Double taxation for both employer and employee

The unfairness does not end there. When the employer deducts the amount as a penalty for not serving the notice period from the employee's salary, it is treated as income for the employer. This employer's income is also subject to tax. The result? The same amount is taxed twice-once in the hands of the employee (who did not even receive it) and again in the employer's hands.

To illustrate, an employee earns a monthly salary of Rs. 1,00,000. Upon resignation, his employer recovers two months' salary (Rs. 2,00,000) as notice period recovery. The new employer compensates the employee by paying him Rs. 2,00,000. As a result, the employee is taxed on Rs. 1,00,000 * 12 + Rs. 2,00,000 = Rs. 14,00,000, even though he effectively received only Rs. 12,00,000 after accounting for the notice period recovery. The original employer also pays tax on the Rs. 2,00,000 recovered as income. This creates a scenario of double taxation on the same amount.

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Why is this unfair to employees?
Under the Income-tax Act, salary income is taxed on a "due or receipt" basis, whichever comes first. Section 15 of the Income-tax Act imposes the charge when salary becomes due, whether paid or not. However, the Income-tax Act does not provide explicit relief for employees in cases of notice period recovery.

The Income-tax Act allows three deductions from salary income: Standard Deduction, Deduction for Entertainment Allowance, and Deduction for Professional Tax. Unlike businesses that can claim deductions for bad debts or other operational losses, employees have no option to adjust for the salary they never received. This leaves employees at a significant disadvantage, facing a tax burden on non-existent income.

Will Budget 2025 provide relief on double taxation of salary from employees?
This inequitable treatment requires immediate correction. Here are some proposed reforms to address the anomaly:

Allow deduction of salary recovered from taxable income: Amend the Income-tax Act to allow employees to claim a deduction for notice period recovery under Section 16. This ensures employees are not taxed on income they never received.
Streamline reporting requirements: Introduce a law requiring employers to report recovered amounts separately in Form 16 so the adjusted net salary is reflected in the employee's taxable income.
Tax notice period recovery in the employer's hands: If the amount recovered is treated as income for the employer, ensure it is taxed only once and not simultaneously in the hands of the employee.

Taxing employees on amounts they never received only adds to their burden. The current taxation system for notice period recovery is an inequitable anomaly that penalises employees and results in double taxation. Budget 2025 presents an opportunity to rectify this oversight. Introducing an explicit provision to exempt notice period recovery from taxable income for employees would provide much-needed relief.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

This story originally appeared on: India Times - Author:Faqs of Insurances