Is severance pay received under a VRS taxable for all employees? Know what the Income Tax law says

If you are planning to retire early through the Voluntary Retirement Scheme (VRS) then you can get a tax exemption of Rs 5 lakh, but any amount over will be taxed. On the flip side, severance pay received through VRS it is not taxable since it is considered a capital receipt. This is why it is crucial to grasp the difference between the two.

Recently there was a case in ITAT Pune involving an employee from a pharma company in Aurangabad. The company shut down, leading the employee to receive Rs 65 lakh for voluntarily retiring because of the closure. However, instead of treating it as capital receipt, the employee reported it for tax and claimed substantial relief under Section 89 for arrears or advance salary.

In the end, the tax tribunal sided with the employeebecause, based on the case’s details, the severance payment was deemed a voluntary ex-gratia payment received under a specially designed financial scheme and not a contractual payment due to job termination.


ITAT Pune also pointed out that the employer had set up the scheme as voluntary retirement instead of an employer-initiated termination, and the payment wasn’t made under any legal or contractual obligation.

Akhil Chandna, Partner, Global People Solutions Leader, Grant Thornton Bharat says: “Following its earlier decisions in similar matters involving employees under the same scheme, the Tribunal concluded that the receipt was capital in nature and therefore not liable to tax.”

So to sum it up, whether severance pay is taxable really hinges on the legal nature of the payment, and not just when it’s paid or that it’s given when employment ends.

For those curious about normal severance pay, it’s important to point out that according to Section 17(3) (iii), the law clearly states that any amount received in connection with the commencement or cessation of employment is taxable salary, unless there is a specific exemption under Section 10.

So, after April 1, 2002, the tax status of these payments doesn’t rely on what they are called (like severance, ex-gratia or compensation), how they are paid or if the payment was voluntary or contractual.

Chartered Accountant Suresh Surana says: “The legal presumption now is that all termination-related amounts constitute “profits in lieu of salary” and are taxable, except where expressly exempted under the Income Tax Act.”

Also read: Employee wrongly reported Rs 65.21 lakh VRS payout in ITR, lost tax relief; ITAT Pune rules the amount is not taxable and grants him relief

Read on to know more about taxation of severance pay received under a VRS scheme.

Summary of what had happened in the ITAT Pune case

Chartered Accountat Suresh Surana says that in this case (ITA No.2180/PUN/2025) ITAT Pune allowed the appeal of the employee and held that the amount received by him under the Pfizer Healthcare India Private Limited Finance Scheme for Employees at Aurangabad, 2019 was a capital receipt and not chargeable to tax.

According to Surana, the taxpayer was an ex-employee of Pfizer Healthcare India Pvt. Ltd., Aurangabad.

During FY 2018-19, Pfizer India introduced a financial scheme for employees at its Aurangabad plant due to closure of the said plant. So this taxpayer had opted for voluntary retirement under the scheme and received an aggregate amount of Rs 65 lakh, comprising ex-gratia/severance pay, early bid and group participation incentives, and notice period payout.

However, in his income tax return (ITR) the taxpayer had claimed relief under section 89 of the Income-tax Act, 1961, treating the Rs 65 lakh amount as advance salary. This mistake was caught by the Income Tax Assessing Officer who at once rejected his claim of relief under section 89.

Feeling aggrieved when the taxpayer filed an appeal, the CIT(A)/NFAC held that the amount was taxable as “Income from Other Sources” under section 56(2)(xi), on the basis that it was received in connection with termination of employment.

Thus the taxpayer filed another appeal with ITAT Pune and argued that the Rs 65 lakh amount he got from Pfizer India was received on his voluntary retirement/resignation under a special scheme and not due to termination of employment.

To support his arguments, the taxpayer presented judgements of earlier decisions of ITAT Pune which involved similarly placed employees of Pfizer India, where similar receipts under the same scheme were held to be capital receipts not chargeable to tax.

The taxpayer's chartered accountants Nikhil S Pathak and Archana Shetty further argued that Section 56(2)(xi) applies only where compensation or other payment is received in connection with termination of employment or modification of employment terms, whereas the scheme itself clarified that the cessation of employment constituted resignation and not retrenchment or termination by the company.

Ultimately after hearing their arguments, the ITAT Pune accepted the taxpayer's contentions. ITAT Pune said that as per the legal clauses of the scheme floated by Pfizer India employees opting for voluntary retirement were not entitled to compensation or notice pay under the Industrial Disputes Act, 1947, and their cessation from employment was specifically treated as resignation, not retrenchment or termination of employment by the company.

Surana says: "On this basis, the ITAT Pune held that section 56(2)(xi) could not be applied, since the amount was not received in connection with termination of employment."

ITAT Pune also said that the lower authorities had failed to follow binding precedent and consistency on an identical factual matrix.

Is severance pay received under a voluntary retirement scheme taxable?

The taxability of severance pay cannot be determined solely by the fact that it is received under a voluntary retirement scheme. The character of the payment, the terms of the employer’s scheme, and the statutory provision under which it is sought to be taxed are equally relevant.

In the recent ITAT Pune ruling as explained above, Chandna says the tax tribunal observed that where an employer voluntarily grants an ex-gratia amount under a specially designed separation scheme, without any contractual or statutory obligation, and the payment is made towards loss of employment rather than as remuneration for services or termination, such receipt may assume the character of a capital receipt.

Chandna says: “Consequently, in the specific facts before the tax tribunal, the amount was held not chargeable to tax.”

However, this should not be interpreted as a blanket exemption. Salary components, notice pay, contractual termination benefits or payments specifically covered by charging provisions would continue to be taxable based on their nature.

Are ex-gratia payments received on loss of employment always taxable?

No. Ex-gratia payments are not taxable merely because they are received at the time of separation from employment. According to Chandna, their tax treatment depends on the legal character of the payment.

Thus, if an ex-gratia payment is made pursuant to an employment contract, statutory obligation or represents compensation in lieu of salary, it would generally fall within the charging provisions of the Income-tax law.

On the other hand, when the payment is entirely discretionary, made voluntarily by the employer and is not linked to any enforceable right of the employee, Chandna points out that courts have, in appropriate situations, treated these as capital receipts.

Chandna says: “Accordingly, the existence of an employer-employee relationship alone is not decisive; the underlying legal obligation and purpose of the payment assume greater significance.”

Also read: Rs 2.25-crore notice under Black Money Act to Delhi couple over Singapore, British Virgin Islands assets: ITAT Delhi gave full relief to taxpayer, know why

Does the wording of an employer's VRS determine the taxability of severance pay?

Yes, the drafting of the scheme can have significant tax implications. Courts and tribunals generally consider the substance of the arrangement rather than relying solely on what it is called.

In the recent ruling, considerable importance was given to the language of the employer’s scheme, which specifically treated the employee’s exit as voluntary resignation instead of termination of employment. The ITAT Pune considered this distinction while evaluating the applicability of provisions relating to termination compensation.

Chandna says: “That said, documentation alone cannot determine taxability. The actual nature of the payment, surrounding circumstances and statutory framework will continue to govern the final tax position.”