QUESTION: Our firm had to pay damages along with interest as a result of the order of the Labour Court for wrongful termination of service of an employee. The employee had filed a legal opinion stating that neither the damages nor interest would require tax deduction at source. We had apprehensions as regards the correctness of the legal opinion, since Sec. 17(3)(iii)(B) brings to tax all payments “after cessation of his employment”, while interest should ordinarily be taxable under “Other sources” and tax deductible under Sec. 194A. We, however, have disbursed the part relating to damages without deduction of tax, but deducted tax from interest part. We have now received a request for refund of tax deducted on the ground that the deduction is incorrect. What is the legal position?
ANSWER: Now that tax has been deducted at source in respect of interest and deposited with the government, the only course for the employee is to file a return and claim refund of the tax deducted, while claiming that the damages, including interest, would not be liable to tax. Reference to Sec. 17(3)(iii)(B) is misplaced, because it refers to payment in the nature of salary for services rendered and cannot possibly cover compensation for wrongful dismissal. Where the compensation is given for sterilisation of a source of income, such compensation is a capital receipt as was decided by the Supreme Court in P. H. Divecha v CIT (1963) 48 ITR 222 (SC) and a number of other decisions following the same.
As for interest, the test to be applied is, whether interest given is part of the damages measured with reference to the delay in grant of such damages or whether interest is independently payable for the delay in disbursement of damages.
Where interest is statutorily to be given independently of damages, it is bound to be treated as interest liable to tax as decided in CIT v T. N. K. Govindarajulu Chetty (1087) 165 ITR 231 (SC) .
Where, however, interest is awarded by the Court in its discretion, such interest has to be treated as part of damages as was decided in identical circumstances, where damages along with interest was paid to an employee for wrongful dismissal in Sushil Kumar Das v ITO (2011) 11 ITR (Trib) 17 (Kolkata) . In fact, in this case, the assessee had wrongly included interest as part of his taxable income and paid the tax on the same but contested the taxability by filing an appeal, which was allowed by the Tribunal in CIT v Charanjit Jawa (2004) 270 ITR 173 (P&H) . In another case, where compensation was awarded by Motor Accident Claims Tribunal along with interest, such compensation as well as interest was treated as not taxable being a capital receipt with interest being a component of the damages, so as to be not liable for tax deduction at source as held in New India Assurance Co. Ltd. v Mani (2004) 270 ITR 394 (Mad) .
