Skipping notice period leads to a tax trap. Budget 2025 should address this | Mint

Switching jobs often brings excitement—a new role, better pay, fresh challenges. But it also comes with its share of challenges, and one of the trickiest is serving out your notice period. For many employees, the solution seems simple: allow the employer to deduct the penalty for skipping the notice, especially if the new company agrees to compensate you. Problem solved, right? Not quite. What most employees fail to realize is that this workaround can trigger an unexpected tax burden, leaving them paying taxes on income they never actually received.

Skipping a notice period doesn’t just mean forfeiting salary—it can also lead to double taxation. Employees are taxed both on the salary deducted by their previous employer and on the compensation paid by their new employer. It’s a tax trap that catches many by surprise.

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Consider this: skipping a notice period doesn’t just cost you a salary deduction—it could result in double taxation. Employees end up taxed on both the salary the previous employer deducts and the compensation the new employer pays to make up for it. It’s a tax trap that catches many by surprise.

Take the example of Mr. A, who earns a monthly salary of ₹1 lakh. Upon resigning, he is required to serve a two-month notice period, but chooses not to. As a result, his employer recovers ₹2 lakh, classifying it as notice period recovery. While Mr. A doesn’t mind this deduction, as his new employer compensates him with ₹2 lakh for joining early, he is taken aback when he realizes he is taxed on his full 12-month salary by his previous employer. Additionally, the ₹2 lakh received from the new employer is also taxed. As a result, he ends up paying tax on ₹14 lakh, despite only receiving ₹12 lakh in total.

“If the employer deducts an amount from the employee’s salary for unserved notice, the entire gross salary (before the deduction) is considered taxable income. This means the employee pays tax on income he never received. On the other hand, if the new employer repays the notice period to the employee recovered from him, this payment is added to the employee’s taxable income,” said CA Naveen Wadhwa, vice president, Research and Advisory at Taxmann.

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The root of this issue lies in the Income-Tax Act, which taxes salary income on a “due or receipt” basis, whichever occurs first, Wadhwa explains. According to Section 15 of the Act, employees are taxed on the full salary owed to them, regardless of whether they actually receive it. While businesses can claim deductions for bad debts or unrecovered income, employees have no such recourse to adjust for the salary they never pocketed.

Why does this happen?

Under the Income-Tax Act, salary income is taxed on a “due or receipt” basis, whichever comes first. As CA Naveen Wadhwa explains, Section 15 of the Act charges tax when salary becomes due, regardless of whether it is actually paid. This framework offers no explicit relief for employees in cases of notice period recovery. 

While the Act permits three deductions from salary income—Standard Deduction, Deduction for Entertainment Allowance, and Deduction for Professional Tax—it does not allow employees to adjust for salary they never received. In contrast, businesses can claim deductions for bad debts or operational losses. This imbalance leaves employees at a distinct disadvantage, effectively forcing them to bear a tax burden on non-existent income.

What needs to change?

Addressing this anomaly should be a priority in Budget 2025. 

Wadhwa suggests amending the Income-Tax Act to allow employees to claim deductions for notice period recovery under Section 16. This adjustment would ensure that employees are not taxed on amounts they never received. To implement this, employers would need to report recovered amounts separately in Form 16 so that the adjusted net salary is accurately reflected in the employee’s taxable income.

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Additionally, Wadhwa highlights the need to prevent double taxation. If recovered amounts are treated as income for the employer, they should not simultaneously be taxed in the hands of the employee.

This unexpected tax implication is inherently unfair, Wadhwa notes. The employee is taxed on income they never received, while the employer also pays tax on the recovered amount as part of its income.

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With Budget 2025, the finance ministry has an opportunity to rectify this oversight, he said. Introducing a provision to exempt notice period recovery from taxable income for employees would provide much-needed relief and establish greater fairness in the tax system.