An ex gratia payment is an extra payment made by the employer, and such an amount without any legal obligation is not taxable. In other words,Ex gratia is the additional payment made by the employer out of their goodwill.

While various courts have held that such voluntary payment of ex gratia without any legal obligation and not in lieu of services rendered by the employee would be considered as a capital receipt and, therefore, not taxable, most of these decisions were before the introduction of section 56(2)(x).

Section 56(2)(x) of the Income Tax Act taxes any money, property, or other assets received without adequate consideration if their value exceeds Rs. 50,000. It was introduced to prevent tax evasion through gifts and non-compensatory transfers, thereby ensuring transparency and fairness in asset transfers.Any income which is not chargeable to tax under any other heads of income and which is not to be excluded from the total income shall be chargeable to tax as residuary income under the head “Income from Other Sources”

You can consult any lawyer from this forum or a Chartered accountant in the local for all such further clarifications.

Based on established judicial precedents and the specific fact pattern, the ex-gratia payment should be treated as a capital receipt and is not taxable.

Key Legal Principles

1. Voluntary vs Obligatory Payment
Since the payment is explicitly described as discretionary and voluntary without any legal obligation in the employment agreement, it qualifies as a true ex-gratia payment.

2. Judicial Precedents Supporting Capital Receipt Treatment:

• CIT v. Jamini Mohan Kar (1989) 176 ITR 127 (Cal): Payment was ex-gratia, totally voluntary, and not compensation implying obligation to pay

• Arunbhai R. Naik v. ITO (2015) 379 ITR 511 (Guj): Ex-gratia amount without employer obligation is not taxable as profits in lieu of salary

• Recent ITAT Ahmedabad ruling (2025): Severance compensation for employment loss is capital receipt, not profits in lieu of salary

Analysis by Tax Provisions

Section 17(3) - Does NOT Apply:

• Requires "compensation" which implies legal obligation

• True ex-gratia payments are voluntary without obligation

• Resignation vs Termination: The distinction is irrelevant when payment is genuinely voluntary without contractual obligation

Section 56(2)(xi) - Does NOT Apply:

• This provision typically covers gifts/receipts from non-employers

• Employment-related voluntary payments fall under capital receipt doctrine

Employer's TDS Deduction Issue

The fact that employer deducted TDS and showed it under "Salaries" in Form 16 does not determine the tax treatment. The legal nature of the receipt depends on:

• Absence of legal obligation

• Voluntary nature of payment

• Purpose of compensation (goodwill gesture)

Recommended Action

1. Claim as capital receipt in ITR-2

2. Seek refund of TDS deducted by employer

3. File representation with employer to issue corrected Form 16

Supporting Documentation

Maintain evidence showing:

• Mutual Separation Agreement terms

• Absence of obligation in employment contract

• Voluntary and discretionary nature of payment

Ex gratia payments are not taxable in India unless they are made in lieu of salary or wages.

2) ur can be treated as capital receipt 

3) . Taxable income under "profits in lieu of salary" [s.17(3)]: This applies when the ex-gratia is received in connection with the termination of employment or modification of its terms and conditions, or as part of a settlement for a legal dispute related to employment.

4) Taxable income under "income from other sources" [s.56(2)(xi)]: This could potentially apply if the ex-gratia payment doesn't fall under "profits in lieu of salary" (Section 17(3)) and it is a voluntary payment received without consideration from a person, like an employer. 

It’s not taxable if not given in place of salary 

1. Tax Treatment of Ex-Gratia Payment:

• Ex-gratia payments made voluntarily by the employer without any legal or contractual obligation are generally considered as capital receipts and hence non-taxable under the Income Tax Act, unless made in lieu of salary or wages.

• However, if the ex-gratia payment is paid "in connection with the termination of employment" or in lieu of salary, it is taxable under Section 17(3) of the Income Tax Act as “profits in lieu of salary,” and included under the head “Income from Salary.” Tax Deducted at Source (TDS) under Section 192 on such payments is consistent with this interpretation.

• Taxation under Section 56(2)(xi) as “Income from Other Sources” generally applies to compensation or payments received in cases like termination or changes in terms of contract where it does not amount to salary income. This, however, is less common for ex-gratia payments relating to employment cessation.

1. Judicial Precedents and Thought Process:

• Several judicial rulings, including by the Calcutta High Court in CIT v. Ajit Kumar Bose and CIT v. Jamini Mohan Kar, have held that when ex-gratia payments are entirely voluntary and not compensation for loss of employment or salary, such amounts are capital receipts and not taxable as salary income.

• The key factor is the nature and terms of payment: if the payment lacks any obligation by the employer and is over and above all due amounts, it may qualify as a capital receipt.

1. Effect of Resignation vs Termination on Sections 17(3) and 56(2)(xi):

• Section 17(3) refers broadly to payments on or in connection with "termination of employment" which includes resignation, retirement, or dismissal.

• The fact that the employee resigned and was not terminated does not automatically exclude the applicability of Section 17(3), as courts have interpreted “termination” to include resignation for these purposes. However, the circumstances and agreement terms are important to examine whether the payment is indeed “in lieu of salary” or “voluntary.”

• Section 56(2)(xi) also refers to compensation on termination or change in contract, but its relevance depends on facts and whether the payment is distinct from salary income.

1. Applicable Legal Provisions:

• Section 17(3) of the Income Tax Act, 1961: covers “profits in lieu of salary” including compensation on termination.

• Section 56(2)(xi): covers “income from other sources” including compensation not chargeable under salary heads.

• Section 10(10B) and Section 10(10C): provide exemptions for retrenchment compensation and voluntary retirement scheme payments respectively, which do not appear applicable here.

Summary:

Given the Mutual Separation Agreement specifies the ex-gratia as a discretionary payment, additional to amounts due and without any legal obligation by the employer, you have a strong basis to contend it is a capital receipt and not taxable under salary income. However, the employer's classification and TDS deduction under salary may indicate their view of it as profits in lieu of salary under Section 17(3).

The distinction depends on detailed factual and documentary analysis, including the terms of your separation, correspondence, and the nature of the payment. Judicial precedents favor non-taxability when truly voluntary, but tax authorities may take a different stance.

If you require, we can assist in drafting a detailed legal opinion after a comprehensive review of your documents and, if needed, represent you for any clarifications or dispute with the tax authorities.

Please contact us at https://share.google/bu3E5OkfoZj2TKOSO to engage our services for a formal legal opinion on this matter or any further assistance you may require.