Salaries - 1 | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

Any remuneration paid by an employer to an employee for the services rendered by him is called salary. Salary for income tax purpose not only includes the cash received but also includes the value of facilities and benefits provided to the employee. 

The taxable income under the "Salaries" category includes:

• Any salary owed by a current or former employer from the previous year, regardless of whether it was actually paid during that period.
• Any salary paid or granted to an employee during the previous year by or on behalf of an employer, even if it wasn't yet due or payable.
• Any outstanding salary payment made to an employee during the previous year by or on behalf of an employer or former employer, if it hadn't been previously taxed in an earlier year.
• Any wages received from a current or former employer during the previous year.
• Any pension received by an employee from an employer during the previous year.

According to Section 17 (1) of the Income Tax Act, the term ‘salary’ encompasses:

• Basic salary or Wages
• Bonus
• Commission, fee, and interim relief
• Overtime payments
• Annuity
• Advance salary and arrears of salary
• Annual accretion in the employee’s recognized provident fund
• Taxable part of transferred balance
• Contribution made by the Central Government in the previous year under a notified pension scheme in employees’ account referred to in section 80CCD
• Encashment of earned leave
• Gratuity
• Pension
• Compensation on retrenchment
• Amount received on voluntary retirement

Some Important Points Regarding Salary:

There are some points related to salary that are crucial to understand as they aid in computing the taxable salary of an individual. They are as follows:

• Salaries and Wages: The Income Tax Act makes no distinction between salaries, i.e., remuneration received by executives, and wages, i.e., remuneration received by workers. Both salaries and wages are categorized under the head "salaries."
• Relationship of employee and employer: Any payment will fall under the head ‘salaries’ only when there exists a relationship between employer and employee as the payer and the payee. A person may hold an office and still may not be an employee, for example, a director of a company.
• Salaries and Professional Income: A profession involves the making of successive employment. If such employment is incidental to the exercise of the profession, the remuneration received thereby will be taxed under Section 28. For example, if a Chartered Accountant is appointed to audit the accounts for a particular year, the income from such a contract is professional income and if he is employed to investigate the accounts of the company regularly, the income so received will be salaried income.
• Payment made after cessation of employment: When the employee leaves the organization, the employer pays him a certain sum like gratuity, etc. Any such payment though received after the employee leaves the organization is taxable under the head salaries as it is received for service rendered in the past.
• Tax-free salary: Sometimes, the employer deducts the tax at source and pays net salary to the employee. In such cases, the individual has to show the aggregate salary, i.e., net salary plus tax paid in his gross total income.
• Deductions by employer: There are certain compulsory deductions from salary like contribution to provident fund or charges for providing accommodation which are deducted by the employer and the net salary is given to the employee. Even though the amount has been deducted, it is included in the salary income. The reason is that it is only the application of income.
• Dearness Pay: It is a part of basic salary and is assumed to be given under the terms of employment. For the valuation of rent-free house, house rent allowance, gratuity (other than gratuity under the Payment of Gratuity Act), leave salary, recognized provident fund, and perquisite of gas, electricity, water, it shall be treated as part of basic salary only when it enters into the computation of superannuating or retirement benefits of the assessee concerned.

Due date of salary: The rules are as follows:

• For Government and semi-government employees, the salary is due on the first date of the next month, i.e., the salary for February is due on 1st March. For this purpose, the previous year’s salary will be from 1st March to 28th February of the next year.
• For bank employees and non-government organizations, the salary is due on the last date of the same month, i.e., the salary for February is due on 28th February. For this purpose, the previous year's salary will be from 1st April to 31st March of the next year.
• Dearness allowance: Dearness allowance is deemed to be under the terms of employment in the following two cases:
  • When it is included in ‘salary’ for the purpose of computation of the annual contribution in the recognized provided fund.
  • When it is included in ‘salary’ for the purpose of computation of retirement benefits payable to an employee.
• Voluntary payments: Every payment, in cash or in kind, made by an employer to his employee in consideration of his service under a contract of service or voluntarily, is taxed under the head ‘salaries’. Thus, salary, perquisite, or allowance may come as a gift to an employee, yet it would be taxable. Any payment made by the employer to his employee will not be excluded from his salary income merely because the employer made it voluntarily.
• Salary foregoing or surrendering: Section 15 of the Income Tax Act, 1961, charges salary on a due basis. Tax liability is created at the time the salary becomes due. If an employee foregoes or surrenders his salary, he cannot escape from his tax liability.
• Deduction from salary: Deductions made by the employee out of the salary due to an employee are regarded as the application of income. These deductions may be compulsory or optional or under a contract or voluntarily. In every case, deductions from salary are regarded as the application of income.
• Place of accrual of salary: According to Section 9 of the Act, salary is deemed to accrue at the place where the service for which it is paid is rendered. Salary accrued in India is deemed to accrue or arise in India though it has been paid outside India.

The definition of 'salary' varies depending on the context. The purposes for which the definition of salary differs are as follows:

• Computation of taxable income under the head 'salaries'.
• Calculating the exempted amount of House Rent Allowance under Section 10(13A).
• Calculating the value of rent-free accommodation or accommodation provided at a concessional rate.
• Calculating the qualifying amount of provident fund contributions.
• Calculating the entertainment allowance.
• Calculating exempted gratuity, the exempted portion of encashment of earned leave, etc.
• Calculating the perquisite value of gas, electricity, or water.
• Determining the salary of Rs. 50,000 regarding the taxability of perquisites under Section 17(2)(iii)(c) (specified employees).
• Compensation on retrenchment under Section 10(10B).

Testimonials and personal gifts, which are given purely out of personal affection and regard, although received by an employee from his employer, would not be considered taxable as salary income. However, in a given previous year, if the aggregate value of such gifts, vouchers, or tokens exceeds Rs. 5,000, the excess amount will be considered a taxable perquisite.

Main Items Included in Salary

Salary or Wages

Let us analyze the components of salary income: In the eyes of the law and based on the principle, there is no distinction between salary and wages received by a laborer and the salary received by corporate employees; they are both taxable under the head ‘Salaries’. From an income tax perspective, there is no difference between the two terms. Both salary and wages are taxed under the head salaries. The process of computing taxable salary may be understood through the following headings:

• Computation of gross salary
• Deductions from gross salary
• Computation of taxable salary

Salary or Wages

The term 'salary' may refer to payments made to white-collar workers or higher category employees, such as assistants or officers, while 'wages' may denote payments made to blue-collar workers or casual laborers, etc. However, this distinction is not material for income tax purposes, as both types of payments are taxable under the head 'Salaries'.

According to Section 17(1) of the Income Tax Act, the term 'salary' includes the following receipts:

• Basic salary or Wages;
• Bonus;
• Commission, fee, and interim relief;
• Overtime payments;
• Annuity;
• Advance salary and arrears of salary;
• Annual accretion in the employee’s recognized provident fund;
• Taxable part of transferred balance;
• Contribution made by the central government in the previous year under a notified pension scheme in employees' accounts referred to in section 80CCD;
• Encashment of earned leave;
• Gratuity;
• Pension;
• Compensation on retrenchment;
• Amount received on voluntary retirement.

Illustration 1: Shri Shanker Dayal has been getting a salary @ 3,600 per month since 1st April 2022. He has been allowed an increment of Rs. 200 on 1st August, 2022.Compute his basic salary.
Solution: Computation of basic salary of Shri Shanker Dayal for the Assessment

Encashment of Earned Leave on Retirement

When an employee retires from service or resigns, they may be entitled to different types of leave, such as medical leave, casual leave, and earned leave. Some employers offer cash in exchange for these leaves, which is known as 'leave salary' or 'encashment of earned leave'. This payment is an incentive for employees who do not use their entitled leave, as they receive cash in lieu of the leave not taken. If earned leaves are encashed during service, the entire amount received is taxable to all types of employees, whether they are government or non-government employees. Employees can request relief under Section 89(1) in such cases.

• Encashment of leave at the time of retirement or death: When an employee retires or resigns from service, they may be given a sum of money for their earned leave, known as encashment of earned leave or leave salary. This is also called discounting of leaves. A portion of this money received by the employee is taxable, and the remaining portion is exempt. The provisions of the Income Tax Act regarding the exemption of encashment of earned leave are outlined below:
• Government Employee: The entire amount received by a Central or State Government employee as encashment of earned leave at the time of retirement (whether due to superannuation or otherwise) or resignation is fully exempt from tax. This exemption also applies to voluntary retirement but does not include termination of service. Therefore, this exemption is not available in the case of termination of service. Encashment received by the family members of government employees is also exempt from tax. 'Leave salary' paid to the legal heirs of a deceased employee regarding privilege leave standing to his credit at the time of his death is not taxable as salary; it is fully exempt.

Non-Government Employee (including employees of Local Authorities, Statutory Corporations, and Public Sector Enterprises): The least amount of the following four items is exempt from tax, and the remaining amount is included in the salary:

• Actual amount of encashment of earned leave received, or
• Salary of a maximum of 10 months calculated based on the average salary of the 10 months immediately preceding retirement, or
• Calculated amount of encashment of leave for the approved period not taken during service (maximum period of 30 days for each completed year is approved for encashment of earned leave), or
• The amount specified by the Government, i.e., Rs. 3,00,000

Note:

• The meaning of salary is (Basic Salary + Dearness Pay + Dearness Allowance (if under the terms of employment) + Commission at a fixed rate on turnover achieved by the employee).
• When calculating earned leave, only the total number of years of service completed is considered. Incomplete numbers of months or days are ignored.

Bonus, Fees, Commission, Profit in Lieu of Salary

An employee may receive a bonus, fees, commission, profit in lieu of salary, interim relief, etc., from their employer. Bonuses may be paid monthly, annually, or based on a certain percentage of sales or other measurements. This income is taxable in the year of receipt. If an employee receives arrears of a bonus from a previous year, they can claim relief under Section 89(1).

Pension

• After retirement, an employee is entitled to a monthly pension as per the terms of their employment. Pension received by both government and non-government employees is taxable under the head 'Salaries'. It is taxable on an accrual basis, whether received voluntarily or under a contract. Pension is a periodical or lump-sum payment received by an employee from their employer after retirement from service, and it is taxable as salary income.
• If the employee was receiving tax-free salary, the pension payable to their widow would also be tax-free but treated as family pension in income from other sources. A similar rule applies to the pension paid by a foreign government to its employees serving in India. However, the pension earned and received in the hands of an ordinary resident is taxable.
• Salary and pension received from the United Nations Organization (UNO) are not chargeable to tax in India.

A new pension scheme has been introduced for employees joining Central Government service on or after January 1, 2004. This scheme is mandatory for every employee. Subsequently, most State Governments have also adopted the National Pension System (NPS) for their employees. The law relating to pension is briefly stated below:

• Periodical Pension (Uncommuted Pension): Monthly, yearly, or otherwise paid pension is taxable as salary income in the hands of all employees, including both government and non-government employees.
• Commuted Pension: Sometimes, an employee may opt to receive a lump-sum payment in lieu of monthly pension. This lump sum is known as commuted pension. The provisions for such commutation are as follows:
  
  

• Commutation of pension Section 10 (10A): When an employee receives a lump sum as consideration for commuting his pension, the sum received is considered salary and is taxable according to the following provisions:

• Commuted pension received by Government employees: Any commuted pension received by a Government employee is fully exempt. Additionally, the entire commuted value of the pension received by a government servant who voluntarily resigns and joins the services of a public sector corporation is exempt.

• Commuted pension received by Non-government employees: Commuted pension in this case is exempt from tax to the extent stated below:

  • If the employee is in receipt of gratuity, the commuted value of 1/3rd of the total pension is exempt.

  • In any other case, the commuted value of 1/2 of the total pension is exempt. Any excess over such exempted amount is taxable as salary.

• When the pensioner pays tax on a higher slab rate due to the taxation of commuted pension, he is entitled to relief under section 89(1). Arrears of pension are taxable on a due basis, whether received or not.

Annuity

An annuity is a certain sum paid by the employer to the employee over a specific period for the services rendered. Here are some key points regarding annuity:

• Annuity paid by the current employer is taxable as salary.
• Annuity received from a former employer is also subject to tax.
• Annuity from any other source, such as LIC under an insurance policy, is taxable as 'income from other sources'.

Gratuity [Section 10(10)]

Gratuity is a gift or present given by the employer to the employee in recognition of their long and meritorious services, usually at the time of retirement or death. The Payment of Gratuity Act, 1972 has legally recognized this concept, and most employers provide for gratuity through the terms of employment. The gratuity amount is paid to the employee if they survive until retirement or to their spouse or children if they die before retirement.

The provisions regarding gratuity are as follows:
For government employees [Sec 10(10)(i)]: Any death-cum-retirement gratuity received by Central, State, or Local Government employees is fully exempt from income tax. For employees covered by the Payment of Gratuity Act, 1972 [Sec 10(10)(ii)]: Any gratuity received by an employee covered by the Payment of Gratuity Act, 1972 is exempt from tax to the extent of the least of the following:

• 15 days' salary (7 days in case of employees of a seasonal concern) for each year of service (a period of more than 6 months is considered one year's service) based on the salary last drawn.
• Rs. 20,00,000 as the maximum amount.
• The actual amount of gratuity received.

The taxable gratuity is calculated as the actual gratuity received minus the exempted gratuity. (The meaning of salary for the purpose of computing gratuity includes the last drawn salary plus the last drawn D.A. by the employee, excluding all other payments.)

Note:

• Any bonus, commission, H.R.A., overtime wages or any other allowances is not included.
• Salary of 15 days is calculated as below:

• Salary of 15 days in case of piece rated employee is calculated as below:
• For the purpose of this Act, one month is regarded as 26 days.
• 6 months or more than 6 months shall be considered as one year.

 Compensation on Retrenchment

An employee may be retrenched from service under Industrial Disputes Act, 1947.Two points are important in this connection:

• Retrenchment on winding-up of business
• Transfer of employee from one service to another

If an employee gets some amount of compensation from his employer due to retrenchment, it is included in gross salary. But whole amount of compensation is not taxable. Some part of it is tax-free. Least of the following amounts shall be exempt and remaining taxable amount will be included in the gross salary:

• Actual amount of compensation received;
• Salary for service period calculated on the basis of 15 days’ average salary for each completed calendar year (6 months or more shall be treated one year);
• Amount declared by Central Government- Rs. 5, 00,000. 26 days shall be taken for one month

Computation of 15 days salary shall be computed as below:

Meaning of average salary

Meaning of salary = Basic salary + Dearness Allowance (Whether it is under terms of conditions or not) + Dearness Pay  
Average salary of three months (Including dearness allowance) x 15/26

Note:

• A workman refers to a worker who is covered under the Industrial Dispute Act. This does not include managers, administrators whose salary exceeds Rs. 10,000 per month, and those who are involved in managerial affairs, as well as personnel employed in the army, police services, and navy services.
• A workman can seek relief under Section 89(1) if the amount of compensation on retrenchment exceeds the exempted limit mentioned above.

Voluntary Retirement [Section 10(10C)]:

If an employee of a Public Sector Company or any other organization, authority, corporation, cooperative society, university, Indian Institute of Technology, or management institute notified by the Central Government takes voluntary retirement, the entire amount received or receivable in this context is exempt up to a maximum limit of Rs. 5,00,000. This exemption of up to Rs. 5,00,000 is also applicable to employees of renowned organizations that are nationally or state-famous and are notified by the Central Government. If the sum is received under such a scheme in installments, the exemption can be availed up to a total limit of Rs. 5,00,000. The least of the following is exempt from tax:

• Actual compensation amount received.
• Salary for a 3-month service period of the full year of service.
• The remaining months of service multiplied by the salary at the time of retirement.
• The maximum amount of Rs. 5,00,000.

Advance Salary

Advance salary refers to the salary received by an employee before it is earned by them. It is included in the taxable income of the recipient. However, it is not included when it becomes due. Tax is applicable to all salaries:

• That are due, whether actually paid or not.
• That are paid, whether due or not, to the employee during the financial year.

In accordance with this specific provision, even advance salary received for services yet to be rendered would be taxable in the year of receipt, although such salary is not yet due to the employee. Thus, salary is taxable at the earliest point in time, i.e., on the date of accrual, when it becomes due, or on receipt of salaries.

Advance against salaries:

This refers to a loan obtained by an employee, which will be repaid to the employer in installments along with interest or free of interest, as the case may be. This loan is not treated as salary.

Relief:

It should be noted that when advance salary is taxed in the year of receipt, more than 12 months' salary may be taxed in one previous year. This will increase the income limit, and higher slab rates may be applied in calculating tax payable. In such cases, the employee can apply to the assessing officer in the prescribed form for relief, which will be granted to them under the provisions of Section 89.

Allowances:

All monetary payments made by an employer to employees, other than salary, are termed as allowances. They are fixed, predetermined, and given regularly in addition to salary for the services rendered by the employee. They may be given in the form of reimbursement of some expenditure incurred by the employee or may be given irrespective of actual expenditure. From the income tax viewpoint, allowances may be classified into three parts: fully taxable, partially exempted, and fully exempted, as shown in Table below:

Fully Taxable

Allowances Fully taxable allowances which are shown in the table received by an employee from his employer are included fully in his salary income to ascertain his tax liability.

Partially Exempted Allowances

The allowances which are partially exempted, and the remaining part is taxable treated under this category. The taxable portion is ascertained as below:
(A) House Rent Allowance [Sec 10 (13A)]
Generally, employees receive house rent allowance from their employers to meet the expenditure incurred by them towards house rent. It is exempt from tax subject to the following limits:
Least of the following is exempt from tax:

• Actual House Rent Allowance received by the employee in respect of the relevant period; or
• Rent paid by the employee in excess of 10% of salary due to him in respect of the relevant period; or
• 50% of salary due to him in respect of the relevant period if the accommodation is situated at Mumbai, Kolkata, Delhi, or Chennai; or
• An amount equal to 40% of the salary due to him in respect of the relevant period if the accommodation is situated at any other place.

The least amount is exempt from tax and the remaining amount shall be taxable and is included in the gross salary.  

Note:

• Meaning of salary = Basic salary + Dearness allowance (if it is under the terms of employment) + commission at fixed rate on sale.

'Profits' in Lieu of Salary

Profit in lieu of salary, as defined in Section 17(3), includes:

• Compensation received by an employee upon the termination of their employment or upon the modification of their terms of employment. Compensation is essentially a capital receipt since it is the very source of income, i.e., the salary. Capital receipts are not taxable unless treated as income. In this case, termination compensation is specifically treated as profit in lieu of salary and is thus taxable as salary. Sometimes, future modifications to the terms and conditions of employment may lead to employees receiving lower salaries in exchange for an immediate lump sum consideration. Such payments are also taxable as salary.
• Payments from an unrecognized fund. Any payment received by an assessee from an unrecognized provident fund or any fund (other than an approved superannuation fund) to the extent it consists of the employer’s contribution and interest thereon is taxable as profits in lieu of salary.

Specific exemptions

However, the following payments do not constitute profits in lieu of salary:

• Exempted Gratuity - Section 10(10)
• Exempted value of Commuted Pension - Section 10(10A)
• Exempted amount of Retrenchment Compensation - Section 10(10B)
• Payment from Statutory Provident Fund - Section 10(11)
• Exempted amount from Recognized Provident Fund - Section 10(12)
• Payment from Approved Superannuation Fund - Section 10(13)
• House Rent Allowance.