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Tax implications on salary received in arrears
June, 04th 2009

The entire concept of 'arrears of salary' has shot into the lime light as a result of the recent recommendations of the Sixth Pay Commission, which have resulted in a revision in the pay scale of government and public sector employees with a retrospective effect from January 1, 2006. According to reports, the Government has allocated an amount of approximately Rs. 29,000 crores for the purpose of paying 'arrears' to around 5 million central government employees. But, along with this big bonanza, there is also a question that is dwelling in the minds of these employees. The question arises that arises is how much Income tax is payable on the salary arrears and is there any relief available?

It is not just government employees, but even you and me who could end up getting a salary cheque from a former employer, especially during these tough financial times, when an employer, say a start -up company, may not be able to pay salary and may do so much later.

Debate on taxability of the arrears

Salary due in earlier years from an employer or a former employer, which has not been paid or charged to tax in those years, constitutes 'arrears' of salary. As per the provisions of the Income tax Act, 1961 ('Act'), any arrears of the salary paid or allowed to an employee in the previous year by or on behalf of an employer or a former employer, if not charged to income-tax for any previous year, are chargeable to income tax during the given year under the head 'Salaries'.

In other words the same is taxable in the year of payment of the arrears.

As far as the Sixth Pay Commission announcements are concerned, in an effort to reduce the burden of the pay hikes on the exchequer, the Government announced that 40 per cent of the arrears from the period January 1, 2006 to August 31, 2008 would be disbursed in the financial year 2008-09 and the balance 60 per cent of the arrears in the financial year 2009-10. The decision to disburse the arrears in two installments, however, led to conflicting views about the tax to be deducted at source on such arrears paid to employees.

Putting an end to this debate, the Central Board of Direct Taxes ('CBDT') issued a clarification on September 30, 2008 stating that only the tax on the first installment payable in financial year 2008-09 will be deducted in the financial year 2008-09. Since the balance 60 per cent of arrears does not fall in the category of due or paid in the financial Year 2008-09, the tax on the same will be deducted in the financial Year 2009-10. This clarification proved to be a welcome respite to the government servants, since, for most of the senior officials the tax burden of the lump-sum salary arrears would have almost negated the effect of the entire amount of 40 percent arrears to be paid to them this year.

The arrears of salary relating to past services could lead to a higher tax incidence for the employees as a result of being taxed in the year of receipt. This is primarily due to progressively increasing slab rates of tax. A change in the income tax slab results in a corresponding change in the rate and quantum of income-tax and surcharge. This could result in a higher tax incidence, which would be unfair to the employees, since, had they originally received the money in the year(s) that it pertains to, the additional tax would have been staggered over the years, instead, of accumulating in a single year as a lump sum payment.

The provisions of Section 89 of the Act come as a relief in this context, as they allow a tax deduction for this additional tax burden on employees receiving salary arrears.

Section 89 is a beneficial provision under Chapter VIII of the Income-tax Act (the Act), which relates to "Rebates and Relief". The objective of this section is to mitigate hardship caused because of high incidence of tax due to progressively increasing slab rates. The benefit under this is available to every taxpayer who gets salary in advance or in arrears irrespective of being a government employee or private sector employee.

Basically, the relief under Section 89(1) is arithmetical and involves ascertaining two amounts of tax. The first is the amount of tax applicable to the total income, including, the arrears in the year of receipt. The second is the amount of tax by adding arrears to the total income of the years to which they relate. The difference between the two amounts of tax is the amount of deduction allowed. In other words, if the taxpayer is required to pay any additional amount of tax (in the year of receipt) than what he would have originally paid had he received the money in the year(s) that he was supposed to receive it, such additional tax can be reduced from the tax payable.
Accordingly, the tax payer can claim relief in the return of income for the financial year in which the arrears are received.

Therefore, the government employees who have received arrears for the financial year 2005-06 to the financial year 2007-08 in the financial year 2008-09, have an option to compare the tax on the arrears, as per the tax slabs for the relevant past years with the tax computed, as per the stipulated rate for the financial year 2008-09. The relief can be worked out and allowed at the time of deduction of the tax at source by his present employer in the year in which arrears are received. The employee will have to provide the necessary particulars of salary arrears to his present employer in Form 10E. Further, such tax payer is required to maintain the true and authentic statement of the total income of the earlier years to which the arrears pertain.

The following example will illustrate this concept (all numbers are illustrative in nature):

   Particulars         Amount 
1  Tax payable on total income for FY 2008-09, including the arrears   40,000 
2  Tax payable on total income for FY 2008-09, excluding the arrears   20,000 
3  Difference between the tax payable as per step (1) and (2)    20,000 
4  Tax payable on total income for FY 2005-06 to FY 2007-08
   separately including the arrears       84,000 
5  Tax payable on the total income for FY 2005-06 to FY 2007-08
   separately excluding the arrears       66,000 
6  Difference between the tax payable as per step (4) and (5)    18,000 
7  Amount of relief = Amount as per Step (6)-Step (3)     2,000 

Employee A received Rs. 3 lakh as arrears of pay in the financial year 2008-09 for the FY 05-06, FY 06-07 and FY 07-08. Let us assume, under ordinary circumstances he would have paid a tax of Rs. 20,000. However, after inclusion of the arrears, his tax liability increases to Rs. 40,000.

Further, let us assume that Employee A paid a tax of Rs. 21,000, Rs. 22,000 and Rs, 23,000 for the FYs 05-06, 06-07 and 07-08, respectively.

Had he received the income in the year they were due, the tax liability would have been of Rs. 26,000, Rs. 28,000 and Rs. 30,000 respectively.

Using this data, the tax deduction available to Employee A is computed below:

Lastly, if the tax payable in the year of receipt works out to be lower than that payable in the past, the provisions of Section 89(1) do not apply. In other words, if there is no excess tax that the taxpayer is being subjected to on account of receipt of arrears, no relief is admissible.

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