Salary paid in arrears – tax treatment

Though this is a topic that has been covered in the past, at least from our email box, it seems to us that reader understanding of this subject is not too clear. Routinely, we receive emails querying the income tax treatment, if any, on arrears of pay. Some taxpayers weren’t even aware of the tax deduction available and went ahead and paid full tax on the income without claiming any deduction. Therefore, a reiteration of this topic is well overdue.

When arrears of pay are received in any particular year, it could artificially raise the tax liability in that year. This happens because due to the receipt of arrears, the total income and consequently the tax payable increases. For instance, Vikram worked as a sales representative of a leading branded jewellery manufacturer. His remuneration was payable on a salary cum commission basis. On account of some reconciliation issues with the head office, the commission payable in respect of some sales made in the year 2011 remained unpaid. In time, the issue was resolved and the outstanding amount due to Vikram was paid to him in 2018. However, this was unfair to Vikram. Had he originally received the money in the years that he was supposed to receive it, the additional tax would have been staggered over the years instead of converging in one year as a lump sum payment.

Therefore, the law allows a tax deduction under Sec. 89(1) for this additional tax burden and we will be examining the same in detail. Incidentally, this deduction is available to every taxpayer who gets salary in advance or in arrears, whether such person is a government employee or is working in the private sector.

Sec. 89(1)

Basically, the relief under Sec. 89(1) is arithmetical. It involves the ascertaining the two amounts of tax – the first is the amount of tax applicable to the total income including the extra amount in the year of receipt. The second is calculating the amount of tax by adding the arrears to the total income of the years to which they relate. The difference between the two amounts 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 otherwise paid, had he received the money in the year(s) that he was supposed to receive it, such additional tax need not be paid i.e. it can be reduced from the tax payable.

Let us take a numerical example to understand this issue.

In the aforementioned case, let’s say Vikram receives Rs 2 lakh in the current year as arrears of pay. This money was actually the additional sales incentive pertaining to the year 2011.

Now let’s assume that ordinarily, as per his salary level, Vikram would have paid a tax of Rs 1,80,000. But just because of the inclusion of the sales incentive his tax payable climbs to Rs 2,40,000. Now, for a moment let’s go back to the year 2011. That year, Vikram had paid a tax of Rs 1,35,000. But had the sales incentive been paid to him then itself, he would have paid a higher tax of Rs 1,70,000. Given this data, let us calculate the tax deduction available to Vikram. (Note that these figures are hypothetical and meant as an example for ease of understanding – in reality, actual computations will have to be undertaken.)

To sum

For simplicity and ease of understanding, in the example, we have assumed that the arrears are being received only in respect of one year i.e. 2011. In practical life, generally, arrears may be received for multiple years in the past. In such cases, the computation of tax for each individual year would have to be undertaken to arrive at the accurate amount of the additional tax payable.

Also it is important to note that since a deduction under Sec. 89(1) reduces the final amount of tax payable, to that extent, it would also reduce the TDS on salary. Employees should indicate to the employer that a lower TDS needs to be deducted by way of furnishing Form No. 10E. This form represents a true and authentic statement of the total income of the earlier yeas to which the arrears pertain. There is no warrant for a notice under Sec. 148 or calling for returns of income of the earlier years. (Circular No. 331, dated 22.3.1982)

Lastly, since it is the extra tax on the arrears that is the relief admissible under Sec. 89(1), it follows that if there is no excess, no relief is admissible. In other words, if the tax in the year of receipt works out to be actually lower than what was payable in the past, no relief under Sec. 89(1) can be claimed.