How are Arrears of Salary Taxed Under the Income Tax Act?

You’ve just received a significant lump sum in your bank account from your employer as ‘salary arrears’. While it’s great news, it also brings a common worry: will you have to pay a much higher tax this year? This is a frequent concern for many salaried professionals, especially when a delayed pay hike inflates their annual income. The Indian tax system has specific provisions to handle such situations, and understanding how arrears of salary [are] taxed under the Income Tax Act is crucial to avoid an unnecessary tax burden. Receiving a large sum can push you into a higher tax bracket for the current financial year, leading to a substantial tax outgo. However, to prevent this unfair tax burden, the Income Tax Act provides a special relief mechanism. This article will guide you through the rules, the available relief, and the steps you need to take to save tax legally. For a broader overview, you can also explore the Top 10 Tax Deductions for Salaried Employees in India.

What Exactly are Salary Arrears?

Before diving into the tax implications, it’s essential to understand what constitutes salary arrears. A clear grasp of this concept forms the foundation for managing your tax liability effectively.

A Simple Definition of Salary Arrears

In simple terms, salary arrears are past dues that an employer pays to an employee in the current financial year. It represents the difference between what an employee should have earned in a previous period and what they were actually paid during that time. This amount is paid later due to various reasons but pertains to the work done in a prior financial year. For instance, if your company announces a salary increase in September but makes it effective from April of the same year, the accumulated difference for April through August, paid in September, is considered salary arrears. This is a key concept for understanding salary arrears tax in India.

Common Scenarios Leading to Salary Arrears

Salary arrears can arise from several common situations faced by employees in both the public and private sectors. Being able to identify these scenarios can help you anticipate the tax implications.

Retrospective Salary Increments: This is the most common reason. A company might finalize its appraisal cycle and announce salary hikes a few months into the financial year but make them effective from the beginning of the year (e.g., a hike announced in August but effective from April).
Implementation of Pay Commission Recommendations: Government employees often receive substantial arrears when a new Pay Commission’s recommendations are implemented, as these are usually applied retrospectively from an earlier date.
Settlement of Legal Disputes: If there was a dispute between an employee and employer regarding wages, a settlement or court order might result in the payment of past dues as arrears.
Delayed Payments by the Employer: Sometimes, due to administrative delays or financial constraints, an employer might delay the payment of a revised salary, leading to the accumulation of arrears.

The General Rule: How is Arrears of Salary Taxed Under the Income Tax Act?

The fundamental principle governing the taxation of salary is straightforward but can be disadvantageous when it comes to arrears. According to the income tax act salary arrears India, any salary, including arrears, is taxable in the financial year in which it is received by the employee, regardless of the year(s) to which it pertains. This is known as the “due or receipt, whichever is earlier” basis, but for arrears, it almost always falls under the ‘receipt’ basis.

This rule can create a significant tax problem. Let’s illustrate with a simple example. Suppose your taxable income for the financial year is ₹8,00,000, which places you in the 20% tax slab under the old tax regime. Now, imagine you receive ₹3,00,000 in salary arrears related to the previous two years. Because it’s taxed in the year of receipt, your total taxable income for the current year shoots up to ₹11,00,000. This increase pushes a portion of your income into the 30% tax slab, forcing you to pay a much higher tax than you would have if the amount was paid on time. This is one of the most important salary arrears taxation rules India that every salaried individual must know.

Tax Relief Under Section 89(1): Your Key to Saving Tax

To address the unfairness of being taxed at a higher rate due to delayed payments, the Income Tax Act offers a powerful remedy: Relief under Section 89(1). This provision is designed specifically to protect taxpayers from an increased tax burden arising from income received in arrears or advance.

The core principle behind this relief is to calculate your tax liability as if the arrears were received in the respective years they were originally due. The system then compares the tax you are paying in the current year (with arrears) against the sum of taxes you would have paid if the amounts were received on time in the previous years. The difference is provided as a tax relief, ensuring that you don’t pay more tax simply because of your employer’s delay. This relief is a significant benefit for the taxation of salary arrears for salaried individuals.

However, there is a crucial condition to claim this benefit. It is mandatory to file Form 10E online on the income tax portal. If you claim relief under Section 89(1) in your Income Tax Return (ITR) without first submitting Form 10E, the Income Tax Department will likely process your return without the relief and may even send you a notice for incorrect tax computation.

Step-by-Step Guide to Salary Arrears Tax Calculation in India

The calculation for relief under Section 89(1) can seem intimidating, but it follows a logical, step-by-step process. The goal is to determine the excess tax you are paying in the current year due to the arrears and subtract the additional tax you would have paid if the arrears were received in the past.

Here’s a breakdown of the salary arrears tax calculation India:

Step 1: Calculate Tax on Total Income (Including Arrears) for the Current Year

First, compute the tax payable on your total income for the current financial year. This income includes your regular salary, any other income, and the full amount of salary arrears received. Let’s call this final tax amount Tax (A).

Step 2: Calculate Tax on Total Income (Excluding Arrears) for the Current Year

Next, calculate the tax payable on your income for the current financial year without including the salary arrears. This shows how much tax you would have normally paid. Let’s call this amount Tax (B).

Step 3: Find the Tax Difference for the Current Year

Subtract the tax from Step 2 from the tax in Step 1. The formula is (Tax A – Tax B). This result represents the additional, and potentially higher, tax you are paying on the arrears amount in the current year.

Step 4: Calculate Tax for the Pertaining Year(s)

Now, you need to go back to the financial year(s) to which the arrears belong. For each of those years, recalculate your total income by adding the portion of the arrears that pertains to that specific year. Then, compute the tax on this revised income. Let’s call this Tax (C). After that, find the actual tax you paid for that year (on income without the arrears portion). Let’s call this Tax (D).

Step 5: Find the Tax Difference for the Previous Year(s)

For each relevant past year, calculate the difference using the formula (Tax C – Tax D). This result is the additional tax you would have paid in that year if the arrears had been received on time. If the arrears pertain to multiple years, repeat this step for each year and add all the differences together to get a total.

Step 6: Determine the Final Tax Relief

The final step is to find the difference between the excess tax paid in the current year (Step 3) and the sum of additional taxes that would have been paid in the previous years (Step 5).

Final Relief = (Result of Step 3) – (Result of Step 5)

If this final number is positive, it is the amount of tax relief you can claim under Section 89(1). If it is negative, no relief is available.

Actionable Tip: This calculation requires historical salary and tax data and can be complex. To avoid errors, it is highly recommended to use the income tax department’s online utilities or consult a tax professional. The experts at TaxRobo can handle this complex calculation for you, ensuring accuracy and maximum relief.

How to Claim Relief: A Practical Guide to Filing Form 10E

Claiming the relief is not automatic; you must proactively file Form 10E. Here’s a practical guide on how to do it correctly.

Form 10E must be filed electronically through the official Income Tax India E-Filing Portal. It cannot be filed physically. The process involves logging into your account, navigating to the e-File section, and selecting ‘Form 10E’.

The most important rule to remember is the deadline: Form 10E must be filed before you file your Income Tax Return (ITR). For more details on the general process, you can refer to our Step-by-Step Guide to Filing Income Tax Returns for Salaried Individuals in India. The portal will not allow you to claim relief under Section 89(1) in your ITR form if a corresponding Form 10E has not been filed for that assessment year. Properly filing Form 10E is essential to manage the income tax implications of salary dues.

To complete the form, you will need the following information:

Your PAN and the relevant Assessment Year.
Your employment details.
A detailed breakup of the salary arrears received, specifying the amounts pertaining to each previous financial year. This information is typically provided by your employer in Annexure-I of the form.

Once you fill in the details and submit the form, a confirmation is generated. You do not need to attach this with your ITR, but you should save a copy for your records.

Conclusion

Receiving salary arrears can significantly boost your finances, but it shouldn’t come at the cost of an unfair tax burden. By understanding how arrears of salary [are] taxed under the Income Tax Act and utilizing the provisions available, you can ensure your tax liability remains fair and justified.

Let’s quickly recap the key takeaways:

Taxed on Receipt: Salary arrears are taxed in the financial year you receive them, not when they were earned.
Higher Tax Slab Risk: This can artificially inflate your income for the year, pushing you into a higher tax bracket.
Section 89(1) is the Solution: The Income Tax Act provides relief under Section 89(1) to prevent this excess tax burden.
Form 10E is Mandatory: To claim this relief, you must file Form 10E online before filing your ITR.

Navigating tax rules can be tricky. If you need help with your salary arrears tax calculation India or ITR filing, the experts at TaxRobo are here to assist. Contact us today for seamless tax compliance!

FAQs: Taxation of Salary Arrears

Q1. Is it mandatory to file Form 10E to claim relief on salary arrears?

A: Yes, absolutely. As per the guidelines from the Central Board of Direct Taxes (CBDT), filing Form 10E on the e-filing portal is a mandatory prerequisite for claiming relief under Section 89(1). If you claim the relief in your ITR without having filed the form, your claim will be disallowed by the tax department during processing.

Q2. What happens if I received arrears but forgot to claim relief under Section 89(1)?

A: If you fail to claim the relief, you will end up paying a higher tax for that year. The entire arrears amount will be added to your income and taxed according to the slab rates of the year of receipt. However, if you are still within the time limit for filing a revised return, you can file Form 10E and then submit a revised ITR to claim the relief you missed.

Q3. Can my employer provide me relief under Section 89(1) and deduct lower TDS?

A: Yes. An employee can submit a filled Form 10E to their employer. Based on the details provided in the form, the employer can calculate the relief under Section 89(1) and factor it in while computing the monthly Tax Deducted at Source (TDS). This is part of Section 192: TDS on Salary – Employer’s Responsibilities. This will result in a lower tax deduction from your salary, improving your in-hand income during the year.

Q4. Does this tax relief apply to advance salary as well?

A: Yes, the relief under Section 89(1) is not limited to arrears. It can also be claimed on salary received in advance. The calculation procedure is similar, where the tax impact is spread over the years to which the advance salary pertains, ensuring you are not unfairly taxed in the year of receipt.