Tax on arrears of salary to employed assessees- An analysis

Arrears of salary refer to income that pertains to an earlier financial year(s) but is received in a subsequent financial year. Employees may get salary arrears for the current year for any outstanding balances from previous years in a variety of situations to provide modifications.

Further, receiving arrears of salary can significantly impact an individual’s tax liability, often pushing them into a higher tax bracket due to the sudden addition of past income in a single financial year. To address the potential tax burden and ensure fairness, the Income Tax Act, 1961 provides specific provisions for handling arrears of salary.

Arrears are added to the current year's income and taxed at the applicable slab rate. This sudden increase in taxable income can result in-

• A higher tax liability due to progression into a higher tax slab.

• A potential surcharge if total income exceeds prescribed thresholds.

Taxability of Arrears of salary-

Arrears of salary shall be taxable in the year of receipt under Section 15(c) of the Income Tax Act, 1961 if the following two conditions are satisfied.

• 1. That the arrears of salary must have been received in the year; and

• 2. That the arrears so received were not charged to income-tax in any earlier year.

Relief under section 89(1)

To mitigate the tax burden caused by arrears, the Income Tax Act provides relief under Section 89(1), read with Rule 21A of the Income Tax Rules. Relief is granted to ensure the arrears are taxed as if they were received in the year(s) to which they relate, rather than the year of receipt.

Section 89 provides relief from the increased tax burden resulting from receiving arrears of salary relating to earlier years or receiving an advance salary, which shall fall due in succeeding previous years. This relief allows the employee to be placed in the same situation as he would have been if such salary had been taxed on an accrual basis instead of being taxed on a receipt basis.

The relief in respect of receipts enumerated above shall be calculated in the following steps.

Step 1: Calculate tax on the total income of the current year, including the above receipts

Step 2: Calculate tax on the total income of the current year, excluding the above receipts

Step 3: Calculate tax on the total income of the year to which the above receipts relate after excluding these receipts

Step 4: Calculate tax on the total income of the year to which the above receipts relate after including these receipts

Step 5: Calculate the difference between (Step 1 minus Step 2) and (Step 4 minus Step 3) If the result of the calculation in Step 5 is positive, the excess amount is allowed as a relief. If the result of Step 5 is negative, no relief shall be allowed to the employee.

Furnishing of Form No. 10E

The employee should claim relief in the return of income for the year in which the lump sum payment is received. To do this, the employee must furnish Form No. 10E before filing his Income-tax return.

If Form 10E is not filed and the taxpayer claims relief u/s 89, the ITR filed will be processed but the relief claimed will not be allowed. It is mandatory to file Form 10E to claim a tax relief on arrear/advance income under Salary.

Tax liability on salary arrears and postponed payments might be greatly decreased by submitting a Section 89 relief claim. Taxpayers may guarantee a seamless and compliant process. With proper planning and compliance, employees can mitigate the financial impact of receiving arrears while staying aligned with tax regulations.