Computation of income under the head Salary – Part I

Covering basic component of salary, VRS and Allowances

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Updated A.Y. 2018-19

“Salary is the recompense or consideration given to a person for the pains he has bestowed upon another’s business” – Stroud’s Judicial Dictionary

Basic elements of salary

  • Payer and payee must have employer and employee (or Master & Servant) relationship; and
  • Payment must have been made by the employer in such capacity
Employer-employee relationship

A payment can be construed as salary only if the payer is the employer and payee is the employee of the payer.

  • Criteria for employer-employee relationship

    The key criteria to hold this relationship is that, employee is always bound to work as per direction and supervision of the employer.

  • Payment in employer’s capacity

    To treat any payment as salary it is necessary that payer, being the employer, must have made the payment in such (employer’s) capacity.

  • Contract of service vs contract for service

    In “contract of service”, the employer can direct and control the duties and the manner of performance of employee hence employer-employee relationship exists in such contract. However, in case of “contract for service” the contractee can simply decide and quote the object or target to be achieved but cannot decide or direct the manner of performance.

  • Agent and Principal

    If a person is acting as an agent for his principal, any commission or remuneration earned by the agent is not taxable under the head “Salaries”. This is because, an agent is not the employee of his principal.

  • Salary received by a partner from its firm

    Salary received by a partner from its firm shall not be taxable as salary, because there is no employer-employee relationship between the firm and the partner. Such salary shall be taxable under the head “Profits & gains of business or profession”.

  • Salary received by proprietor

    Salary received by proprietor from his proprietorship firm is not an income. As proprietor and proprietorship firm are the same person and no one can earn from himself.

  • Remuneration to director

    Remuneration to director from his company can be treated as salary only if the director is employee of the company, otherwise the same shall be taxable under the head “Income from other sources”. Hence, remuneration received by managing director (or any other employee-director) is taxable under the head “Salaries” as he is employee of the company
    Note: Directors’ sitting fee is taxable under the head “Income from other sources”.

  • Pension received by the widow or legal heir

    Pension received by the widow or legal heir of deceased employee is not taxable as salary as no employer-employee relationship exists between the payer and the payee. However such amount shall be taxable under the head “Income from other sources”.

  • Remuneration received by Judges

    Remuneration received by Judges is taxable under the head “Salaries” even though they are not having any employer.

Concluding the above discussions, a payment received for services rendered, from a person other than employer, is not taxable under the head “Salaries” but may be taxed under the head “Profits & gains of business or profession” or “Income from other sources”.

State whether the following receipts should be treated as salary or not?

  • A teacher receives emoluments in kind from school in which he teaches.

    Yes, it is immaterial whether salary has been received in cash or in kind.

  • A teacher of a college receives fees from a University for checking answer sheets.

    No, as employer – employee relationship does not exist between payer and payee. (College-teacher is not the employee of the University). Such receipt shall be taxable under the head ‘Income from other sources’. However, if such fee for checking answer sheet is given by the college (i.e. employer) then such fee shall be taxable under the head ‘Salaries’.

  • A payment made to the Member of the Parliament or the State legislature.

    No, as employer-employee relationship does not exist. A member of the Parliament or the State legislature is not treated as employee of the Government. Payment received by them shall be taxable under the head “Income from other sources”.

Definition of Salary [Sec. 17(1)]

As per sec. 17(1) of the Income-tax Act, 1961, salary includes the following:

  1. Wages;
  2. Any annuity or pension;
  3. Any gratuity;
  4. Any fees, commission, perquisite or profits in lieu of or in addition to any salary or wages;
  5. Any advance of salary;
  6. Any payment received in respect of any period of leave not availed of by the assessee;
  7. The portion of the annual accretion in any previous year to the balance at the credit of an employee, participating in recognised provident fund, to the extent it is taxable;
  8. Transferred balance in a Recognised Provident Fund to the extent it is taxable.
  9. Contribution made by the employer in the previous year, to the account of an employee under a pension scheme referred to in sec. 80CCD.
General Notes
  • Salary & Wages are identical in the Income-tax Act\
  • Voluntary Payments

    The Act does not make any difference between voluntary and contractual payment. Both are taxable as salary.

  • Overtime

    Overtime remuneration is taxable as salary.

  • Remuneration for Extra Work

    Where an employee gets extra payment from his employer (in such capacity) for work performed outside the duties of his office and thus, such payment shall be taxable as salary.

  • Salary from more than one source

    If an individual receives salary from more than one employer during the same previous year, salary from each employer shall be accumulated and taxable under the head “Salaries”.

  • Salary from former, present or prospective employer is chargeable to tax under the head “Salaries”. E.g. Pension from a former employer and advance salary from prospective employer shall be taxable under the head “Salaries”.
  • Salary income must be real and not fictitious

    Salary from dummy employment is not taxable. Further such payment shall not be deducted while computing income under the head ‘Profits & gains of business or profession’ of the employer.

  • Foregoing of salary

    Once salary has been earned by an employee, its subsequent waiver does not make it exempt from tax liability. Such waiver shall be treated as application of the income. Hence, salary foregone is taxable
    Note: However, where an employee opts to surrender his salary to the Central Government u/s 2 of Voluntary Surrender of Salaries (Exemption from Taxation) Act, 1961, the salary so surrendered shall not be taxable.

  • Salary paid tax-free

    If tax on salary is paid by the employer, then it is termed as ‘salary paid tax-free’. In such case, to compute the income under the head ‘Salaries’ the amount of tax paid by the employer (on behalf of employee) has to be added to the amount received by the employee. However, tax paid by the employer should be subtracted from tax liability of the employee.

Basis of charge [Sec. 15]

Salary is chargeable to tax either on ‘due’ basis or on ‘receipt’ basis, whichever is earlier. Hence, taxable salary includes:

  • Advance salary (on ‘receipt’ basis)

    Salary paid in advance is taxable under the head ‘Salaries’ in the year of receipt.

    Note: Such advance salary shall not be included again in the total income when the salary becomes due.

  • Outstanding salary (on ‘due’ basis)

    Salary falling due is taxable under the head ‘Salaries’ in the year in which it falls due.
    Note: Such due salary shall not be included again in the total income when it is received.

  • Arrear salary

    Any increment in salary with retrospective effect which have not been taxed in the past, such arrears will be taxed in the year in which it is allowed. Arrear salary are taxable on receipt basis

Advance salary vs Advance against salary

‘Advance salary’ is taxable u/s 17(1)(e) whereas ‘Advance against salary’ is treated as loan hence, not taxable under the head “Salaries”.

Place of accrual of salary

Salary which is received in India or earned in India shall be taxable in hands of all assessee whether resident or non resident in India. Salary is deemed to be earned in India provided –

  • The service is rendered in India;
  • The rest period or leave period, which is preceded and succeeded by the service rendered in India and forms part of the service contract of employment.

Exception

Salary paid to a Government employee, being a citizen of India, is deemed to accrue in India, irrespective of place of work [Sec. 9(1)(iii)].
Taxpoint: Salary is earned at the place where service is rendered.

General components of salary

Basic Salary

It is the sum paid by employer to employee as salary.
Treatment: Fully taxable in all cases.

Pay-Scale (Grade system)

It is a system of payment where increment scale is pre-known to employee. E.g. Basic salary is given as 5,000 – 1,000 – 8,000 – 2,000 – 12,000. The above data indicates the increment schedule. As per this schedule initial payment is ₹ 5,000 p.m. which will increase by ₹ 1,000 every year until salary reaches to ₹ 8,000 p.m. Once salary reaches to ₹ 8,000 then increment will be ₹ 2,000 every year till salary reaches the scale of ₹ 12,000. Accordingly, basic salary is calculated.

Dearness Allowance (DA) or Dearness Pay (DP)

It is an extra amount given to an employee to meet the burden of inflation or increased cost of living.

Treatment: Fully taxable in all cases

If it is mentioned that DA/DP is not forming a part of retirement benefit (Leave encashment, Pension, Provident Fund, etc.). In such case, DA/DP itself shall be fully taxable. However, for calculating taxable Leave encashment, Pension, HRA, etc., DA/DP will be included in ‘salary’ only if it forms a part of retirement benefit.

Fees

An employee may be given apart from basic salary, extra remuneration for doing specific job under the terms of employment. Such extra remuneration is termed as fee.

Treatment: Fully taxable in all cases.

Commission

It may be as a percentage of turnover or as a percentage of profit.

Treatment: Fully Taxable.

Bonus

Bonus may be contractual or voluntary.

Treatment:

  • Fully taxable.
  • Contractual bonus is taxable as bonus whereas voluntary bonus is taxable as perquisite.
  • It is taxable in the year of receipt.

Note: If arrear bonus is received, assessee can claim relief u/s 89(1).

Voluntary Retirement Compensation (VRS) [Sec. 10(10C)]

Meaning

If an employee accepts retirement willingly in lieu of compensation then such retirement is known as Voluntary Retirement.

Treatment

Voluntary retirement compensation received or receivable by an employee is eligible for exemption subject to the following conditions:

  1. Compensation is received from following specified employer
    • Any company; or
    • An authority established under Central, State or Provincial Act; or
    • A local authority; or
    • A Co-operative society; or
    • A specified University; or
    • An Indian Institute of Technology (IIT); or
    • Any State Government; or
    • The Central Government; or
    • Notified Institution of Management (IIM Ahmedabad, IIM Banglore, IIM Calcutta, IIM Lucknow, and the Indian Institute of Foreign Trade New Delhi); or
    • Notified Institution.
  2. Compensation is received as per Voluntary Retirement Scheme (VRS) framed in accordance with following guidelines being prescribed under rule 2BA
    1. Scheme (VRS) must be applicable to all employees (other than director) who have either completed age of 40 years or has completed 10 years of service. (This condition is, however, not applicable in the case of an employee of a public sector company)
    2. Such scheme must be framed to reduce the number of employees.
    3. The vacancy caused by VRS is not to be filled up.
    4. The retiring employee is not to be employed in another company or concern belonging to the same management.
    5. The amount of compensation does not exceed:
      • the amount equivalent to 3 months salary for each completed year of service; or
      • salary at the time of retirement multiplied by the balance month of service left.
        Salary here means [Basic + DA (if forms a part of retirement benefit) + fixed percentage of commission on turnover], last drawn.

Amount of exemption

Exemption shall be minimum of the following:

  1. Actual amount received as per guidelines; or
  2. 5,00,000

Where exemption is allowed to an assessee under this section in any assessment year then no deduction is allowed in any subsequent assessment years. It means deduction under this section is allowed once in life of an assessee.

Allowances

Allowance means fixed quantum of money given regularly in addition to salary to meet particular requirement. The name of particular allowance may reveal the nature of requirement, e.g. House Rent Allowance, Tiffin Allowance, Medical Allowance etc.

Allowances at a glance

General AllowanceHouse Rent Allowance, City Compensatory Allowance, Tiffin Allowance, Medical Allowance, Servant Allowance, Entertainment Allowance
Allowance u/s 10(14)(i), deductions from which depends upon actual expenditure stated in Rule 2BB(1)Travel or Transfer allowance, Daily Allowance, Conveyance Allowance, Assistant Allowance, Professional Development Allowance, Uniform Allowance
Allowance u/s 10(14)(ii), deductions from which do not depend upon actual expenditure stated in Rule 2BB(2).Children Education Allowance, Children Hostel Allowance, Truck Drivers’ Allowance, Transport Allowance, Tribal Areas Allowance, Special Compensatory Allowance, Border Area Allowance, etc.
Allowances to a Government employee being an Indian citizen working outside India [Sec. 10(7)]
Allowances received from UNO
Compensatory allowance under Article 222(2) of the Constitution
Allowance to judges of the High Court and the Supreme Court
Allowances to teacher / professor from SAARC Member States
Allowance or Perquisite to member of Union Public Service Commission [Sec. 10(45)]
Any other Allowance

Treatment of allowance does not depend on the name of the allowance but on the purpose for which such allowance is given. E.g. Room-rent allowance shall also be treated as House rent allowance, Children tuition fee allowance shall be treated as Children education allowance, etc.

Tax Treatment of few Allowances

Following allowances are fully taxable:

AllowancesMeaning
City Compensatory AllowanceAn allowance to meet personal expenses, which arise due to special circumstances, or to compensate extra expenditure by reason of posting at a particular place.
Tiffin AllowanceAn allowance to meet the expenditure on tiffin, refreshment etc.
Medical AllowanceAn allowance to meet the expenditure on medical treatment etc.
Servant AllowanceAn allowance to meet the expenditure of servant for personal purpose.
Non-practicing AllowanceAllowance given to professionals to compensate them for restriction on private practice.
Warden or Proctor AllowanceAllowances given to employees of educational institutions for working as warden of the hostel or working as proctor in the institutions.
Deputation AllowanceAllowances given to an employee, when he is sent on deputation for a temporary period from his permanent place of service.
Entertainment AllowanceIt is an allowance to meet expenditure on entertainment, by whatever name called.
Government employee can claim deduction u/s 16(ii).
House rent allowance (HRA) [Sec. 10(13A) and rule 2A]

Meaning

An allowance to meet the expenses in connection with the rent of the house, by whatever name called.

Tax Treatment

Minimum of the following is exempted from tax:

  1. Actual HRA received
  2. An amount equal to 50% of salary1 (when house is situated in a metro city) or 40% of salary1 (when house is situated in any other place) for the relevant period
  3. The excess of rent paid over 10% of salary1. [Arithmetically, (Rent Paid – 10% of Salary)]

Notes

  • Salary here means: Basic + D.A. (if it forms a part of retirement benefit) + Commission as a fixed % on turnover.
  • Salary shall be determined on due basis for the period for which the employee occupies rented accommodation in the previous year and gets HRA.
  • Exemption is not available if employee lives in his own house, or in a house for which he does not pay any rent.
  • For criteria of 50% or 40% of salary as deduction, place of employment is not significant but place where the house is situated is important.
  • Deduction from HRA depends on Salary of the employee, Amount of HRA, place of residence (not place of employment), rent paid by the employee.
Allowances, deduction from which depends on actual expenditure [Rule 2BB(1)]
AllowanceMeaning
Travel or transfer AllowanceAn allowance, by whatever name called, to meet the cost of travel on tour. Cost of travel includes any sum paid in connection with transfer, packing and transportation of personal effects on such transfer.
Daily AllowanceAn allowance, by whatever name called, granted on tour (or for the period of journey in connection with transfer) to meet the ordinary daily charges incurred by employee on account of absence from his normal place of duty.
Conveyance AllowanceAny allowance granted to meet the expenditure on conveyance in performance of duties of the office, provided free conveyance is not provided by the employer.
Taxpoint: Expenditure for covering the journey between office and residence is not treated as expenditure in performance of duties of office and consequently not covered under this allowance. (Refer Transport allowance)
Helper / Assistant AllowanceAny allowance (by whatever name called) to meet the expenditure of assistant or helper, provided such helper is appointed for the performance of duties of an office.
Taxpoint: Servant allowance is fully taxable.
Research AllowanceAny allowance, by whatever name called, granted to encourage academic, research and other professional pursuits.
This allowance may also be termed as Professional Development / Academic allowance
Uniform AllowanceAny allowance, by whatever name called, to meet the expenditure on purchase or maintenance of uniform wear, during the performance of duties of an office.
Taxpoint: Uniform allowance is different from Dress allowance. Dress allowance is fully taxable.

Tax Treatment of aforesaid allowances:

Minimum of the following shall be exempted:

  1. Actual amount received; or
  2. Actual expenditure incurred for such purpose.
Allowances, deduction from which do not depend on actual expenditure [Rule 2BB(2)]

Few Examples.

Children Education Allowance

Meaning

An allowance to meet the expenses in connection with education of children, by whatever name called.

Treatment

Minimum of the following is exempted from tax:

  1. ₹ 100 per month per child (to the maximum of 2 children)
  2. Actual amount received for each child (to the maximum of 2 children)

Children Hostel Allowance

Meaning

An allowance to meet the hostel expenses of children, by whatever name called.

Treatment

Minimum of the following is exempted from tax:

  1. ₹ 300 per month per child (to the maximum of 2 children)
  2. Actual amount received for each child (to the maximum of two children)

Notes for Children Education Allowance and Hostel Allowance:

  • Child includes adopted child, step-child but does not include illegitimate child and grandchild.
  • Child may be major or minor child.
  • Deduction is available irrespective of actual expenditure incurred on education of child.

Truck Driver’s Allowance

Meaning

Any allowance (by whatever name called) granted to an employee working in any transport system to meet his personal expenditure during his duty performed in the course of running of such transport (from one place to another place), provided such employee is not in receipt of daily allowance.

Treatment

Minimum of the following shall be exempted:

  1. 70% of allowance
  2. ₹ 10,000 p.m.

Taxpoint: If assessee is in receipt of Daily allowance then above allowance shall be fully taxable.

Transport Allowance

Meaning

An allowance, by whatever name called, to meet the expenditure for the purpose of travelling between the place of residence and the place of duty.

Treatment

Minimum of the following shall be exempted:

  1. Actual amount received; or
  2. ₹ 1,600 p.m. (in case of blind / deaf and dumb / orthopaedically handicapped employee ₹ 3,200 p.m.)

Allowance to Government employees outside India

As per sec. 10(7), any allowance or perquisite allowed outside India by the Government to an Indian citizen for rendering services outside India is wholly exempt from tax.
Taxpoint:

  1. Assessee must be:
    • Government employee
    • Citizen of India; and
    • Working outside India
  2. Any allowance or perquisite to such employee shall be exempted u/s 10(7)

Allowance received from UNO (United Nations Organisation)

Basic salary or Allowance paid by the UNO to its employees is not taxable.

Compensatory allowance under Article 222(2) of the Constitution

It is fully exempt from tax.

Allowance to judges of the High Court or the Supreme Court

Any allowance paid to Judges of the High Court u/s 22A(2) and sumptuary allowance u/s 22C of the “High Court Judges (Conditions of Service) Act, 1954” is not taxable. Allowance to the Supreme Court Judges u/s 23B of the “Supreme Court Judges (Conditions of Service) Act, 1958” is also exempt.

Salary to teacher or professor from SAARC Member States [DTAA]

Salary including allowances and perquisites of a teacher or professor or research scholars from SAARC Member States shall not be taxable if following conditions are satisfied:

  1. Such professor, teacher or research scholar is a resident of other SAARC member State (i.e., Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan & Sri Lanka) prior to visiting another member State.
    Taxpoint: An individual is deemed to be a resident of a member State if he/she is resident in that member State in the fiscal year in which he visits the other member State or in the immediately preceding fiscal year.
  2. Such visit is for the purposes of teaching or engaging in research or both at a university or college or similar approved institution in that other Member State.
  3. The remuneration from aforesaid activities in other Member State is exempt for a period of 2 years from the date of arrival in the other member State.

Allowance or Perquisite to member of Union Public Service Commission [Sec. 10(45)]

Any allowance or perquisite, as may be notified by the Central Government in the Official Gazette in this behalf, paid to the Chairman or a retired Chairman or any other member or retired member of the Union Public Service Commission is exempt.

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