INTRODUCTION
Among the five heads of income recognized under the Income Tax Act, 1961, income from salary occupies a central position. For a significant portion of India’s working population, salary constitutes the primary source of livelihood and consequently, the primary basis of tax liability. However, what appears to be a simple monthly payment is, in legal terms, a carefully structured category governed by statutory provisions, interpretative rules, and judicial principles.
Sections 15 to 17 of the Act lay down the chargeability, permissible deductions, and the inclusive definition of salary. A critical examination of these provisions reveals that salary taxation extends beyond basic pay and includes allowances, perquisites, and even certain payments received after cessation of employment. This article explores the conceptual foundation, statutory scheme, practical computation, and recent judicial developments concerning salary income.
Employer–Employee Relationship: The Core Requirement
Income is taxable under the head “Salaries” only when an employer–employee relationship exists between the payer and the recipient. Any payment made by an employer to an employee for services rendered is chargeable to tax as salary. If such a relationship does not exist, the income cannot be taxed under this head.
For example, remuneration received by a partner from a firm is not treated as salary because the relationship between a firm and its partners is not that of employer and employee.
Case Law: CIT v. Smt. Shanti Devi (1992) 64 Taxman 251
Determination of employer-employee relationship is difficult when the position holder could operate in dual capacity, say for instance a managing director of a company who often discharges his functions in several capacities. He may be a director or an employee or a trustee or an agent of a company. Therefore, in order to prove that a director is an employee it should be established on record as fact and not merely as paperwork.
Place of Accrual of Salary
Salary is deemed to accrue in India if services are rendered in India, even if paid abroad. Government salary to an Indian citizen for services outside India is taxable in India, but related foreign allowances are exempt under Section 10(7).
Remuneration Received by Constitutional Functionaries
| Office | Tax Head | Case Law |
| MP/MLA | Income from Other Sources | CIT v. Shiv Charan Mathur |
| Chief Minister | Salaries | Lalu Prasad v. CIT |
| Judges (SC/HC) | Salaries | Justice Deoki Nandan Agrawala v. Union of India |
| Advocate-General | Business/Profession | CIT v. Govindaswamy Naidu |
| Partner (Firm) | Business Income (Sec 28(v)) | CIT v. Ghansham Dass |
BASIS OF CHARGE [SECTION 15]
Section 15 tells us the basis of charge under the head “Salaries.” But what if April 2024 salary is received in March 2024, or March 2024 salary is received in April 2024 when is it taxed?
Section 15 establishes a clear rule to determine the year of taxability and prevents double taxation of the same salary income.
Chargeability on Due or Receipt Basis
Under Section 15, salary is taxable in the following circumstances:
1. Salary due from an employer or former employer, whether paid or not, during the previous year.
2. Salary paid or allowed, though not due, during the previous year.
3. Arrears of salary paid or allowed, if not taxed earlier.
Thus, if salary becomes due during a previous year, it is taxable in that year even if it is not received. Conversely, if salary is received before it becomes due, it is taxable in the year of receipt. The principle of “earlier of due or receipt” prevents postponement of tax liability.
Case law : CIT v. Sardar Arjun Singh Ahluwalia (1999)107 Taxaman 246/240 ITR 693(SC)
Facts : The contract of employment of S was terminated and he was not given his dues during the relevant previous year. Subsequently, after a prolonged litigation and upon a decree by court, the salary was due was revised.
Held: Since this said amount was not charged to income tax for any previous year, it falls within section 15 clause C and can be brought to tax in the year of receipts as arrears in the salary.
Advance Salary
Advance salary refers to salary received by an employee before it becomes due. Since salary is taxable on due or receipt basis, whichever is earlier, advance salary is taxable in the year of receipt.
For example, if an employee receives April’s salary in March, it will be taxed in the financial year in which it is received, even though it relates to the subsequent month.
Arrears of Salary
Arrears of salary arise when salary pertaining to an earlier period is received in a later year. Normally, salary is taxed on due basis. However, in cases where the amount was not due earlier such as salary revision with retrospective effect the arrears are taxable in the year of receipt.
Common situations leading to arrears include implementation of pay commission recommendations, retrospective promotions, or revision of allowances with backdated effect.
Example : If the Central Government announces an increase in House Rent Allowance (HRA) during the previous year 2023–24, effective from 1.1.2022, then the arrears relating to the period from 1.1.2022 to 31.3.2023 will be taxable in the previous year in which they are paid, since they were not due earlier. Relief under section 89 may also be claimed in this case.
SALARY , PERQUISITES AND PROFIT IN LIEU OF SALARY [SECTION 17]
Scope and Definition of Salary
In common parlance, salary refers to remuneration paid to a person in return for services rendered. According to legal dictionaries, salary is generally understood as periodic payment made to an individual for services in an employer’s business. It is typically associated with employment of a permanent or substantially permanent character and usually relates to non-manual or skilled work.
Definition under the Income-tax Act, 1961
Section 17 of the Income-tax Act, 1961 provides an inclusive definition of the term “salary”.
Accordingly, “salary” includes:
(1) Wages
In common parlance, the term “wages” refers to fixed and regular payment received for work or services rendered. The expressions wages, salary and basic salary are often used interchangeably. Under the Income-tax Act, these payments form part of salary income.
In addition to basic wages, payments such as bonus, dearness allowance and other regular components are also included within the scope of salary. These amounts are generally fully taxable.
However, the tax treatment of payments received from an employer depends on their nature. Certain payments are:
- Fully taxable,
- Partly taxable, or
- Fully exempt.
(2) Annuity or Pension
Section 17(1) includes annuity and pension within the meaning of “salary.”
Meaning of Annuity
An annuity refers to a fixed annual payment. It is a yearly grant payable in respect of a particular year. If a person invests a sum of money and becomes entitled to receive equal annual payments, such annual receipts are treated as annuities in the hands of the investor.
The tax treatment of annuity depends upon the source:
- Annuity received from a present employer is taxable as salary, irrespective of whether it is paid under a contractual obligation or voluntarily.
- Annuity received from a former employer is taxable as profits in lieu of salary.
- Annuity received from a person other than an employer is taxable under the head “Income from Other Sources.”
Thus, the nature of relationship between payer and payee determines the head of income.
Pension
Pension is a periodic payment made by the Government, company or other employer to an employee in consideration of past services, payable after retirement.
Pension is broadly classified into:
1. Uncommuted Pension
Uncommuted pension refers to pension received periodically (generally monthly).
It is fully taxable in the hands of both Government and non-Government employees.
2. Commuted Pension
Commuted pension means a lump sum amount received in lieu of a portion or whole of future pension. It involves converting the right to receive periodic payments into a one-time lump sum payment.
Exemption in Respect of Commuted Pension [Section 10(10A)]
The exemption depends on the category of employee:
| Employee Category | Tax Treatment of Commuted Pension (Section 10(10A)) |
| Government Employees | Full exemption for Central/State Govt, local authorities, statutory corporations, Civil/Defence Services. |
| Non-Government Employees | If gratuity received: 1/3 exempt; if not: 1/2 exempt; remaining amount taxable. |
(3) Gratuity
Gratuity is a voluntary payment made by an employer in appreciation of services rendered by an employee. Over time, gratuity has become a statutory right under the Payment of Gratuity Act, 1972, and is now commonly paid by most employers.
Exemption of Gratuity – Section 10(10)
The tax treatment depends on the employee category and timing of receipt.
| Employee Category | Tax Treatment on Gratuity |
| During Service | Fully taxable |
| Government Employees | Fully exempt on retirement/death |
| Payment of Gratuity Act Employees | Exempt: least of ₹20L, actual, 15 days’ last salary × years |
| Not Covered by Act | Exempt: least of ₹20L, actual, ½ month’s average salary × years |
(4) Fees, Commission, Perquisites or Profits in Lieu of or in Addition to Salary
Section 17(1) includes within the scope of salary any payment received by an employee from the employer in the form of fees, commission or similar remuneration. Such payments are fully taxable under the head “Salaries.”
In addition, the term salary also includes:
- Perquisites, as defined under Section 17(2), and
- Profits in lieu of salary, as defined under Section 17(3).
(5) Any Advance of Salary
Advance salary refers to salary received by an employee before it becomes due. Since salary is taxable on due or receipt basis, whichever is earlier, advance salary is taxable in the year of receipt.
(6) Leave Salary or Leave Encashment
During the course of employment, employees are entitled to leave. Such leave may be:
- Availed during service,
- Allowed to lapse,
- Accumulated for future use, or
- Encashable either annually or at the time of retirement/termination.
If leave is not availed and is encashed, the amount received is known as leave encashment or leave salary. Such payment forms part of salary income.
However, Section 10(10AA) provides exemption in respect of leave encashment received at the time of retirement.
(7) Provident Fund
A Provident Fund (PF) is a retirement benefit scheme designed to provide financial security to employees after retirement. Under this scheme, a specified portion of the employee’s salary is deducted periodically as the employee’s contribution. The employer generally contributes an equal amount. These contributions are invested in approved securities, and the interest earned is credited to the employee’s account.
The accumulated balance is paid to the employee at the time of retirement or resignation. In case of death, it is paid to the legal heirs.
Types of Provident Funds
The Income-tax Act recognizes four types of provident funds:
1. Recognised Provident Fund (RPF)
A fund recognized by the Commissioner of Income-tax and governed by Part A of Schedule IV to the Income-tax Act, 1961. Funds established under the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952 are treated as RPFs. Schedule IV regulates recognition, contributions, and treatment of accumulated balance.
2. Unrecognised Provident Fund (URPF)
A provident fund not recognized by the Commissioner of Income-tax. It does not enjoy the tax benefits available to an RPF.
3. Statutory Provident Fund (SPF)
Governed by the Provident Funds Act, 1925, mainly applicable to Government employees, railways, local authorities, universities, and recognized educational institutions.
4. Public Provident Fund (PPF)
Operates under the Public Provident Fund Act, 1968 and is open to individuals, including self-employed persons. Contributions (₹500–₹1,50,000 annually) qualify for deduction under Section 80C.
Tax Treatment of Provident Funds
| Fund Type | Tax Treatment |
| SPF & PPF | Employer contribution, interest, lump sum: fully exempt (Section 10(11)) |
| RPF | Employee contribution: 80C deduction; Employer contribution: exempt up to 12%; Interest: exempt up to 9.5%; Accumulated balance exempt after 5 years |
PERQUISITES – SECTION 17(2)
In simple terms, a perquisite means any extra benefit or advantage attached to employment in addition to regular salary. Modern salary packages often include non-cash benefits such as house, car, insurance, concessional loans, etc.
Under Section 17(2), perquisites include benefits or amenities provided by an employer to an employee, either in cash or in kind, which are capable of being valued in money.
Key Features of Perquisites
- Perquisites may be provided in cash or in kind.
- Reimbursement of expenses incurred wholly for official duties is not a perquisite.
- If a benefit arises from employer–employee relationship → taxable as Salary.
- If it arises from professional relationship → taxable under Business/Profession.
- An unauthorised benefit taken without employer’s approval is not a perquisite.
Classification of Perquisites
Perquisites are broadly classified into:
(A) Perquisites Taxable in the Case of All Employees
The following benefits are taxable for every employee:
1. Rent-Free Accommodation (RFA)
If an employer provides accommodation free of rent, its value is taxable.
2. Accommodation at Concessional Rent
If the rent charged from employee is less than prescribed value, the difference is taxable.
3. Employer Pays Employee’s Obligation
If the employer pays an expense that the employee was legally required to pay, it becomes taxable.
4. Life Insurance / Annuity Premium Paid by Employer
If employer pays premium on employee’s life insurance or annuity policy, it is taxable.
5. Specified Security / Sweat Equity Shares
If shares are allotted at free or concessional rate, the difference between Fair Market Value (FMV) and amount paid is taxable.
6. Employer’s Contribution to Funds (Limit ₹7,50,000)
If employer’s total contribution to:
- Recognised Provident Fund (RPF)
- National Pension Scheme (NPS)
- Approved Superannuation Fund
exceeds ₹7,50,000 in a year → excess is taxable.
Interest/dividend earned on such excess contribution is also taxable.
7. Other Fringe Benefits (Rule 3)
These includeloans, car use, food, gifts, club and credit expenses.
(B) Perquisites Taxable Only in Specified Employees
Certain facilities are taxable only in the hands of specified employees.
Examples:
- Sweeper, gardener, watchman
- Free electricity or water
(C) Tax-Free Perquisites
Certain perquisites are fully exempt:
| Perquisite | Tax Treatment |
| Telephone at residence | Fully exempt |
| Employer’s contribution to staff group insurance | Exempt |
| Personal accident insurance premium | Exempt |
| Refreshments during office hours | Exempt |
| Training expenses | Exempt |
| Leave Travel Concession (LTC) | Exempt subject to conditions |
| Medical facilities (specified cases) | Exempt |
In ACIT v. P.R. Parthasarathy, it was held that expenses of a spouse accompanying an employee on an official tour are not taxable if the company requires such presence.
PROFITS IN LIEU OF SALARY – SECTION 17(3)
Section 17(3) of the Income-tax Act expands the scope of “Salary” by including certain receipts that arise from employment but are not regular salary. These amounts are taxable under the head “Salaries” as profits in lieu of salary. The key test is whether the payment is connected with the employer–employee relationship.
Below is a structured explanation of what is covered under this provision.
(i) Compensation Received from Employer
Any amount due to an employee as a right under a statute, award, settlement, or contract of employment is taxable as profits in lieu of salary. Even if the employee is not legally entitled to receive the amount, once it is paid by the employer or former employer in connection with employment, it becomes taxable.
The provision ensures that any benefit flowing from employment does not escape taxation merely because it is described differently.
(ii) Compensation on Termination of Employment
Any compensation received from an employer or former employer at or in connection with termination of employment is taxable. Termination may occur due to:
- Resignation
- Dismissal
- Compulsory retirement
- Superannuation
- Voluntary retirement
Even notice pay received at the time of termination is treated as compensation and is taxable under this head.
Although such compensation may ordinarily be considered a capital receipt, Section 17(3) specifically treats it as a revenue receipt chargeable to tax under “Salaries.”
(iii) Compensation for Modification of Terms and Conditions
Where the employment continues but the terms and conditions are altered for example, a lump sum is paid in exchange for a reduction in future salary the amount received is taxable as profits in lieu of salary.
Even though the payment compensates for loss of future income, it arises from employment and is therefore taxable.
(iv) Payment from Provident or Other Funds
Any payment received from a provident fund or other similar fund maintained by the employer is taxable, except where specific exemption is provided under Section 10 (such as gratuity, pension, recognised provident fund, approved superannuation fund, etc.).
Unrecognised Provident Fund – Tax Treatment
At the time of maturity:
- Employer’s contribution and interest thereon → Taxable as salary
- Employee’s contribution → Not taxable (already taxed earlier)
- Interest on employee’s contribution → Taxable under “Income from Other Sources”
(v) Keyman Insurance Policy
A Keyman Insurance Policy is taken by an employer on the life of a key employee whose services are vital to the business. It protects the company against financial loss in case of the employee’s death. If the policy is later assigned to the employee, for example upon retirement, the surrender value received by the employee is fully taxable as profits in lieu of salary, and no exemption is available.
(vi) Payments Before Joining or After Cessation of Employment
Any payment received from an employer or former employer before joining employment or after leaving employment is taxable if it is connected with employment.
The scope of the expression “any payment” is wide and includes all amounts paid to an employee for something done in his capacity as an employee.
Retrenchment Compensation – Section 10(10B)
Retrenchment compensation is taxable as profits in lieu of salary. However, exemption is available under Section 10(10B) if paid under the Industrial Disputes Act, 1947 or any similar law relating to termination of service.
Voluntary Retirement Compensation – Section 10(10C)
Compensation received on voluntary retirement is taxable as profits in lieu of salary, but exemption up to ₹5,00,000 is available under Section 10(10C), subject to conditions.
Exclusions and Clarifications
Not every payment from an employer is taxable as profits in lieu of salary. The payment must arise because of services rendered.
The following are not taxable:
- Compensation for personal loss (e.g., reimbursement for loss of personal assets).
- Payments made purely on personal grounds without any connection to employment.
- Genuine personal gifts given out of affection and not as remuneration.
However, if a payment accrues by virtue of employment, it is taxable regardless of whether it was voluntary or compulsory.
Case law : Reed v. Seymour (1927) 11 TC 625
If the payment is made by an employer as personal gift for appreciation of qualities of employee or for reasons unconnected with employment cannot be considered as profits in lieu of salary.
Case Law : Lachhman Dass v. CIT (1980) 3 Taxman 560/124 ITR 706 (Delhi)
Payments made on personal grounds where there is no element of remuneration for services do not fall within the ambit of profits in lieu of salary under sec. 17(3)(ii) and are not taxable in their hands.
DEDUCTIONS FROM SALARY
Income chargeable under the head “Salaries” is computed after allowing certain specific deductions under Section 16 of the Income-tax Act. These deductions are limited in nature and are available only to salaried taxpayers.
The following deductions are permitted:
1. Standard Deduction – Section 16(ia)
2. Entertainment Allowance – Section 16(ii)
3. Professional Tax – Section 16(iii)
Standard Deduction
A flat standard deduction of ₹75,000 or the amount of salary, whichever is lower, is allowed to all salaried employees.
This deduction is automatic and does not require any proof of expenditure. It is granted to reduce the taxable salary income and is available irrespective of the actual expenses incurred by the employee.
Entertainment Allowance
Any entertainment allowance received by an employee is fully taxable and must first be included in the gross salary.
However, a deduction under Section 16(ii) is available only to Government employees. Non-government employees are not entitled to this deduction.
The amount of deduction shall be the least of the following:
- One-fifth (20%) of basic salary
- ₹5,000
- Actual entertainment allowance received
Professional Tax on Employment
Professional tax is a tax levied by a State Government under Article 276 of the Constitution. It is allowed as a deduction under Section 16(iii) only in the year in which it is actually paid.
The maximum professional tax payable in respect of any person cannot exceed ₹2,500 per annum. However, if an employee pays arrears relating to earlier years during the previous year, the deduction will be allowed in the year of payment, even if the amount paid exceeds ₹2,500.
Thus, the key condition for claiming deduction of professional tax is actual payment during the relevant previous year.
RELIEF UNDER SECTION 89
Section 89 of the Income-tax Act provides relief to taxpayers when salary income is received in a lump sum, resulting in a higher tax burden due to increased slab rates. The objective of this provision is to mitigate the additional tax liability arising merely because income pertaining to different years is taxed in a single year.
The manner of computation of such relief is prescribed under Rule 21A.
1. Arrears or Advance Salary
Relief is available when salary is received in arrears/advance, for more than 12 months in one year, or as lump-sum profit in lieu of salary. Tax is recomputed by spreading income over relevant years to reduce hardship.
2. Family Pension Arrears
“Family pension” refers to a regular monthly payment made by the employer to a member of the family of a deceased employee.
Relief is also available on lump-sum arrears of family pension.
3. No Relief with VRS
If exemption under Section 10(10C) is claimed (VRS), relief under Section 89 cannot be claimed on the same amount.
CRITICAL ANALYSIS
The scheme of salary taxation under the Income-tax Act, 1961 reflects a deliberate attempt to widen the tax base while maintaining conceptual structure. Sections 15–17 adopt an inclusive definition, ensuring that all economic benefits arising from employment whether cash, kind, present, or deferred are taxed, thereby preventing re-characterisation of remuneration.
However, the framework is complex. The distinction between salary, perquisites, and profits in lieu of salary can be technically demanding, and Section 17(3) brings even certain capital-like receipts within the revenue net. While Section 15 ensures certainty through the due-or-receipt rule, retrospective revisions and arrears create practical difficulties, requiring relief under Section 89. Differential exemptions and capped retirement benefits also raise concerns of equity. Overall, the law is comprehensive but compliance-heavy.
CONCLUSION
Salary income under the Income-tax Act, 1961 is far more than periodic remuneration; it is a legally structured concept encompassing allowances, perquisites, retirement benefits, and compensation linked to employment. Sections 15–17, supported by judicial interpretation, create a comprehensive and anti-avoidance-oriented framework. While the system ensures broad tax coverage and prevents revenue leakage, its complexity and differential treatment across categories highlight the continuing tension between equity, efficiency, and administrative simplicity in salary taxation.
References
1. CIT v. Smt. Shanti Devi, (1992) 64 Taxman 251.
2. CIT v. Shiv Charan Mathur,(2008) 306 ITR 126 (Raj).
3. Lalu Prasad v. CIT,(2009)1053/316 ITR 186 (Patna).
4. Justice Deoki Nandan Agrawala v. Union of India, (1999) 237 ITR 872 (SC).
5. CIT v. Govindaswamy Naidu, (1998) 101 Taxman 1/233 ITR 264 (Madras).
6. CIT v. Ghansham Dass, (2002) 121 Taxman 355/254 ITR 355 (Punjab).
7. CIT v. Sardar Arjun Singh Ahluwalia, (1999) 107 Taxman 246 / 240 ITR 693 (SC).
8. ACIT v. P.R. Parthasarathy, (1979) 118 ITR 869 (AP).
9. Reed v. Seymour, (1927) 11 TC 625.
10. Lachhman Dass v. CIT, (1980) 3 Taxman 560 / 124 ITR 706 (Delhi).
11. Dr. Neha Pathak, Principles of Taxation, 1st Edition, Taxmann Publications Pvt. Ltd., Delhi, India.
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