Understanding Taxation of Salary: What’s Taxable and What’s Not?
Summary: Salary taxation under the Income Tax Act, 1961, encompasses various components, including basic salary, bonuses, commissions, allowances, and perquisites. Section 17(1) defines salary broadly to include wages, gratuity, pension, and other forms of compensation. Salaries are taxed either on a “due” or “receipt” basis, whichever occurs earlier. The place of accrual, such as services rendered in India or abroad, and the employee’s residency status also impact taxability. Perquisites, such as rent-free accommodation, medical reimbursements, and employer-provided devices, may be tax-exempt under specific conditions, while benefits like subsidized housing or employer-provided vehicles are taxable. Profits in lieu of salary, including severance payments, deferred bonuses, and gratuities, are taxed as income but may qualify for exemptions under sections like 10(10) for gratuities or 10(10AA) for leave encashment. Deductions like the standard ₹50,000 and professional taxes are allowed under Section 16. Understanding these provisions is critical for employees and employers to optimize tax planning, ensuring compliance and financial efficiency. The proper structuring of salary packages with attention to allowable exemptions and deductions can significantly impact tax liabilities.
INTRODUCTION
Salary is the compensation that an individual receives or accrues over time for services done as a result of an express or implied contract. Regarding its taxability, the actual wage received in the prior year is not significant. The prerequisite for taxing a specific receipt under the heading of “salaries” is the presence of an employer-employee connection. Under Income Tax Act, 1961, the term salary includes any payment an employee receives from their employer in cash, kind, or in the form of a facility. It includes a number of components, including basic salaries, commissions, bonuses, perquisites, allowances, and profits in lieu of salary.
The term “salary” is broad and encompasses a variety of compensation that workers get during their employment. According to Section 17(1) of the Income Tax Act 1961, the term ‘salary’ includes:
a) Basic salary or Wages
b) Bonus
c) Commission, fee and interim relief
d) Over time payments
e) Annuity
f) Advance salary and arrears of salary
g) Annual accretion in employee’s recognized provident fund Taxable part of transferred balance
h) Contribution made by Central Government in previous year under notified pension scheme in employees’ account referred to in section 80CCD
i) Encashment of earned leave
j) Gratuity
k) Pension
l) Compensation on retrenchment
m) Amount received on voluntary retirement
BASIS OF CHARGE FOR SALARY INCOME
The basis of charge is covered under Section 15 of the Income Tax Act,1961. Either the “due basis” or the “receipt basis,” whichever is earlier, will apply to the taxation of salaries.
For additional clarification, the following will be included in the annual salary income:
- Any sum given to the employee before it became due or payable.
- Every salary that is due to the employee throughout the year, whether it is paid or not.
- Salary arrears that were paid to the employee throughout the year but were not taxed in previous years
PLACE OF ACCRUAL OF SALARY
One of the most important factors in determining whether salary income is taxable under section 17(1) of the Income Tax Act is the place of accrual.
The place of accrual is established as follows:
- Services rendered in India: The salary is deemed to have accrued or arisen in India if the services for which it is paid are rendered in India. This is true regardless of the employer’s location or the employee’s residential status. As a result, any compensation received by an individual for work done inside India’s borders is subject to Indian taxation, Section 9(ii).
- Employee residency status: All salary income, whether received domestically or abroad, is subject to Indian taxation for tax residents of India. However, regardless of their citizenship or country, non-residents are only taxed on income that is earned or generated in India (Section 6).
- Salaries paid outside of India for services rendered in India: Any salary payments made to a non-resident person outside of India for work done in India are subject to Indian taxation. The salary might not be taxable in India, though, if it relates to services that were provided outside of the country.
- Exceptions and treaties: For people who work in India but get their salaries from overseas employers, the taxability of their pay income may be impacted by specific exceptions or clauses under double taxation avoidance agreements. The DTAA’s provisions take precedence over domestic tax law in these situations.
DEDUCTION FROM SALARY INCOME
According to Section 16 of the Income-tax Act, the following deductions from salary income are permitted.
- The Professional/Employment taxes imposed by State government.
- Entertainment Allowance: Government employees are eligible to deduct up to Rs. 5,000 or 20% of his salary or actual amount received, whichever is less. It should be noted that starting on April 1, 2019, or AY 2020–21, a standard deduction of Rs. 50,000/- is available from salary income.
PERQUISITES
According to Section 17(2) of the Income Tax Act, Perquisites are extra benefits or advantages that an employer provides to an employee in addition to their basic salary. These perks may be in cash or kind and are typically taxable, except in cases the Act specifies otherwise.
Any amount you get as a profit in lieu of a salary is taxable under the “Income from Salaries” heading, just like ordinary salaries. Your overall income and tax bracket will determine the tax rate on such income
Perquisites are broadly classified into two categories:
Exempt Perquisites
These are certain benefits that, under certain circumstances, are either totally or partially exempted from taxation:
Rent-Free or Concessional Accommodation: Depending on the employee’s location and pay scale, exclusions may apply if provided by the employer.
Medical Benefits: Government or employer-run hospitals do not charge taxes on medical care. Furthermore, up to the specified limits, reimbursement for medical costs incurred overseas is excluded.
Health Insurance Contributions: Group health insurance policies that cover employees and their families are exempt from taxes if the employer pays the premiums.
Employer-Provided Electronic Devices: Mobile phones and laptops that are given by the employer for either personal or business use are exempt from taxes.
Provident Fund Contributions: Within certain thresholds, employer contributions to the Public Provident Fund (PPF) and Recognized Provident Fund (RPF) are tax-exempt.
Superannuation Fund Contributions: Up to ₹1.5 lakh annually can be made tax-free to an authorised superannuation fund.
Leave Travel Concession (LTC): Under certain circumstances, employees’ and their families’ domestic travel expenses are tax-exempt twice in a four-year period.
Taxable Perquisites
An employee’s taxable salary includes several benefits that their employer provides.
Rent-Free or Subsidised Accommodation: If the accommodation is owned by the employer, taxes are imposed according to the region; in metro areas, they are 15% of the pay, while in other areas, they are 10%.
Vehicle provided by employer: Fuel and maintenance costs are included in the employee’s taxable income if they are covered by the company.
Interest-free or low-interest loans: The difference between the current State Bank of India lending rate and the interest rate levied by the employer, if any, is the taxable value. Up to ₹20,000 in loans are excluded.
PROFITS IN LIEU OF SALARY
According to Section 17(3) of Income Tax Act, Payments provided to employees in substitute of regular salaries are referred to as Profits in lieu of salaries. These payments are taxed according to the applicable income tax slab rates since they are regarded as salary income.
Compensation for Job Termination: Upon resignation, termination, or involuntary retirement the payments received are considered as compensation for job termination and are subject to exemption under Section 10(10C)).
Payment Due to Changes in Employment Terms: Any compensation received as a result of changes in job conditions, such as a demotion or a reduction in benefits, is referred to as payment due to changes in employment terms.
Post Employment Payments: Deferred bonuses, gratuities over exemption limitations, and any other sums paid after retirement that are connected to prior service are examples of post-employment payments.
Pre Employment and Post Employment Payments: Payments made both before and after an employee leaves their job include severance benefits and signing bonuses.
Payouts from a Keyman Insurance Policy: Sums that an employee or their legal heir receives from an employer-purchased Keyman insurance policy.
Payments from Employers or Third Parties: Any monetary amount obtained in connection with employment from an employer or a related entity.
Exemptions and Deductions
While most profits in lieu of salary are taxable, certain exemptions can lower tax liability:
Section 10(10) Gratuity Exemption: Depending on the employer category and the duration of service, a portion of the gratuity is tax-free.
Section 10(10AA) Leave Encashment Exemption: Employees who encash unused leave upon retirement or resignation may be eligible for a full or partial tax exemption under Section 10(10AA) of the law.
Benefits of the Voluntary Retirement Scheme (VRS) (Section 10(10C)): If VRS compensation satisfies the requirements, it is tax-free up to ₹5,00,000.
CONCLUSION
One of the primary sources of income is salary income. Any compensation that a company gives to an employee for services provided is referred to as a salary. For tax purposes, a salary might signify many different things. It comprises not just the money received but also the monetary worth of the perks and amenities provided by the workplace. Salary or earnings, bonuses, pensions, annuities, gratuities, leave encashment, advances, fees or commissions, provident fund contributions, and profit in lieu of salary are all included. Every employee must understand the tax implications of salary income so that he can properly manage his money. It is very crucial to understand that what is taxable and what is not.
Both employers and employees must have a solid understanding of Perquisites and Profits in Lieu of Salary. Depending on the type of benefit, perquisites may be taxable even when they provide extra cash benefits. Profits in lieu of salaries that result from job changes, terminations, or postponed payments are likewise taxed, although they might qualify for exemptions. People may optimise their financial planning and tax efficiency by carefully arranging their compensation packages and making use of any applicable exemptions.
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Author: Mehakpreet Kaur, 4th year student of BBA.LLB (Hons.), Lovely Professional University
