Guide to Income under the Head Salaries and Its Computation

Table of Contents

1. What do you understand by the Expression “Salary”
2. What is Basis of Charge of Salary Income
3. Different Forms of Salary – How Taxed

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1. What do you understand by the Expression “Salary”

In order to understand the meaning of expression “salary”, one has to keep in mind the following norms:

1.1 Relationship between payer and payee

The relationship between payer and payee should be of an employer and employee. In other words, the amount received by an individual shall be treated as salary only if the relationship between payer and payee is of an employer and employee or master and servant. Employer may be an individual, firm, association of persons, company, corporation, Central Government, State Government, public body or a local authority. Likewise, employer may be operating in India or abroad. The employee may be a full-time employee or part-time employee.

A Member of Parliament or of State Legislature is not treated as an employee of the Government. Salary and allowances received by him are, therefore, not chargeable to tax under the head “Salaries” but are chargeable to tax under section 56 under the head “Income from other sources”.

1.2 Salary and wages – Conceptually not different

Remuneration received by an individual is taxable under the head “Salaries” whether the remuneration is termed as salary or wages.

1.3 Salary from more than one source

If an individual receives salary from more than one employer during the same previous year (maybe due to change of employment or due to employment with more than one employer simultaneously), salary from each source is taxable under the head “Salaries”.

1.4 Salary from former employer, present employers or prospective employer

Remuneration received (or due) during the previous year is chargeable to tax under the head “Salaries” irrespective of the fact whether it is received from a former, present or prospective employer.

1.5 Foregoing of salary

Section 15 taxes salary on “due” basis even if it is not received. If, therefore, an employ0ee foregoes his salary, it does not mean that salary so foregone is not taxable. Once salary has accrued to an employee its subsequent waiver does not make it exempt from tax liability. Such voluntary waiver or foregoing by an employee of salary due to him is merely an application of income and is nonetheless chargeable to tax.

1.6 Salary paid tax-free

If salary is paid tax-free by the employer, the employee has to include in his taxable income not only salary received but also amount of tax paid by the employer. It does not make any difference whether tax is paid under terms of contract by the employer or voluntarily.

1.7 Voluntary payments

Salary, perquisite or allowance may be given as a gift to an employee, yet it would be taxable. The Act does not make any distinction between gratuitous payment and contractual payment.

1.8 Salary under section 17(1)

Under section 17(1), salary is defined to include the following :

1. wages ;
2. any annuity or pension ;
3. any gratuity ;
4. any fees, commission, perquisites or profits in lieu of or in addition to any salary or wages;
5. any advance of salary ;
6. any payment received by an employee in respect of any period of leave not availed by him;
7. the portion of the annual accretion in any previous year to the balance at the credit of an employee participating in a recognised provident fund to the extent it is taxable ;
8. transferred balance in a recognised provident fund to the extent it is taxable; and
9. the contribution made by the Central Government or any other employer to the account of an employee under a notified pension scheme referred to in section 80CCD.

2. What is Basis of Charge of Salary Income

The basis of charge is explained in the following paras—

Basis of charge as per section 15 – Basis of charge in respect of salary income is fixed by section 15. Salary is chargeable to tax either on a “due” basis or on a “receipt” basis, whichever matures earlier. Moreover, any amount received as arrears of salary is taxable in the year of receipt if it was not taxed earlier.

For instance, if salary of 2024-25 is received in advance in 2023-24, it is included in the total income of the previous year 2023-24 on “receipt” basis (as tax incidence matures earlier on “receipt” basis, “due” basis is not relevant in this case; therefore, salary will not be included in total income of the previous year 2024-25). On the other hand, if salary which has become due in 2022-23 and received in 2023-24, is included in total income of the previous year 2022-23 on “due” basis (as incidence of tax matures earlier on “due” basis, “receipt” basis is inapplicable; salary will, therefore, not be included in total income of the previous year 2024-25).

• Accounting method of the employee not relevant – It is worthwhile to mention that salary is chargeable to tax on “due” or “receipt” basis (whichever matures earlier) regardless of the fact whether books of account, in respect of salary income, are maintained by the assessee on a mercantile basis or cask  Metkod of accounting cannot, therefore, vary the basis of charge fixed by section 15.

2.1 Place of accrual of salary income [Sec. 9(1)]

Income under the head “Salaries” is deemed to accrue or arise at the place where the service (in respect of which it accrues) is rendered. Keeping in view the aforesaid general observation, the rules are given below—

• If service is rendered in India, salary income is deemed to accrue or arise in India. Conversely, if service is rendered outside India salary income cannot be deemed to be earned in India. However, this rule has an exception. Salary received by an Indian citizen from the Government of India for rendering service outside India is deemed to accrue or arise in India. Suck salary is taxable in the kinds of the concerned employee, even if he is a non-resident. However, allowances and perquisites received from the Government by an Indian citizen for rendering service outside India are exempt from tax.
• Pension paid abroad is deemed to accrue in India, if it is paid in respect of services rendered in India.
• Likewise, leave salary paid abroad in respect of leave earned in India is deemed to accrue or arise in India.
• The above provisions are summarized below (it is assumed that salary is paid at the place where service is rendered)—

2.2 How to compute salary income

Salary income is calculated as under—

3. Different Forms of Salary – How Taxed

The term “salary” signifies a recompense or consideration given to any person for pains bestowed upon another person’s business.

Tax treatment of different receipts is given below –

*The following are treated as Government employees (Govt.) or non-Government employees (N Govt.) –

3.1 Leave Salary

If a leave (standing to the credit of an employee) is not taken within a year, as per the service rules, it may lapse or it may be encashed or it may be accumulated. The accumulated leaves standing to the credit of an employee may be availed by the employee during his service time or, subject to service rules, such leaves may be encashed at the time of retirement or leaving the job. Encashment of leave by surrendering leave standing to one’s credit is known as “leave salary”.

• Leave salary received while in service – It is always taxable in the hands of employee getting leave salary. This rule is applicable whether the employee is a Government employee or non-Government employee.
• Leave encashment received at the time of retirement or leaving job by a Government employee – It is exempt³ from tax. Government employee for this purpose is a Central Government employee or a State Government employee³.
• Leave encashment received at the time of retirement or leaving job by a non-Government employee – It is exempt³ from tax depending upon a few conditions which are discussed in the para given below.

3.1.1 Non-Government Employees getting leave encashment at the time of retirement [Sec. 10(10AA)(ii)]³

In the case of a non-Government employee (including an employee of a local authority or public sector undertaking), leave salary is exempt from tax on the basis of least of the following—

Notes:

1. How to find out leave standing to the credit of an employee at the time of retirement or leaving the job – It will be calculated as follows—

Step (a) Find out duration of service in number of years (ignore any fraction of year).

Step (b) Find out rate of earned leave entitlement from the service rules — how many days leave is credited for each year of service (earned leave entitlements cannot exceed 30 days for every year of actual service rendered for the employer from whose service he has retired). For instance, if earned leave is credited at the rate of 40 days leave for each year of service, for Step (b) calculation shall be made at the rate of 30 days leave for each year of service. If, however, earned leave is credited at the rate of 25 days leave for each year of service, for Step (b) calculation shall be made at the rate of 25 days leave for each year of service.

Step (c) Find out earned leave actually taken or encashed (in number of days) during the service time.

The computation shall be made as follows—

2. How to find out average monthly salary – Salary, for this purpose, means basic salary and includes dearness allowance if terms of employment so provide⁵. It also includes commission based upon fixed percentage of turnover achieved by an employee. “Average salary” for the aforesaid purpose is to be calculated on the basis of average salary drawn during the period of 10 months immediately preceding the retirement.

• When earned leave encashment is received from two or more employers – Where leave salary or leave encashment is received by a non-Government employee from two or more employers (may be in the same year or different years), the maximum amount of exemption under section 10(10AA)(ii) during the lifetime of the concerned employee cannot exceed Rs. 25,00,000.

3.1.2 Other Points

The following other points should also be kept in view:

• Even if there is any voluntary retirement from service by way of resignation, the provisions of section 10(10AA) would apply.
• Relief under section 89 would be admissible in respect of encashment of leave salary by an employee when in service.
• Salary paid to the legal heirs of the deceased employee in respect of privilege leave standing to the credit of such employee at the time of his/her death is not taxable as salary.
• Sum equivalent of leave salary received by the family of a Government servant who died in harness, is not taxable in the hands of recipient.

3.2 Gratuity

Gratuity is a retirement benefit. It is generally payable at the time of cessation of employment and on the basis of duration of service. Tax treatment of gratuity is given below:

• Gratuity received by a Government employee – It is exempt from tax under section 10(10)(i)⁶. An employee of the Central Government or a State Government or a local authority, is treated as “Government employee” for this purpose.
• Gratuity received by a non-Government employee – Exemption is available under section 10(10)(ii)⁶ when gratuity is received under the Payment of Gratuity Act, 1972. Conversely, if gratuity is received by a non- Government employee (not covered by the Payment of Gratuity Act), exemption is available under section 10(10) (iii). These rules are given below –

3.2.1 Gratuity Received by a Non-Government Employee

Gratuity received by a non-Government employee is exempt from tax to the extent of least of the following:

The least of the above three is exempt from tax. Gratuity in excess of the aforesaid limits is taxable in the hands of the assessee (i.e., non-Government employee). However, the assessee can claim relief under section 89. A few relevant points are given below:

• Non-Government employee covered by Payment of Gratuity Act – In this case exemption⁶ is available under section 10(10)(ii). The following are frequently asked questions –
  How to find out length of service – If the period of service is 6 months or less than 6 months, it shall be ignored for this purpose. Conversely, if the period of service is more than 6 months, it shall be taken as one full year.
  What is salary – “Salary” for the purpose of the aforesaid limits means salary last drawn by an employee and includes dearness allowance but does not include any bonus, commission, house rent allowance, overtime wages and any other allowance.
  How to determine 15 days’ salary – Salary of 15 days is calculated by dividing salary last drawn by 26, i.e., maximum number of working days in a month. For instance, if monthly salary at the time of retirement is Rs. 2,500, 15 days’ salary would come to Rs. 1,442.31 [i.e., Rs. 2,500 × 15+26].
• Non-Government employee not covered by Payment of Gratuity Act – In this case exemption⁶ is available under section 10(10) (iii). The following are frequently asked questions:
  How to find out completed years of service – For calculating length of service any fraction of the year shall be ignored. For instance, if length of service is 24 years, 11 months and 29 days, completed years of service will be 24 for the purpose of section 10(10) (iii).
  What is salary for this purpose – Salary for this purpose means basic salary. It includes dearness allowance if the terms of employment so provide (or if dearness allowance/pay is taken into account for computing retirement benefits)⁷. It also includes commission if commission is payable at a fixed percentage of turnover achieved by an employee.
  How to find out average monthly salary – Average monthly salary is calculated on the basis of average salary for the ten months immediately preceding the month in which the employee has retired. For instance, if a person retires on March 16, 2024, average salary will be considered on the basis of salary drawn from May 1, 2023 to February 29, 2024.
  When gratuity is received from two or more employers – Where gratuity is received by a non-Government employee (not covered by the Payment of Gratuity Act) from two or more employers (maybe in the same year or different years), the maximum amount of exemption under section 10(10)(iii) during the lifetime of the concerned employee cannot exceed the notified amount (i.e., Rs. 20,00,000).

3.2.2 Other Relevant Points Applicable to Government and Non-Government Employees

The following points are applicable whether gratuity is received by a Government employee or a non-Government employee:

• Gratuity paid while in service – Any gratuity paid to an employee while he continues to remain in service (whether or not after he has put in a minimum specified period of service) is not exempt from tax, though the assessee can claim relief under section 89.
• Gratuity received by family members after the death of the employee – If gratuity is paid after the death of an employee (say X is the employee), then the case may fall in one of the following situations:

*After the death of X.
In Situation 1, the gratuity becomes due (and paid) during the lifetime of X. Therefore, it is taxable in the hands of X. However, he can claim exemption under section 10(10).

In Situation 2, gratuity becomes due on June 30, 2023 at the time of retirement. It is taxable in the hands of X even if it is received by his legal heirs on July 11, 2023 after his death. After claiming exemption under section 10(10) the balance shall be included in the salary income of X. Income-tax return shall be submitted by Mrs. X (or her children) as legal heirs of X. It is incorrect to state that in this case, income is taxable in the hands of Mrs. X as income from other sources.

In Situation 3, X dies on July 6, 2023 while in service. Gratuity is sanctioned after his death on July 6, 2023. It cannot be taxed in the hands of deceased employee X, as it becomes due and is paid after his death. This amount is not taxable in the hands of legal heirs also as it does not partake the character of income in their hands but is only a part of the estate devolving upon them. It is incorrect to state that income is taxable in the hands of Mrs. X as income from other sources.

3.3 Pension

Pension is a retirement benefit scheme. Tax treatment of pension is given below –

• Regular pension or monthly pension received by a Government or non-Government employee – Regular pension or monthly pension (i.e., uncommuted pension) is taxable as salary in the hands of an employee. This rule is applicable whether the concerned employee is a Government employee or a non-Government employee. Family pension received by the family members after the death of an employee, is taxable in the hands of recipient family member(s) under the head “Income from other sources” (a standard deduction of Rs. 15,000 or 1/3 of family pension, whichever is lower, is available). Pension from UNO is not chargeable to tax.
• Lump sum pension (i.e., commuted pension) received by a Government employee – It is a lump sum payment in lieu of periodical payment. For instance, after his retirement, X gets Rs. 2,000 per month as monthly pension. As per service rules, he gets 25 per cent of his pension commuted for Rs. 60,000 (after commutation he will get the remaining 75 per cent, i.e., Rs. 1,500 by way of monthly pension). In this case, Rs. 60,000 is commuted pension which X has received in lieu of 25 per cent of his monthly pension. Commuted pension is not chargeable to tax in the case of a Government employee (i.e., an employee of Central Government, State Government, local authority or statutory corporation).
• Lump sum pension (i.e., commuted pension) received by a non-Government employee – In the case of non-Government employee, commuted pension is exempt11 to the extent given below:

1. 1. one-third of normal pension is exempt if the employee receives gratuity; or
   2. one-half of normal pension is exempt from tax if the employee does not receive gratuity.

3.4 National Pension System (NPS)

NPS is applicable to new entrants to Government service or any other employer. As per the scheme, it is mandatory for persons entering the Government service on or after January 1, 2004, to contribute 10 per cent of salary every month towards NPS. A matching contribution is required to be made by the employer to the said account. The tax treatment under NPS is as follows:

1. Contribution by the employer to NPS is first included under the head “Salaries” in hands of the employee.
2. Such contribution is deductible to the extent of 10 per cent (14 per cent in the case of a Central Government/State Government employee) of the salary of the employee under section 80CCD(2).
3. Employee’s contribution to NPS (to the extent of 10 per cent of the salary of the employee) is also deductible under section 80CCD(1)⁸.
4. When pension is received out of the aforesaid amount, it will be chargeable to tax in the hands of the recipient.
5. “Salary” for the purpose of points 1 and 2 (supra) includes dearness allowance, if the terms of employment so provide, but excludes all other allowances and perquisites. It also includes commission if commission is payable at a fixed percentage of turnover achieved by an employee.
6. The aggregate amount of deduction under sections 80C, 80CCC and 80CCD(1) [i.e., contribution by employee (or any other individual) towards NPS] cannot exceed Rs. 1,50,000⁸
7. Moreover, from the assessment year 2016-17, the employee (or any other individual who has joined NPS) can contribute an additional amount (up to Rs. 50,000) towards NPS and claim the same as deduction under section 80CCD(1B)⁸. Contribution under section 80CCD(1B) is not covered by cumulative ceiling which is given in point No. 6 (infra).

1. When compensation is paid under any scheme approved by the Central Government, these limits are not applicable and the entire amount is exempt.
2. Compensation is equivalent to 15 days’ “salary” for each year (or part thereof exceeding 6 months) of service. The mode of computation of “salary” and length of service for this purpose and for the purpose of gratuity (covered under the Payment of Gratuity Act) is same.
3. Exemption under section 10(10AA) is available even under the alternative tax regime under section 115BAC.
4. The limit of Rs. 25,00,000 is applicable with effect from April 1, 2023 [inserted vide Notification No. S.O. 2276(E), dated May 24, 2023]. During April 1, 1998 and March 31, 2023, it was Rs. 3,00,000.
5. Dearness allowance/pay shall be considered only when it is part of salary for computing all retirement benefits (like pension, leave encashment, gratuity, provident fund, etc.). If dearness allowance/pay is part of salary for computing only some (not all) of the retirement benefits, then it is not taken into consideration for this purpose.
6. The exemption under section 10(10) is available even under the alternative tax regime under section 115BAC.
7. Dearness allowance/pay shall be considered only when it is part of salary for computing all retirement benefits (like pension, leave encashment, gratuity, provident fund, etc.). If dearness allowance/pay is part of salary for computing only some (not all) of the retirement benefits, then it is not taken into consideration for this purpose.
8. Deductions under section Section 80C, 80CCC, 80CCD(1)/(1B) is not available under the alternative tax regime under section 115BAC.