Tax relief on arrears payment

This week’s article is on the tax deduction available on arrears of salary. Readers would know that the Central government has announced an average increase of 21% in salaries of its employees, retrospectively effective from January 2006.

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The arrears are to be paid in two installments -- 40% this year and the rest next year in order to reduce the burden on the exchequer. As per reports, the tax on first installment will be deducted in the current fiscal and that on the second installment will be deducted next year.

However, the TDS is just part of the story. It must be remembered that TDS is not the same as your tax liability. The final tax liability will be computed on the basis of the income tax rates which again depend upon the total income and the exemptions, deductions and rebates you can claim. The TDS can be set off against the final tax payable and the taxpayer needs to pay only the difference. In case the TDS is higher than the tax liability, one can apply for a refund.

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Now, when arrears of pay are received in any particular year, it could artificially raise the tax liability in that year. This happens because due to the receipt of arrears, the total income increases and consequently the tax payable increases. However, this is unfair to the taxpayer. Had he originally received the money in the year(s) that he was supposed to receive it, the additional tax would have been staggered over the years instead of converging in one year as a lump sum payment.

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Therefore, the law allows a tax deduction under Sec. 89(1) for this additional tax burden and we will be examining the same in detail. Incidentally, this deduction is available to every taxpayer who gets salary in advance or in arrears, whether such person is government employee or is working in the private sector.

Sec. 89(1)

Basically, the relief under Sec. 89(1) is arithmetical. It involves the ascertaining the two amounts of tax — the first is the amount of tax applicable to the total income including the extra amount in the year of receipt. The second is calculating the amount of tax by adding the arrears to the total income of the years to which they relate. The difference between the two amounts is the amount of deduction allowed.

In other words, if the taxpayer is required to pay any additional amount of tax (in the year of receipt) than what he would have otherwise paid, had he received the money in the year(s) that he was supposed to receive it, such additional tax need not be paid i.e., it can be reduced from the tax payable.

Let us take a numerical example to further amplify this issue.

Say Vishal who works as a sales manager for a private sector company receives Rs. 2 lakh in the current year as arrears of pay. This money was actually the additional sales incentive pertaining to the year 2004. Now let’s assume that ordinarily, as per his salary level, Vishal would have paid a tax of Rs. 1,80,000. But just because of the inclusion of the sales incentive his tax payable climbs to Rs. 2,40,000.

Now, for a moment let’s go back to the year 2004. That year, Vishal had paid a tax of Rs. 1,35,000. But had the sales incentive been paid to him then itself, Vishal would have paid a higher tax of Rs. 1,70,000. Given this data, let us calculate the tax deduction available to Vishal.

(Note that these figures are hypothetical and meant as an example for ease of understanding — in reality, actual computations will have to be undertaken.)

Year	Particulars	Amt (Rs.)	Amt (Rs.)
2008	Tax payable with arrears	2,40,000
	Tax payable without arrears	1,80,000
	Difference		60,000
2004	Tax payable including incentive	1,70,000
	Tax payable excluding incentive	1,35,000
	Difference		35,000
	Extra tax payable by Vishal just on account of the arrears (Sec 89(1) deduction)		25,000

To Sum

For simplicity and ease of understanding, in the example, we have assumed that the arrears are being received only in respect of one year i.e. 2004. In practical life, generally, arrears may be received for multiple years in the past. In such cases, the computation of tax for each individual year would have to be undertaken to arrive at the accurate amount of the additional tax payable.

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Also it is important to note that since a deduction under Sec. 89(1) reduces the final amount of tax payable, to that extent, it would also reduce the TDS on salary. Employees should indicate to the employer that a lower TDS needs to be deducted by way of furnishing Form-10E. This Form represents a true and authentic statement of the total income of the earlier yeas to which the arrears pertain. There is no warrant for a notice under Sec. 148 or calling for returns of income of the earlier years. (Circular No. 331, dated 22.3.1982)

Lastly, since it is the extra tax on the arrears that is the relief admissible under Sec. 89(1), it follows that if there is no excess, no relief is admissible. In other words, if the tax in the year of receipt works out to be actually lower than what was payable in the past, no relief under Sec. 89(1) can be claimed.

The authors may be contacted at wonderlandconsultants@yahoo.com