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Reduce tax liability on arrears

Sandeep Shanbhag  |  Mumbai 

Show Form 10E which gives the true picture of salary earned in the earlier years.

When salary or other income arrears are received in any particular year, one’s liability for that year increases. Simply because one’s total income for that year has increased. Most salaried individuals will be able to identify with such situations. But having to pay a higher on account of arrears is unfair to the taxpayer. Had he originally received the money in the year(s) that he was supposed to receive it, the additional would have been staggered over this time, instead of converging in one year as a lump sum payment.

Our Income tax law has taken the same into consideration and allows a tax deduction under Section 89(1) for this additional tax burden on the tax payer. At times, the employee appraisal process (where the employee can expect a revised salary), takes longer than expected, and the actual payments are postponed. Also, commissions and other cash incentives for sales and marketing personnel, could be reconciled at a later date.

Year Particulars

Amt (Rs)

2011 Tax payable with arrears  2,40,000
Tax payable without arrears 1,80,000
Difference   60,000
2006 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)

So, payment delays spill over to the next financial year or if any arrears payable pertain to previous years, then (and only then ), is one be allowed a tax deduction under Section 89. Let us examine how the deduction works. Deductions under this section is available to every taxpayer, who gets his salary in advance or in arrears.And this is true for everyone, whether such a person is a government employee or is working in the private sector.

Basically, the relief under Section 89(1) is arithmetical. It involves 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 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) he was supposed to receive it, such additional tax can be reduced from the tax payable. Let us take an example.

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 2006. Now, let's assume that ordinarily, going by 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. Return, for a moment, to the year 2006. In that year, Vishal had paid a tax of Rs 1,35,000. Had the sales incentive been paid to him then itself, he would have paid a higher tax of Rs 1,70,000. Given this data, the difference between the tax paid and the actual payable tax (had he received the money in the same year ) is what he can claim. (Note that these figures are hypothetical and meant as an example for ease of understanding).

For simplicity and ease of understanding, in the example we assume the arrears are being received only in respect of one year that is 2006. In practical life, such 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.

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

Finally, since it is the extra tax on the arrears that is the relief admissible under 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 Section 89(1) can be claimed.

The writer is Director, Wonderland Consultants

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First Published: Sun, September 25 2011. 00:55 IST