Introduction to Income Tax on Salary under the Income Tax Act, 1961

The Income Tax Act, 1961 is the primary legislation governing the taxation of individuals and entities in India. Within the act, one of the most significant sources of taxable income for individuals is income from salary. Salary income is earned by employees, including government employees, private sector employees, and professionals who are compensated by employers in return for services rendered.

In India, income received by an individual from their employer in the form of salary, wages, pension, or any other similar payment is subject to taxation under the head “Income from Salary.” The taxation of salary income is governed by several provisions, mainly Section 15 to Section 17 of the Income Tax Act, 1961, which outline the basis of charge, components of salary, and the exemptions or deductions available under various circumstances.

Why is Salary Taxable?

Salary income is one of the most straightforward types of income to tax, as it is typically received by employees on a regular basis and can be easily monitored by employers. The tax system aims to collect taxes from this income to fund public services and infrastructure, while also considering various exemptions and deductions to ease the tax burden on salaried individuals.

Key Considerations in Taxation of Salary

The taxability of salary income involves several important factors:

1. Scope of Salary Income: The salary paid by the employer, including all components like basic salary, allowances, bonuses, and perquisites, is subject to tax.

2. Exemptions and Deductions: Certain components of salary, such as House Rent Allowance (HRA) and Leave Travel Concession (LTC), may be partially exempt from tax under specific conditions. Additionally, standard deduction and professional tax can be deducted from the total salary.

3. Taxable Income Calculation: Salary income is calculated after considering various allowances, exemptions, and deductions, which reduces the total taxable amount.

Objective of Taxation on Salary

The primary objective behind taxing salary income is to ensure that individuals contribute to the national revenue system while maintaining a balanced approach that recognizes different financial situations, such as living in rented accommodation or paying for official travel.

As we explore the details of salary taxation, it is crucial to understand the various sections that lay the foundation for calculating salary income, the components involved, applicable exemptions, and how deductions are applied. Understanding these provisions can help employees efficiently manage their taxes and optimize their tax liabilities.

1. Definition of Salary Income (Section 15 to Section 17) of the Income Tax Act, 1961

The Income Tax Act, 1961, provides a clear framework for the taxation of salary income under Sections 15 to 17. These sections outline the scope of salary income, its components, and how it is taxed. Below is a detailed breakdown of these sections:

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Section 15 – Basis of Charge (Salary Taxability)

Section 15 of the Income Tax Act defines when salary income is chargeable to tax. According to this section, income from salary is taxable if it is due or paid during the previous year.

• Income Due: The salary is chargeable to tax when it is due, even if it has not yet been received. This means that if an employee’s salary is due in one year but paid in the next, it will still be taxed in the year it is due.

• Income Paid: If the salary is paid during the year, even though it may not be due, it will be taxed in the year it is paid.

• Advance Salary: If salary is paid in advance (for example, paid in the current year for work done in the future), it will be taxed in the year it is paid.

• Arrears of Salary: If salary for a previous period is received in the current year (arrears of salary), it will be taxed in the year it is received.

Example:

• If an employee’s salary of ₹1,00,000 for March is paid in April, the salary is taxable in the financial year in which it is due (i.e., the year it was due in March), even though it was received in April.

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Section 16 – Deductions from Salary

Section 16 of the Income Tax Act provides certain deductions from salary income. The purpose of these deductions is to reduce the taxable salary and thereby lower the overall tax liability.

1. Standard Deduction:

   • As of Assessment Year (AY) 2024-25, a standard deduction of ₹50,000 is available to all salaried employees and pensioners. This deduction is provided to reduce the taxable salary without the need to furnish any details.

2. Entertainment Allowance:

   • This deduction is only available for government employees and is the least of:

     • ₹5,000

     • 20% of the salary (basic + dearness allowance)

     • Actual entertainment allowance received

   • Note: This deduction is not available to employees in the private sector.

3. Professional Tax:

   • Any professional tax paid by the employee to the state government during the year is allowed as a deduction. Professional tax is levied by state governments on employees engaged in a profession or calling.

Example:

• If an employee receives ₹10,00,000 in salary and pays ₹5,000 as professional tax, the professional tax of ₹5,000 can be deducted from the salary income.

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Section 17 – Definition of Salary

Section 17 defines the components of salary and clarifies what is considered salary income for tax purposes. The following are included under the term salary:

1. Wages:

   • The regular cash payments made to the employee as agreed upon with the employer. This includes basic salary and other fixed allowances.

2. Annuity or Pension:

   • Payments made periodically to an employee after retirement, based on the agreement between the employer and the employee.

3. Gratuity:

   • Gratuity is a lump sum amount paid by the employer to an employee as a retirement benefit. It is taxable subject to certain exemptions (under Section 10(10)).

4. Fees, Commission, or Profit in Lieu of Salary:

   • Payments made by the employer in addition to the salary, including commission and profits earned due to an employment contract. These are taxable under the head salary.

5. Perquisites:

   • Perquisites refer to any benefits or non-cash compensations provided by the employer to the employee. These can include things like:

     • Rent-free accommodation (valued based on rules under the Act)

     • Cars or other vehicles provided by the employer

     • Stock options or sweat equity provided by the employer to the employee

     • Medical expenses paid by the employer

     • Loans at concessional rates

     • Stock options and similar benefits

   Perquisites are taxable based on the value provided by the employer.

6. Advance Salary:

   • If salary is paid in advance, it is taxable in the year it is paid, even if it relates to work performed in future years.

7. Leave Encashment:

   • Leave encashment is the cash equivalent of unused leave. It is taxable in the hands of the employee, except for exemptions under Section 10(10AA) in specific cases like government employees.

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Other Important Definitions under Section 17

• Salary in Case of a Former Employee: If a person has retired or left a job, the salary income includes the pension or any post-retirement benefits like provident fund withdrawals or gratuity received by the employee.

• Non-Salary Components: Payments such as bonus or incentives made by the employer for performance are also considered salary income and taxable under this head.

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Summary of Sections 15 to 17

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These sections collectively ensure that salary income, which forms a significant part of an individual’s taxable income, is taxed fairly, taking into account all income components, permissible exemptions, and deductions. It also defines when and how income from salary becomes taxable and provides a framework for employees to understand their tax obligations.

2. Taxable Salary Income Components in Detail

Income from salary, as defined under the Income Tax Act, 1961, is made up of various components. Each of these components is treated differently for tax purposes, and some may be fully taxable, partially taxable, or exempt under specific conditions. Below is a detailed breakdown of the taxable salary income components under the Act:

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1. Basic Salary

• Definition: Basic salary is the fixed amount paid to an employee by the employer for the services rendered. It does not include allowances or bonuses, and it forms the foundation for calculating other components such as HRA, Provident Fund, and pension.

• Tax Treatment: Fully taxable as part of salary income.

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2. Dearness Allowance (DA)

• Definition: Dearness Allowance (DA) is an allowance paid to employees to counter the effects of inflation and rising cost of living. It is usually expressed as a percentage of the basic salary.

• Tax Treatment: Fully taxable as part of salary income. However, if a portion of DA is treated as part of the pension, it might be exempt under certain conditions.

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3. House Rent Allowance (HRA)

• Definition: House Rent Allowance (HRA) is provided by the employer to the employee for meeting the cost of renting a house. This is common in cases where employees do not own a house.

• Tax Treatment: HRA is partially exempt from tax under specific conditions. The exemption is calculated based on the following formula:

  Exempt HRA = Least of the following:

  • Actual HRA received

  • Rent paid in excess of 10% of salary (basic + dearness allowance)

  • 50% of salary (for metro cities) or 40% of salary (for non-metro cities)

  Salary for HRA calculation includes basic salary and dearness allowance. To claim HRA exemption, the employee must have paid rent and stay in a rented accommodation.

  Example:
  If an employee receives ₹30,000 as HRA and pays ₹20,000 as rent, the calculation will depend on their basic salary. If their salary is ₹50,000, then:

  • Actual HRA received = ₹30,000

  • Rent paid minus 10% of salary = ₹20,000 – ₹5,000 = ₹15,000

  • 50% of salary (for metro city) = ₹25,000

  The exempt HRA would be the least of ₹30,000, ₹15,000, or ₹25,000, i.e., ₹15,000.

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4. Special Allowance

• Definition: Special allowances are provided by the employer for various purposes, such as travel, uniform, or phone bills.

• Tax Treatment: These are fully taxable, unless specifically exempt under the Act (such as the telephone allowance in some cases).

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5. Bonus and Incentives

• Definition: Bonus or incentives are variable pay given to an employee, typically based on performance, organizational profit, or achievement of specific targets.

• Tax Treatment: Fully taxable as part of salary income, irrespective of the method of payment (cash, check, or other forms).

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6. Commission

• Definition: Commission is an amount paid by the employer to the employee based on achieving certain targets or goals. It is often used in sales, marketing, or performance-based jobs.

• Tax Treatment: Fully taxable under the head “Income from Salary,” and it is added to the total salary income.

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7. Perquisites

Perquisites are benefits or non-cash compensations provided by the employer in addition to salary. These are typically taxable in the hands of the employee, but the method of taxation depends on the specific benefit provided.

Examples of Perquisites:

1. Rent-Free Accommodation (RFA)

   • If an employer provides accommodation to the employee, the value of this accommodation is taxable.

   • The taxable value is calculated based on factors such as the city of residence (metro vs. non-metro), the type of accommodation, and whether it is furnished or unfurnished.

   • Taxable Value Calculation:

     • For rented accommodation, it is either actual rent paid by the employer or 15% of the salary (basic + DA), whichever is lower. However, this rule varies based on specific conditions.

2. Car Provided by Employer

   • Taxable Value: If the employer provides a car for official or personal use, the value of the car is added to the employee’s taxable income.

   • The value is calculated based on the engine capacity (small or large) and whether the car is used for official or personal purposes.

3. Stock Options

   • Taxable at the time of exercise (when the employee can exercise the option to purchase shares) based on the fair market value of the stock.

   • The taxability depends on whether the stock option is granted at market value or at a concessional rate.

4. Other Perquisites:

   • Medical expenses paid by the employer, club memberships, gifts or awards provided, and insurance premiums paid by the employer are also taxable to the extent they are provided as perquisites.

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8. Gratuity

• Definition: Gratuity is a lump sum payment made by the employer to the employee as a gesture of appreciation for their service, typically at the time of retirement, resignation, or death.

• Tax Treatment: Gratuity is taxable, but there are exemptions based on the type of employment and the amount received.

  • Government Employees: Entire gratuity is exempt from tax.

  • Non-Government Employees: Exempt up to ₹20 lakh (under Section 10(10)).

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9. Provident Fund (PF) and Employee Pension Scheme (EPS) Contributions

• Definition: Contributions made by the employer and employee to the Provident Fund (PF) and Employee Pension Scheme (EPS) are part of retirement benefits.

• Tax Treatment:

  • Employer’s Contribution to PF: The employer’s contribution is not included in salary income, and the interest earned on this is also exempt up to a certain limit.

  • Employee’s Contribution to PF: This is deducted from salary under Section 80C (subject to the overall limit of ₹1.5 lakh) and is exempt from tax.

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10. Leave Encashment

• Definition: Leave encashment is the cash equivalent of unused leaves that an employee has accumulated. This amount is paid when an employee takes long leave or retires.

• Tax Treatment:

  • Exempt: For government employees (under Section 10(10AA)).

  • Taxable: For non-government employees. However, it is exempt up to a certain limit:

    • The exemption is the least of:

      • Actual amount received as leave encashment

      • Amount equivalent to the number of days of leave encashed, calculated based on the salary.

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11. Advance Salary

• Definition: When an employee receives salary in advance for future periods, it is still considered taxable in the year it is received, not the year it is due.

• Tax Treatment: Fully taxable in the year it is received.

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12. Other Payments and Allowances

Some additional allowances or payments are also part of the salary but may have specific exemptions or tax treatments, such as:

• Travel Allowance: If used for official purposes, this allowance is exempt under certain conditions.

• Food Coupons: If provided for work purposes, may be exempt.

• Children Education Allowance: Exempt up to a certain limit under Section 10(14).

The various components of salary are generally taxable, with a few exemptions and deductions allowed under specific circumstances. The key taxable components include basic salary, dearness allowance, bonuses, commissions, and perquisites. In addition, allowances like HRA may be partially exempt based on the employee’s situation (e.g., rented accommodation). Gratuity, leave encashment, and certain employer contributions are also subject to specific rules for exemptions.

It is crucial for employees to understand these components to accurately calculate their taxable income and optimize their tax liability by taking advantage of exemptions and deductions available under the Income Tax Act.

Taxable vs Non-Taxable Salary

The Income Tax Act, 1961 distinguishes between taxable and non-taxable (or exempt) salary components. Below is a detailed comparison between the two:

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Taxable Salary Components

These are the components of salary income that are fully taxable unless specifically exempt under the Act:

1. Basic Salary

• The fixed portion of the salary paid to an employee.

• Taxable: Fully taxable under the head “Income from Salary.”

2. Dearness Allowance (DA)

• An allowance paid to offset the impact of inflation and rising cost of living.

• Taxable: Fully taxable as part of salary income.

3. Bonus

• A performance-based payment made by the employer, usually on an annual basis.

• Taxable: Fully taxable, regardless of the mode of payment.

4. Commission

• Variable compensation based on the employee’s performance or sales achievements.

• Taxable: Fully taxable under salary income.

5. Perquisites (e.g., car, housing)

• Benefits or non-cash compensation provided by the employer, such as:

  • Car: If the employer provides a car for personal or official use, it’s taxable.

  • Housing: The value of rent-free accommodation or housing provided by the employer is taxable, calculated based on specific rules.

• Taxable: Fully taxable, but the tax treatment depends on the type of perquisite.

6. Arrears of Salary

• Any unpaid salary from previous years that is paid in the current year.

• Taxable: Taxed in the year it is received, under the head “Income from Salary.”

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Non-Taxable/Exempt Salary Components

These are salary components that are either fully or partially exempt under specific conditions:

1. House Rent Allowance (HRA)

• Exempt under Section 10(13A) if the employee lives in rented accommodation.

• Conditions for Exemption:

  • Rent paid in excess of 10% of salary (basic + DA).

  • The least of actual HRA received, rent paid minus 10% of salary, or 50% (for metro cities) or 40% (for non-metro cities) of salary.

  • Rent receipts must be provided.

2. Leave Travel Concession (LTC)

• Exempt under Section 10(5) for travel within India (subject to certain conditions).

• Conditions for Exemption:

  • The employee must travel to a destination within India.

  • The exemption applies to the actual amount spent on travel tickets.

3. Gratuity

• Exempt under Section 10(10) for government employees, and partially exempt for non-government employees.

• Exemption for Non-Government Employees: Exempt up to ₹20 lakh or based on the formula provided.

4. Employer’s Contribution to Provident Fund (EPF)

• Exempt under Section 10(11), as long as the contribution is made to an approved Provident Fund scheme.

• Conditions for Exemption: The contribution must be within the statutory limits set by the government.

5. Reimbursements

• Exempt under certain conditions, such as reimbursements for business-related expenses.

• Examples:

  • Travel expenses incurred for official work.

  • Medical reimbursements (if the employer has a medical policy).

  • Telephone bill reimbursement.

• Conditions for Exemption: These reimbursements are not taxable if they are made for official purposes and within the prescribed limits.

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Summary of Taxable vs Non-Taxable Salary Components