Tax deduction on arrears of salary decoded

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 and consequently the tax payable increases.
Vishal worked as a sales representative of a leading branded jewellery manufacturer. His remuneration was payable on a salary-cum-commission basis. On account of some reconciliation issues with the head office, the commission payable in respect of some sales made in the year 2007 remained unpaid. In time, the issue was resolved and the outstanding amount due to Vishal was paid to him in 2011. However, this was unfair to Vishal. Had he originally received the money in the years 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.
Therefore, the law allows a tax deduction under Section 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 one is a government employee or is working in the private sector.
Section 89(1)
Basically, the relief under Sec. 89(1) is arithmetical. It involves ascertaining 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 understand this issue.
In the aforementioned case, let’s say Vishal receives `2 lakh in the current year as arrears of pay. This money was actually the additional sales incentive pertaining to 2007. Now, let’s assume that ordinarily, as per his salary level, Vishal would have paid a tax of `1,80,000. But just because of the inclusion of the sales incentive his tax payable climbs to `2,40,000. Now, for a moment let’s go back to 2007. That year, Vishal had paid a tax of `1,35,000. But had the sales incentive been paid to him then itself, Vishal would have paid a higher tax of `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.)
Conclusion
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. 2007.
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.
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 No 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 writer is director at Wonderland Consultants, a tax and financial planning firm and can be reached at sandeep.shanbhag@gmail.com