Received a Salary Arrear? Here’s How It Affects Your Taxes

Finding out you’re getting a past-due salary payment—an arrear—feels like a bonus. It’s money you rightfully earned. However, from the Income Tax Department’s perspective, it’s income, and it needs to be taxed correctly. The catch? It could push you into a higher tax bracket for the year you receive it, leading to a hefty tax bill.

Understanding how arrears are taxed and how you can potentially lower the burden is crucial. Let’s break it down.

What is Arrear Salary?

Arrear salary is income that was earned in a previous financial year but is paid to you in the current financial year. Common examples include:

• A salary hike or promotion that was implemented retrospectively.
• A backlog of payments from a pay commission award (common for government employees).
• A bonus or commission that was delayed and paid in a later year.
• Settlement of a dispute or court case regarding your pay.

The Tax Problem: The “Clubbing” Effect

The core issue with arrears is the “clubbing” effect. The Income Tax Act follows a receipt basis for salary income. This means income is taxable in the year in which it is received, not in the year it was earned.

When a large arrear payment is added to your current year’s salary, it can:

• Push your total income into a higher tax slab.
• Reduce the benefits of deductions you’re eligible for, as they may have limits.
• Result in a higher tax liability than if the income had been received in the year it was meant for.

Essentially, you end up paying more tax on the same amount of money simply because it was paid late.

The Relief Valve: Section 89(1)

Thankfully, the tax laws provide a solution to this problem. Section 89(1) of the Income Tax Act allows you to claim relief from the additional tax burden caused by receiving arrears.

The goal of this section is to ensure that you pay approximately the same amount of tax that you would have paid if the arrears had been received in the correct year.

How does Section 89(1) work?

It involves a recalculation of your tax liability for both years:

1. Calculate Tax for the Current Year: Calculate your tax liability for the year you received the arrears (including the arrears amount).
2. Calculate Tax for the Previous Year: Recalculate your tax liability for the year to which the arrears belong (as if you had received the money in that year).
3. Find the Difference: The relief is the difference between the tax you paid on the arrears in the current year and the tax you would have paid on it in the previous year.

If the tax in the previous year would have been higher, no relief is available. The relief is only provided if the tax calculation shows you paid more tax due to the delay.

How to Claim Relief under Section 89(1)

Claiming this relief is a manual process that requires careful calculation.

1. Form 10E: The Prerequisite. Before you can claim relief in your ITR, you must file Form 10E on the income tax e-filing portal. This is a mandatory step. Your claim for relief will be rejected if Form 10E is not filed first.

2. Report in Your ITR: While filing your Income Tax Return (ITR-1, ITR-2, etc.), you must report the arrear amount in the dedicated section for “Income from Salary” and then claim the calculated relief under the chapter “VI-A deductions” (even though it’s not a deduction, it’s reported there in the ITR form).

A Practical Example (Simplified):

• Financial Year (FY) 2023-24: You received ₹5,00,000 in salary arrears from FY 2020-21.
• Your total income for FY 2023-24 (with arrears) is ₹15,00,000.
• Your total income for FY 2020-21 (without arrears) was ₹7,00,000.

Without Relief: You pay tax on ₹15,00,000 in FY 2023-24, which falls in the 30% slab, leading to a high tax on the arrears.
With Relief: The tax department will calculate:

• Tax on ₹15,00,000 in FY 2023-24.
• What your tax would have been in FY 2020-21 if your income was ₹12,00,000 (₹7,00,000 + ₹5,00,000 arrears).
  The difference between these two calculations is the relief amount that reduces your tax payable for FY 2023-24.

Conclusion:

• Don’t ignore arrears: They are fully taxable in the year of receipt.
• File Form 10E first: This is non-negotiable for claiming relief under Section 89(1).
• Document everything: Keep the breakdown of the arrear from your employer (Form 16, Part B will show it separately).
• Seek help if needed: The calculation can be complex, especially with changing slab rates. Using tax software or consulting a CA can ensure you claim the correct relief and avoid errors.