Government employees have been looking pretty chuffed lately — and they have good reason to be.

Last month, the government finally accepted the recommendations of the Sixth Pay Commission after a wait of over six months.

Civil servants, who have moaned for years about how small their pay packets are in comparison to their peers in the private sector, finally have pay scales that look pretty decent.

But here’s the bad news: the government employees will receive only 40 per cent of their 32-month arrears (which are payable from January 1, 2006) in this financial year of 2008-09. The remaining 60 per cent will be paid in the next financial year.

And here’s where it gets worse: even if you receive 40 per cent of the arrears this year, you will have to pay tax on the entire sum of arrears this year itself.

This is a spooky thought and is certain to dismay employees who were eagerly waiting to receive the money before heading off on a long-awaited shopping binge just when festival season discounts have started to pop up across malls.

Sleight of hand

According to Section 15 of the Income Tax Act, 1961, which deals with the taxation of salary income, any salary due from an employer or a former employer to an assessee, whether paid or not, shall be chargeable under the head salary.

The entire amount of salary arrears which is due to the government employees will be liable to tax deduction in the current financial year itself even though the employees will be receiving only 40 per cent of their dues.

So, in effect, this is a neat little sleight of hand: the government will be giving with one hand and taking away a substantial amount with the other.

Every year the income tax department comes out with a circular on tax deduction from salary under Section 192 of the income tax act.

In a circular last year, the department had notified that any salary due from an employer or a former employer to an assessee in the previous year, whether paid or not, will be taxed.

This presents a curious situation where the government will be back-loading the payout to avoid putting a strain on its exchequer even as it front-loads the tax to swell its own coffers.

Unless the government comes out with a new circular or issues some new guidelines as a special tax dispensation, harried civil servants and sullen defence service officers (already upset over the civilian bias in pay scale changes) should get ready to face a hefty tax blow this year.

Illusory reliefs

Let us now take a look at Section 89 of the income tax act which provides some relief to those who receive salary arrears or advances. This section says that when an assessee receives a sum in the form of salary, being paid in arrears or in advance, or is in receipt in any one financial year of salary for more than 12 months, then the person is entitled to receive some relief.

If on account of the salary arrears, the total income of the salaried employee is assessed at a higher rate than that at which it would otherwise have been assessed, then the employee can claim a relief. To get this benefit, the employee will have to submit Form No 10E to the employer.

However, it would be of not much use for government employees to claim a benefit under Section 89.

The arrears are due from January 1, 2006. This means that the arrears will cover part of the financial year of 2005-06, all of 2006-07 and 2007-08, and again a part of 2008-09.

So, there are four financial years. The civil servants have a choice: they can either choose to pay tax based on the applicable marginal rate for the relevant years or can have the tax deducted at source in the current financial year after adding the arrears to the salary income for this year.

The purpose of Section 89 is to grant relief to the salaried employees so that the tax burden can be staggered.

But there are two reasons why this won’t work too well for civil servants: first, the income tax exemption limit for the current financial year has been raised; and second, the income tax slabs have also been lowered for this year.

If one chooses to pay tax at the old rates and with the old exemption limit for the three preceding years, one may find the tax burden slightly higher than it would have been if it was paid at the current year’s lower tax rates.

Surcharge twist

Next is the problem of income tax surcharge. Many employees — especially those in the rank of special secretary, secretary and cabinet secretary — may find that while clubbing their arrears with this year’s salary income, they become liable to pay the surcharge as well. A surcharge at the rate of 10 per cent becomes payable when the total taxable salary crosses Rs 10 lakh.

Hence, government employees should stop chalking out elaborate plans to invest their salary arrears.

They should first figure out how much tax they would have to pay. One should also remember that there is a tax implication for some of the allowances that have been raised on the recommendations of the pay commission.

All salaried employees, including civil servants, get a tax exemption under Rule 2BB of Income Tax Rules, 1962, on transport allowance up to Rs 800 per month.

Under the new pay scales, several government employees will get a transport allowance ranging between Rs 1,600 and Rs 3,500. The limit under Rule 2BB hasn’t been raised — which means any amount above Rs 800 would be subject to tax.

The same principle would apply to allowance for children’s education (exemption capped at Rs 100 per month per child) and women suffering from disability after child birth.

There is something good that comes out of this after all: if one pays the tax on the entire sum this year, then one can put to use 60 per cent of the salary arrears that will flow next year.

So, pay the tax this year — and enjoy the real benefit next year.

The author is a tax and investment consultant in New Delhi. He can be contacted at slakhotia@satyam.net.in