When an employee leaves your organisation or their contract changes, they may receive a one-time payment, such as severance pay, a signing bonus, or a payout from an unrecognised fund. Although these are not part of their regular monthly salary, they are still taxable under income tax laws. The Income Tax Act classifies such payments as "profit in lieu of salary", and they must be reported under the “Income from Salaries” section in the employee’s ITR.
If you’ve ever wondered whether a joining bonus or termination compensation is taxable, or how to treat a Keyman Insurance payout, this guide is for you. We’ll explain what counts as profit in lieu of salary, what’s taxable, what’s exempt, and how to stay compliant.
Let’s break it down step by step.
Profit in lieu of salary refers to any payment or benefit received by an employee that is not part of the regular monthly salary but is still connected to their employment, usually at the time of resignation, retirement, termination, or contract changes.
Under Section 17(3) of the Income Tax Act, these amounts are treated as part of "Income from Salaries" and are fully taxable unless specifically exempt.
Here’s what it typically includes:
Compensation received after job termination: As an employer, you’re required to treat any compensation you provide after terminating an employee, such as severance pay or early exit packages beyond statutory benefits, as taxable income.
Payments from unrecognised provident or superannuation funds: Unlike recognised funds, contributions or withdrawals from unrecognised funds are not tax-exempt and are treated as part of profit in lieu of salary when received.
Proceeds from a Keyman Insurance Policy: If you, as the employer, were the proposer and paid the premiums, and the maturity amount is paid to your employee or their nominee, it will be taxable under this category.
These payments, while not part of monthly wages, are still tied to your job and hence come under salary taxation rules.
Now that we’ve understood what falls under profit in lieu of salary, let’s take a closer look at the specific components that are commonly included under this category.
Profit in lieu of salary includes several types of lump-sum or irregular payments that aren't part of your regular monthly wages but are still tied to your employment. These payments become taxable as salary income under Section 17(3) of the Income Tax Act, even if received after leaving the job.
Here are the key components and why they matter:
Severance Pay or Termination Compensation
Compensation given to an employee when their job is terminated, outside of legally defined retrenchment terms.
Why it matters: Even though this is received as a one-time payment, it is directly tied to the employment contract and is fully taxable unless it qualifies for specific exemptions.
Payments from Unrecognised Provident or Superannuation Funds
Any lump sum received from a provident or superannuation fund that the Income Tax Act does not recognise.
Why it matters: These are not eligible for tax exemptions, unlike recognised funds. The full amount is treated as income and taxed accordingly under salary head.
Proceeds from a Keyman Insurance Policy
Amounts received from an employer-owned life insurance policy (Keyman Policy) where the beneficiary is the employee or their nominee.
Why it matters: These payouts are considered part of the employee’s total benefit package and do not qualify as tax-free insurance maturity unless certain conditions are met.
Signing Bonuses, Joining Incentives, or Delayed Payouts
One-time bonuses paid before joining or after leaving the company, often as part of the employment offer or contractual dues.
Why it matters: Although not a monthly salary, these payments arise only due to the employment relationship, and thus must be declared under income from salaries.
Understanding these components ensures that you're not unintentionally missing out on reporting income or misclassifying it, which could lead to tax issues or notices later on.
Now that we’ve identified what counts as profit in lieu of salary, let’s explore how these payments are taxed and what you need to watch out for when reporting them.
While profit in lieu of salary may not seem like regular income, it is still treated as part of an employee’s salary for income tax purposes. This means it must be declared when filing their Income Tax Return (ITR) and can significantly impact their tax liability. Whether it’s severance pay or a joining bonus, understanding how it’s taxed helps you ensure accurate reporting and remain compliant with tax regulations.
1. Taxed as 'Income from Salaries' under the individual's applicable slab rates
What it is: Profit in lieu of salary is not taxed under a separate category—it’s grouped with your regular salary and taxed based on your total annual income.
How it works:
This means you will pay income tax as per the normal slab rates applicable to your income bracket for the financial year. For example, if you receive ₹3 lakhs as severance pay, and this pushes your income above the ₹10 lakh threshold, your tax liability will increase accordingly.
Additionally:
You may lose out on benefits like staying in a lower slab or qualifying for certain deductions (like rebate under Section 87A), if the inclusion of such income pushes you over the exemption threshold.
2. Need for inclusion in gross salary calculation for tax purposes
What it is: All amounts classified under profit in lieu of salary must be included in your gross salary figure when filing your Income Tax Return (ITR).
How it works:
Even if the payment was received after resigning or retiring, or if it's not shown in your final payslip, you are legally required to declare it under “Income from Salaries.” This ensures that the total salary income matches the TDS data reported by the employer and reflected in your Form 26AS or AIS (Annual Information Statement).
Why it matters:
If there is a mismatch between your reported income and what’s reported by your employer to the IT department, you may receive a notice or face delays in processing your refund, if any.
3. Potential for employer’s tax deduction responsibilities under Section 192
What it is: Section 192 of the Income Tax Act mandates that employers must deduct tax at source (TDS) from any salary payment, including components that fall under profit in lieu of salary.
How it works:
Suppose you receive severance pay, a joining bonus, or any payment post-employment that qualifies as profit in lieu of salary. In that case, your employer is obligated to calculate the applicable TDS and deduct it at the time of payment. This deduction will then reflect in your Form 16 and Form 26AS.
Why this is important:
In cases where the employer does not deduct TDS, you (the employee) become responsible for paying advance tax. Failing to do so can result in interest liabilities under Sections 234B and 234C, and may even invite scrutiny during the assessment process.
By understanding how profit in lieu of salary is taxed and ensuring accurate reporting, both employees and employers can avoid tax surprises, stay compliant, and plan finances more effectively.
Not every payout received at the time of resignation, retirement, or termination is considered profit in lieu of salary. Some types of payments are specifically excluded under the Income Tax Act because they are meant to provide financial relief or are considered welfare benefits. These exclusions are generally tax-exempt under various sections and must be reported under the correct head to avoid tax misclassification.
Here are the most common exclusions:
1. Gratuity (Section 10(10))
Gratuity received by employees is fully or partially exempt depending on the category of employer (government or private) and subject to certain limits.
For government employees: gratuity is fully exempt from tax.
For private-sector employees covered under the Payment of Gratuity Act, the exemption is up to ₹20 lakhs (as of the latest update).
The balance, if any, becomes taxable under the salary head.
Why it’s excluded: Gratuity is a retirement benefit—not compensation for loss of job or performance—and is therefore treated separately.
2. Statutory Provident Fund (SPF) and Recognised Provident Fund (RPF)
Any amount withdrawn from Statutory Provident Fund or Recognised Provident Fund after completing 5 years of continuous service is fully exempt from tax.
Withdrawals before 5 years may be taxable unless transferred to a new employer’s PF account.
Public Provident Fund (PPF) withdrawals are always tax-free.
Why it’s excluded: These are long-term savings instruments with built-in tax benefits to encourage retirement planning. They don’t qualify as compensation for services rendered.
3. Leave Encashment (Section 10(10AA))
Leave encashment received:
During service is fully taxable.
At the time of retirement or resignation, it is exempt up to ₹3 lakhs for non-government employees.
For government employees, the amount is fully exempt.
Why it’s excluded: It is considered a deferred wage for earned but unused leave and not an incentive or compensation for job loss.
4. Retrenchment Compensation (Section 10(10B))
Compensation paid to employees during retrenchment (under Industrial Disputes Act) is exempt up to the lower of:
₹5 lakhs, or
The amount calculated under the Act.
Why it’s excluded: It is a statutory entitlement provided to workers in case of downsizing, not a discretionary payment, and hence given separate treatment under the tax law.
Knowing which payments are excluded from profit in lieu of salary helps you avoid over-reporting taxable income and ensures that you're taking full advantage of applicable exemptions during separation or retirement.
Whether you're paying or receiving profit in lieu of salary, proper documentation and tax planning are essential. Both employers and employees have responsibilities to ensure that these payments are accurately handled, reported, and compliant with tax regulations.
1. Advance Tax Planning
Employees receiving profit in lieu of salary should assess their total income for the year and plan for any potential increase in tax liability.
Include such payments when calculating estimated income to avoid underpayment.
If the employer deducts no TDS, be prepared to pay advance tax to avoid interest under Sections 234B and 234C.
Consider consulting a tax advisor if the payout is substantial or overlaps with other taxable income.
2. Documentation and Reporting by Employers
Employers must clearly document any payment that qualifies as profit in lieu of salary.
Provide a detailed breakup in Form 16, mentioning the nature of each component.
Ensure accurate reporting in TDS returns (Form 24Q) and Form 26AS, which reflect in the employee’s tax records.
Keep supporting documents like resignation letters, compensation agreements, or board approvals on file.
3. Accurate Disclosure in Employee’s ITR
Employees are responsible for reporting these payments correctly in their Income Tax Returns (ITR).
Classify them under the correct head—‘Income from Salaries’, even if received post-employment.
Cross-check Form 26AS and Form 16 to ensure consistency with reported income.
Maintain copies of payslips or settlement letters as proof in case of future queries or assessments.
Handling profit in lieu of salary with accuracy—from payment to reporting—helps both employers and employees stay tax-compliant, avoid penalties, and maintain financial clarity.
Understanding the concept of profit in lieu of salary is essential for anyone navigating job transitions, retirements, or one-time compensation arrangements. While these payouts may feel like benefits or rewards, they come with important tax implications that must be handled carefully.
By staying informed and maintaining clear records, both employees and employers can avoid tax surprises, ensure timely reporting, and stay compliant with evolving income tax laws.
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1. What exactly is profit in lieu of salary?
Profit in lieu of salary refers to any payment received by an employee that is not part of their regular salary but is still connected to their employment, such as severance pay, signing bonuses, or proceeds from unrecognised funds. These are taxed under the heading "Income from Salaries."
2. Is severance pay taxable under profit in lieu of salary?
Yes. Severance pay is taxable unless it qualifies under a specific exemption like retrenchment compensation. If it doesn’t fall under a tax-exempt category, it will be treated as profit in lieu of salary and taxed accordingly.
3. Are joining bonuses or delayed payments after resignation also taxable?
Yes. Any bonus or compensation received before joining or after leaving an employer is considered profit in lieu of salary and is fully taxable under the salary head.
4. Do employers need to deduct TDS on profit in lieu of salary?
Yes. Employers are required to deduct tax at source (TDS) under Section 192 for any amount paid as profit in lieu of salary. If TDS isn’t deducted, the employee must pay advance tax on it.
5. What payments are excluded from profit in lieu of salary?
Payments such as gratuity, leave encashment, statutory retrenchment compensation, and withdrawals from recognised or public provident funds (PPF) are not considered profit in lieu of salary if they meet exemption conditions under the Income Tax Act.
