Section 17(3) of the Income Tax Act Explained

Section 17 of the Income Tax Act, 1961 deals with the components of salary income, including basic salary, perquisites, and profits in lieu of salary. Under this, Section 17(3) addresses the taxation of profits or gains received by an employee in place of or in addition to salary. These are amounts that do not form part of the regular salary but are received due to termination, retirement, or other special circumstances.

Section 17(3) of the Income Tax Act defines ‘profits in lieu of salary’ as any payment received by an employee from their current or ex- employer, which is not part of the regular salary. These payments are considered part of the employee’s total income and are taxable under the head ‘Salaries’ for the relevant financial year. Let’s understand this in more detail

The primary components considered as profits in lieu of salary under Section 17(3) are as follows: 

1. Compensation on Termination of Employment

Any compensation received by an employee due to the termination of employment is considered as profits in lieu of salary. This includes severance pay, retrenchment compensation, and any other payments made upon termination. 

2. Keyman Insurance Policy Proceeds

A Keyman Insurance Policy is a life insurance policy taken by an employer on the life of an employee. Any sum received by an employee under such a policy is taxable as profits in lieu of salary. 

3. Payments Received Before or After Employment

Any payments received by an individual from their employer or former employer, either before joining or after leaving the organisation, are considered as profits in lieu of salary. Joining bonuses, non-compete fees, and other similar payments fall in this category. 

4. Payments from Unrecognised Provident Funds

Amounts received from unrecognised provident funds, which are not exempt under Section 10(11) and Section 10(12), are taxable under this section. This includes the employer's contribution and interest accrued on such contributions.

Imagine a scenario like the one given below:

Ravi, a mid-level manager, was laid off due to company restructuring. Along with his final payslip, he received a compensation package that included severance pay, a non-compete fee, and an early retirement bonus. Ravi assumed these were tax-free, but during filing season, he realised that most of this money fell under “profits in lieu of salary” under Section 17(3). 

 

Since they weren’t covered under exemptions like gratuity or recognised provident funds, the entire amount was added to his taxable income,  pushing him into a higher tax slab.

Takeaway

Even if you're not drawing a regular salary, some one-time payments from your employer are still taxable. Understanding Section 17(3) can help you plan smarter and avoid surprises when filing your return.

Income classified under Section 17(3) is taxable under the head ‘Income from Salaries.’ This means that it is added to the total salary income of the individual and taxed according to the applicable income tax slab rates. 

1. Applicable Tax Slabs

As per the latest Union Budget (FY 2025–2026), the income tax slabs under the new tax regime for individual taxpayers are as follows: 

2. Tax Deducted at Source (TDS)

Moreover, employers are required to deduct tax at source (TDS) on profits in lieu of salary under Section 192 of the Income Tax Act. This ensures that tax is collected in advance and reduces the burden on the employee at the time of filing returns. Employees should check their Form 16 for these deductions.

Certain payments related to employment are exempt from tax under Section 17(3) because they are covered under other specific provisions of the Income Tax Act. These include: 

1. Gratuity – Section 10(10)

Gratuity received by government employees is fully exempt from tax. For private sector employees, exemption is available up to a specified limit based on service duration and salary, subject to ₹20 Lakhs. 

2. Pension – Section 10(10A)

Commuted pension received by government employees is fully exempt. For non-government employees, if gratuity is received, one-third of the total pension is exempt; if no gratuity is received, one-half is exempt. Uncommuted pension, however, is fully taxable. 

3. Retrenchment Compensation – Section 10(10B)

Retrenchment compensation is exempt up to the amount calculated as per the Industrial Disputes Act or ₹5,00,000, whichever is lower. Any excess amount is taxable as profits in lieu of salary. 

4. Statutory Provident Fund – Section 10(11)

Any amount received from a Statutory Provident Fund is fully exempt from income tax under the Provident Funds Act, 1925. This includes contributions, interest, and the final lump sum withdrawal. 

5. Recognised Provident Fund – Section 10(12)

Lump sum withdrawals from a recognised provident fund are exempt if the employee has completed five years of continuous service. Employer’s contribution and interest accrued are also exempt, subject to prescribed limits. 

6. Superannuation Fund – Section 10(13)

Payments from an approved superannuation fund are exempt in specific cases. This includes payments received on retirement, death, or as annuity. However, lump sum withdrawals during service are taxable. 

 

These exemptions can help reduce the tax burden on employees receiving retirement or termination benefits.

To reduce the tax liability on profits in lieu of salary, you could consider these strategies:

• Invest in Tax-Saving Instruments: 

Use tax-saving instruments like PPF, EPF, ELSS to claim deductions of up to ₹1.5 Lakh under Section 80C.

• Check for Exemptions: 

Verify if a portion of your compensation is exempt as gratuity, pension, etc. under the various provisions of Section 10.

• Opt for Deferred Compensation: 

If possible, negotiate with your employer to spread the payment over multiple years to reduce your taxable income. 

• Use Standard Deduction:

You also benefit from the standard deduction of ₹75,000, which reduces your taxable income, including profits in lieu of salary.