Section 17(3) of the Income Tax Act – Profits in lieu of Salary

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) of the Income Tax Act 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. This makes salary as per Section 17(3) relevant for employees receiving non-regular income.

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 profits in lieu of salary as per Section 17(3) 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 as per Section 17(3). 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 profit in lieu of salary under Section 17(3).

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 and are taxable as salary as per Section 17(3).

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 Section 17(3) of the Income Tax Act. This includes the employer's contribution and interest accrued on such contributions.

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 exemptions help clearly define what constitutes profits in lieu of salary as per Section 17(3). The key exemptions 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 defined as per section criteria, 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 under 17(3) of Income Tax Act guidelines. 

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 under Section 17(3). 

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, thus not falling under profits in lieu of salary.

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, and are not considered profits in lieu of salary as per Section 17(3).

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 and treated as profits in lieu of salary under Section 17(3).

 

These exemptions can help reduce the tax burden on employees receiving retirement or termination benefits classified under salary as per Section 17(3).

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 profits in lieu of salary as per Section 17(3) are added to the total salary defined as per section criteria 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 receiving salary as per Section 17(3) are as follows: 

 

Income Tax Slabs – New Tax Regime (FY 2025‑26 / AY 2026‑27)

Rebate & Standard Deduction

• Full rebate is offered under Section 87A for taxable income ≤ ₹12 Lakhs.

 

This leads to a zero tax liability for all those earning up to ₹12 Lakhs taxable income.

• Salaried individuals continue to get a standard deduction of ₹75,000.

 

This effectively makes salaried income up to ₹12.75 Lakhs tax-free under the new regime. 

 

Income Tax Slabs – Old Tax Regime (FY 2025‑26 / AY 2026‑27)

Age-based Exemptions under Old Regime

• Below 60 years: Exemption up to ₹2.5 Lakhs

• 60–80 years (senior citizens): Exemption up to ₹3 Lakhs

• 80+ years (super senior citizens): Exemption up to ₹5 Lakhs

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 on payments considered profits in lieu of salary as per Section 17(3), reducing the burden on the employee at the time of filing returns.

 

Employees should check their Form 16 for these deductions and confirm proper treatment under 17(3) of Income Tax Act provisions.

To reduce the tax liability on profits in lieu of salary as per Section 17(3), 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 Lakhs under Section 80C, effectively reducing tax on salary as per Section 17(3). 

• Check for Exemptions:

Verify if a portion of your compensation is exempt as gratuity, pension, etc., under the various provisions of Section 10, thereby lowering taxable profits in lieu of salary. 

• Opt for Deferred Compensation:

If possible, negotiate with your employer to spread the payment over multiple years, which can significantly reduce the tax impact on income classified under Section 17(3) of the Income Tax Act. 

• Use Standard Deduction: 

You also benefit from the standard deduction of ₹75,000, which directly reduces your taxable income, including amounts defined as profits in lieu of salary under 17(3) of the Income Tax Act.

Section 17(3) of the Income Tax Act ensures that any profits in lieu of salary received by an employee—such as termination compensation, joining bonuses, or payouts from unrecognised PF—are taxed under the head ‘Income from Salaries.’ Understanding this provision helps employees correctly classify such payments, plan tax liabilities, and explore relevant exemptions. Proper tax planning under this section ensures compliance and financial clarity.