Chapter 3: Salary

Principles of Taxation
From the desk of M. Khalid Petiwala

Chapter 3
SALARY
1. Basic Tax Structure of Salary

a) Salary is taxable in a tax year on receipt basis.

b) Receipt has been defined as:

o Actually received by the person

o Applied at the instruction of the person or under any law e.g. tax deducted at
source and deposited into the Government treasury

o Made available to the person e.g. a cheque issued to an employee or a

benefit in kind is made available to an employee.

2. Definition of salary
Salary means any amount received by an employee from any employment including:

(a) Pay, wages, leave pay, leave encashment, overtime, bonus, commission, fee,
gratuity or work condition supplements such as for unpleasant or dangerous
working conditions.

(b) Perquisites.

(c) Allowances such as conveyance, rent, utilities, entertainment or travel allowance

excluding any allowance solely expended for office purpose.

(d) Profits in lieu of salary

(e) Pension

(f) Employee share scheme

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2.1 Perquisites
Allowance is a fixed amount irrespective of actual expenditure whereas perquisite is any
item provided by the employer in kind or cash reimbursed for expenses incurred by the
employee other than for office purpose (reimbursement may be subject to a maximum
limit) including:

(a) Motor vehicle provided wholly or partly for private use by an employee

(b) Services of house keeper, driver, gardener or other domestic assistant

(c) Utilities: gas, water, electricity and telephone

(d) Any obligation of an employee to the employer is waived by the employer

(e) Any obligation of an employee to another person is paid by the employer

(f) Housing or accommodation

(g) Fair Market Value (FMV) of any property transferred or any service
provided to an employee as reduced by any payment made by the
employee in this respect.

(h) Loan obtained by an employee from his employer which is interest free or
at a rate lower than the benchmark rate, the difference between actual
rate and the benchmark rate shall be included in his taxable salary.

Benchmark rate is 10%.

This provision is not applicable where the amount of loan does not exceed
Rs.1,000,000.

2.2 Profits in lieu of salary

Any amount received as profit in lieu of salary including:

(a) Provident fund

(b) Amount on termination of employment, compensation for loss of

employment and golden handshake payment.

This amount may be taxable @ last 3 years’ average rate of tax at the
option of taxpayer.

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If this option is exercised then the said amount shall become a separate
block of income on which tax shall be calculated at a rate as under:

Last 3 years’ tax liability

Last 3 years’ taxable income

(c) Consideration for an employee’s agreement to:

 enter into an employment agreement

 any condition or restriction with reference to past, present or future
employment

Question on golden handshake scheme

Mr. M resigned from his employment with A Ltd (AL) with effect from 31.12.20X4.

He received following amounts in final settlement:

- Rs.150,000 as Leave Encashment.

- Rs.4,000,000 under a Golden Handshake Scheme.

Mr. M had received a salary of Rs.350,000 per month for a period of 6 months up to
December 20X4.

His taxable income and tax liability during the preceding 3 tax years were as under:

Tax Year 20X2 20X3 20X4

Taxable income Rs. 2,700,00 3,100,00 3,650,00
0 0 0
Tax liability Rs. 472,500 542,500 650,000

Required:
As a tax consultant, advise Mr. M about the amount of income tax payable by him for
the tax year 20X5, under the Income Tax Ordinance, 2001.

3. Employment relationship
An amount or perquisite shall be treated as received by an employee from any
employment regardless of whether the amount or perquisite is paid or provided –

(a) by the employee’s employer, an associate of the employer, or by a third

party under an arrangement with the employer;

(b) by a past employer or a prospective employer; or

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(c) to the employee or to an associate of the employee or to a third party
under an agreement with the employee.

4. Perquisites taxable at notional value

4.1 Valuation of accommodation provided by the employer

The value of accommodation provided by an employer shall be taken as equal to the
amount that would have been paid by the employer in case such accommodation was
not provided.

The value taken for this purpose shall not be less than 45% of minimum of the time
scale (MTS) or the basic salary in the absence of time scale.

Note:
House rent allowance is fully taxable and there is no concept of minimum 45% in case
of house rent allowance.

4.2 Valuation for conveyance

(a) If a conveyance is provided by an employer, its value to be included in taxable

income of the employee shall be worked out as under:

Conveyance provided Amount to be included in taxable salary

Partly for personal and partly If purchased by the employer:
for office use 5% of the cost of vehicle to the employer

In case of leased car:

5% of FMV of vehicle at the commencement of
the lease.

Note:
FMV at the commencement of lease does not
include finance charge and therefore finance
charge included in the lease transaction is not
taxable for the employee.

For personal use only 10% of the cost of vehicle to the employer or
10% of FMV of vehicle at the commencement of
the lease.

(b) 5% or 10% as above shall be reduced proportionately where the vehicle is provided
to the employee for a part of the year.

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(c) Any deduction from the salary of employee in this respect shall be reduced from the
taxable amount of this perquisite.

(d) Conveyance allowance is fully taxable.

5. Salary – Exemptions under Part I, 2nd Schedule

5.1 Pension
Pension is fully exempt irrespective of age limit subject to two conditions:

o If an employee works for the same employer or any of its associates after
retirement then pension shall be taxable.

o If a person receives more than one pension then exemption shall apply only to
the higher of such pensions received.

These two conditions are not applicable for a person over 60 years of age [FBR’s
Circular 28 of 1991].

5.2 Gratuity

i) Government employees Fully exempt

ii) Approved Gratuity Fund Fully exempt

iii) Approved Gratuity Scheme Exempt up to Rs.300,000

iv) Unapproved Gratuity Exempt up to Rs.75,000 or 50% of

amount receivable whichever is lower.

5.3 Special Allowance

Any allowance specially granted to meet expenses wholly and necessarily incurred in the
performance of office duties is exempt e.g. Travelling allowance and Daily allowance
(TA/DA) for an official trip.

5.4 Certain perquisites without marginal cost to the employer

Value of the following perquisites received by an employee is exempt:

i. Free or subsidized food provided by hotels and restaurants to its employees

during duty hours;

ii. Free or subsidized education provided by an educational institution to the

children of its employees.
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5.5 Medical

a) Medical facility or
reimbursement of medical
expenses:

o In accordance with Fully exempt if National Tax Number (NTN) of

terms of employment medical practitioner and employer’s attestation are
available.

o Not in accordance with Taxable

terms of employment
Note: In case of an individual, CNIC shall be used
as NTN.

b) o Medical allowance Exempt up to 10% of basic salary.

However, medical allowance is fully taxable if it is in

addition to medical facility or reimbursement in
accordance with terms of employment.

Medical allowance + medical facility or

reimbursement in accordance with terms of
employment:
Medical allowance is fully taxable

Medical facility or reimbursement is exempt if NTN of

medical practitioner and employer’s attestation are
available

If NTN of medical practitioner or employer’s

attestation is not available then both the figures are
fully taxable.

6. Provident Fund (PF)

6.1 Unrecognized PF
Employee’s contribution to PF is a part and parcel of salary received by the employee
and therefore not separately taxable in the name of PF.

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Employer’s yearly contribution and yearly interest are taxable when received by the
employee.

6.2 Recognized PF
Employee’s contribution to PF is a part and parcel of salary received by the employee
and therefore not separately taxable in the name of PF.

Accumulated balance is not taxable when received by the employee.

However, there are limits on Employer’s yearly contribution and yearly interest credited
to PF balance. If the amounts are in excess of the limits then the excess shall be taxable
on yearly basis.

Limit on Employer’s yearly contribution is the lower of:

- Rs.150,000; or
- 10% of (Basic + Dearness Allowance [DA])

Limits on Yearly interest credited to PF balance is the lower of:

- 16% interest rate on accumulated balance; or

- 1/3rd of (Basic + DA)

Example:
Basic salary Rs.960,000
Dearness allowance Rs.96,000
Bonus Rs.300,000
Employer’s contribution to the recognized PF Rs.120,000
Interest credited to PF account Rs.432,000 @ 18% of accumulated balance

Answer:
Basic salary 960,000

Dearness allowance 96,000

Bonus 300,000

Employer’s contribution to RPF 120,000

Less: Rs.150,000 or 10% of Basic + DA
whichever is lower 105,600 14,400

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Interest credited @ 18% 432,000
Less: Interest @ 16% 384,000
or 1/3rd of basic + DA 352,000
whichever is lower 352,000 80,000
Taxable salary 1,450,400

7. EMPLOYEE SHARE SCHEME (also called Stock Option Scheme)

7.1 Definition and general concept

A company being an employer may issue shares of the company to its employees free of
charge as an employment benefit.

However, a company may charge an amount (called exercise price) against the issue of
option and / or shares which is less than Fair Market Value (FMV) and therefore an
employment benefit arises.

7.2 Right or option to acquire shares

Right or option to acquire shares is taxable only where the employee disposes the
option in which case gain is taxable in the year of disposal of option under the head
salary as consideration received i.e. sale proceed less cost of right or option.

7.3 Issue of shares

Shares may be issued to employees without any restriction on transfer or it may be with
restriction on transfer.

Taxability of an amount under the head salary is as under:

Issue without any restriction Issue with restriction on transfer

Taxable in the year of issue of shares Taxable in the year in which the
employee has a free right to transfer
the shares

Taxable at FMV at the date of issue of Taxable at FMV at the date at which the
shares less any consideration given by employee has a free right to transfer
the employee for shares / option or the shares less any consideration given
right by the employee for shares / option or
right

7.4 Gain on shares subsequently disposed off falls under the head capital gain and
for this purpose cost of shares shall be the total of consideration given by the employee
for shares / option or right and the amount taxed under the head salary in this respect.

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Question:
Mr. A got an option of 500 shares under Employee Share Scheme (ESS) from a private
company. He paid Rs.3 per share for the option and is required to pay Rs.7 per share at
the time of exercise of option.

He exercised option by paying Rs.3,500 for 500 shares to the company when the FMV of
shares was Rs.33 per share.

Subsequently, he disposed off the shares for Rs.39 per share

Solution:

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 Chapter 3: Salary

Question on salary income with rebates:

Calculate taxable income and tax payable by Mr. Z from the following information:

i. Basic salary Rs.1,440,000

ii. Dearness allowance Rs.144,000

iii. Accommodation facility provided by the employer (fair market rent Rs.540,000).

iv. Bonus Rs.240,000

v. Conveyance allowance Rs.144,000

vi. Leave fare assistance (LFA) Rs.204,000 with reference to a 10 days leave availed
by Mr. Z. This amount represents cash allowance. He visited Islamabad with his
family.

vii. Lunch allowance paid by the company Rs.108,000

viii. Overtime Rs.69,000

ix. Encashment against unavailed leave paid to Mr. Z Rs.97,500

x. TA/DA Rs.240,000 paid by the company in respect of his visit to Lahore to attend
a conference. Actual expense out of TA/DA Rs.183,000

xi. He received medical allowance of Rs.135,000. He also received reimbursement of

medical expenses of Rs.195,000 as per policy for which he has proper receipts
with NTN of the medical practitioners and attestation from the employer.

xii. He paid donation of Rs.81,000 through banking channel to a hospital in Karachi

being run and controlled by local government.

xiii. He received Rs.2,400,000 as inheritance.

xiv. He purchased shares of a private company Rs.240,000 being an original allottee.

He also purchased shares of Rs.261,000 of a listed company being an original
allottee.

xv. Zakat deducted by the bank Rs.87,000

xvi. Tax deducted by the employer Rs.250,000

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Answer:
Mr. Z
Computation of taxable income and tax liability
SALARY
Basic salary 1,440,000
Dearness allowance 144,000
Accommodation: 45% of basic salary 648,000
Bonus 240,000
Conveyance allowance 144,000
LFA: cash allowance 204,000
Lunch allowance 108,000
Overtime 69,000
Leave encashment 97,500
TA / DA: special allowance 240,000 exempt
Medical allowance 135,000
Reimbursement of medical expenses 195,000 exempt
Total income 3,229,500
Less: Zakat 87,000
Taxable income 3,142,500

Tax liability (Salaried Case)

Tax on Rs.2,500,000 195,000
Tax on Rs.642,500 @ Rs.17.5% 112,438
307,438
Less: Rebate on donation
(307,438 / 3,142,500) x 81,000 7,924
299,514
Less: Rebate on investment in shares of listed company
(307,438 / 3,142,500) x 261,000 25,534
Tax liability 273,980
Less: Tax deducted by the employer 250,000
Tax payable with return of income 23,980

Notes:
- Amount received through inheritance is capital receipt and therefore not taxable.
- Rebate is not allowed on purchase of share of a private company.

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Answer to Question on golden handshake scheme

Mr. M has two options as under:

1. The amount of golden handshake is taxable in the current tax year at normal
slab rate along with other salary items of the current tax year; and

2. The amount of golden handshake is not included in taxable income and taxable
as a separate block of income at the last 3 years’ average rate of tax.

Whichever is beneficial for him.

Monthly salary 350,000 x 6 2,100,000

Leave encashment 150,000
Taxable salary excluding golden handshake 2,250,000
Golden handshake 4,000,000
Taxable salary including golden handshake 6,250,000

Working of tax under option 1 (Salaried Case):

Income tax on Rs.6,250,000
Tax on Rs.5,000,000 670,000
Tax on Rs.1,250,000 @ 22.5% 281,250
Total tax liability 951,250

Working of tax under option 2 (Salaried Case):

Income tax on Rs.2,250,000
Tax on Rs.1,8000,000 90,000
Tax on Rs.450,000 @ 15% 67,500

Tax on golden handshake

472,500 + 542,500 + 650,000 x 4,000,000
2,700,000 + 3,100,000 + 3,650,000 704,762
Total tax liability 862,262

Result: Option 2 is beneficial for Mr. M.

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