Tax equalisation allowance: paying an employee's tax for them under the 2025 Act
A tax equalisation allowance or a grossed-up perquisite? How to pay an employee's tax under the Income-tax Act 2025, s.35(a)(i), and what is still open.
Last checked 7 min read
Some pay promises are made in net terms. A seconded engineer is told his take-home in Chennai will match what he earned abroad. A sales head is promised "₹1.2 lakh in hand" as a relocation bonus. A founder wants a Diwali bonus to land in full. In each case the company is offering to carry the employee's tax, and payroll has to decide how to show it. One option, the tax equalisation allowance, has become more attractive since the Income-tax Act, 2025 came into force.
We covered the share-based side, where the company can pay tax on ESOPs under s.392(2)(a), in our post on tax paid by the employer on behalf of the employee. This post is about cash.
Three ways to deliver net of tax salary
When a promise is net of tax salary, there are three lawful ways to run it.
| Method | What the payslip shows | Employer's books |
|---|---|---|
| Recover later | Normal salary and TDS; any shortfall is an advance recovered from later pay | No extra cost |
| Grossed up perquisite | Borne tax shown as a perquisite under s.17(1)(f) | Deductibility now open under s.35(a)(i) |
| Tax equalisation allowance | A cash earning; TDS from the whole salary | Salary cost |
Recovering later is the plain default when the "net" promise is not really a promise. The other two are for genuine net-pay terms.
The grossed up perquisite and section 35(a)(i)
Since Emil Webber v. CIT (Supreme Court, 1993), tax that an employer pays on an employee's salary is the employee's income. The 2025 Act keeps that rule in s.17(1)(f): a perquisite includes any sum the employer pays for an obligation that would otherwise have been the employee's. So a grossed up perquisite is taxable in the employee's hands, and it is grossed up again and again until the tax on tax settles.
For the employer, the old position was comfortable. Section 40(a)(ii) of the 1961 Act disallowed tax "levied on the profits or gains of any business or profession", which is the company's own tax. Tax borne on an employee's salary was salary cost.
The new section 35(a)(i) disallows "any amount on account of tax paid on income". The words about business profits are gone, and nothing says whose income. Read literally, that reaches tax a company pays on an employee's cash salary.
There are good arguments the other way:
- The Ministry of Finance told the Select Committee that clause 35 was "textually simplified and retained with the same intent" as section 40.
- The Act defines "tax" as income-tax chargeable under it (s.2(106)). If clause (i) covered tax on anyone's income, clause (ii), which separately disallows tax the employer pays on non-monetary perquisites, would have nothing left to do.
- Nobody reads clause (i) as disallowing the TDS part of every salary, though that is also an amount on account of tax paid on income.
Our reading is that the better view is still "deductible". But there is no ruling, circular or departmental statement on the point, and it is exactly the kind of question an assessing officer can raise on the plain words. Until your CA confirms, treat borne tax in the perquisite form as an add-back in the tax computation.
How a tax equalisation allowance takes the question away
The allowance changes the legal form, not the numbers. Instead of the company paying the employee's tax, the company pays the employee a cash earning large enough that, after normal TDS on the whole salary, the agreed net amount is left.
The company's expense is then salary paid to the employee. The tax that goes to the government is the employee's TDS out of his own salary, like every other rupee of TDS. Section 35(a)(i) is about amounts that are tax, and a salary payment is not.
This is also how tax protected pay is usually written for expatriates: a tax equalisation clause in the assignment letter, with the employer topping up pay so the employee is no worse off than at home.
A worked example
Neha, a regional manager in Pune, is promised a relocation bonus of ₹1,20,000 "in hand". She is in the 30% slab, and with 4% cess her marginal rate is 31.2%. We ignore surcharge for simplicity.
The allowance is worked out so that tax on it is covered too:
- Gross allowance = ₹1,20,000 ÷ (1 − 0.312) = ₹1,74,419
- TDS on the allowance at 31.2% = ₹54,419
- Neha receives ₹1,20,000
In the allowance form, the payslip shows a "Relocation bonus" of ₹1,20,000 and a "Tax equalisation allowance" of ₹54,419, both taxable, with TDS of ₹54,419 deducted from the month's salary along with her normal TDS. In the perquisite form, the same ₹54,419 would be a perquisite in Form 123 and the deductibility question would arise.
Conditions to keep it clean
- Put it in writing first. A net-pay or tax equalisation clause in the appointment or assignment letter, or a written policy approved before the pay period.
- Show it as an earning. It appears on the payslip and in salary in Form 130 Part C, not among perquisites in Form 123.
- Deduct TDS normally. From the whole salary, under s.392(1). It is ordinary TDS, not tax paid by the employer under s.392(2)(a).
- Keep it out of PF and ESI, with care. The Labour Ministry's FAQ of 30 December 2025 treats variable parts of pay as outside "wages". The allowance varies with tax, so we keep it out. Under the Code's wide wage definition that is not beyond doubt, but the effect is small, because these employees are usually above the ESI ceiling and the PF wage ceiling. The 50% wage rule post explains how such components are counted.
What is still open
Be honest with your finance team about three points:
- The perquisite form. Whether s.35(a)(i) disallows tax borne on cash salary is unsettled. Better view: deductible. Default: add back unless your CA confirms.
- The allowance form. We think it is deductible salary without any add-back, with medium-high confidence. Ask your CA to confirm before you switch.
- The single-stage method. The courts' "gross up once" view rests on the borne tax being a non-monetary perquisite, so it stays in the perquisite form and the add-back question stays with it.
Share-settled ESOPs are different again: there the employer can pay the tax on the perquisite by election, and that tax is not deductible by express words. We go through net-share and sell-to-cover exercises in the ESOP sell to cover post.
Where this shows up in the forms
- Form 130 Part C: the allowance sits in salary.
- Form 123: nothing for the allowance; a perquisite-form gross-up goes in row 20 with the tax in item 23(a).
- Books: the allowance is debited to salary. A perquisite-form gross-up from April 2026 is best kept in its own ledger, flagged as a possible add-back.
Vatsin Payroll recovers a shortfall from later pay by default, and when a company chooses to bear the tax on cash pay, it shows the multi-stage gross-up as a tax equalisation allowance unless the company picks the perquisite form. Whichever you choose, it is a decision for your CA to sign off, not for the payroll software.