Special Allowances - Exemptions and Taxability Under Income Tax Act [Old vs New Tax Act Series]

Special allowances constitute a large portion of your salary package and understanding how to maximize these allowances for tax purposes, as well as to maximize your take-home pay, is vital. Additionally, with the Income Tax Act 2025 replacing the Income Tax Act 1961 by April 1, 2026, and with the continuing trend towards the new tax regime, clarification must be provided regarding which allowances will remain tax-exempt and which will be fully taxable.

This article discusses how an employee views special allowances, compares the provisions of both Acts and describes their treatment under both the old and new tax regimes.

What is a Special Allowance?

Special allowances are the amounts that are paid to you by your employer as an additional payment to your base salary. In contrast to the specific allowances such as House Rent Allowance or Leave Travel Allowance which are paid for a defined purpose, a special allowance is usually a general miscellaneous amount that can be put towards anything you choose.

Key Characteristics:

● Most Special Allowances do not factor into the calculations for the Provident Fund or the Gratuity calculation, unless stated otherwise in the company's policy or by its policy.

● There is flexibility in the way special allowances can be paid as part of an employee's salary structure.

● Some special allowances can be paid based on performance or may be compensation for certain working conditions.

● All special allowances unless given an exemption under sec. 10(14) will be fully taxed.

Section Mapping: Income Tax Act 1961 vs. 2025

The Income Tax Act 2025 reorganizes allowance provisions for better clarity while retaining substantive rules.

Income Tax Act 1961 Income Tax Act 2025

Section 10(14) - Special allowances for official duties Section 11 read with Schedule V and Schedule VI

Section 10(13A) - House Rent Allowance Schedule V under Section 11

Section 10(5) - Leave Travel Allowance Schedule V under Section 11

Section 16 - Standard Deduction Section 19 - Deductions from salary

Section 17 - Salary definition Section 15 - Income under the head "Salaries"

Key Structural Improvements:

● Allowances organized in Schedule V (HRA, LTA, travel concessions) and Schedule VI (duty-related allowances, compensatory allowances)

● Simplified cross-references and removal of complex provisos

● Introduction of unified "Tax Year" terminology

● Better presentation through tabular formats

Categories of Special Allowances

Special Allowances under The Income Tax Act are categorised according to their taxation treatment. Each category provides the ability for employees to determine which component of their salary is taxable and which component of their salary is eligible for tax-free or exempt from taxation..

Category 1: Fully Taxable Allowances (No Exemption)

These Special Allowances are included as gross salary, and will be fully taxable at your applicable Income Tax slab. No exemption is available for Fully Taxable Special Allowance under either Old Tax Regime or New Tax Regime. Common examples of Fully Taxable Special Allowance include DA (Dearness Allowance), City Compensatory Allowance, Performance or Incentive Allowance, Medical Allowance, Meal/Tiffin Allowance, Attendance Allowance, Project Allowance, etc.

Category 2: Allowances Exempt to Extent of Actual Expenditure

These Allowances will receive exemption for tax purposes only to the extent that you incur and provide proof of the expenditure for official business purposes. If you receive an amount in excess of what was actually spent on official business, that excess amount will be taxable.

Category 2 provides additional information about the allowances available in both Old and New Tax Regimes. Examples of Allowances included in both Old and New Tax Regimes are Conveyance Allowance (when you travel for official duties), Daily Allowance (when you travel for official tour), and Travel Allowance (when you travel for official tour or when transferring); all of these fall under Section 10(14)(i) of The Income Tax Act.

Certain types of allowances that fall within the old income tax rules provide access to additional deductions on qualified categories. For example, Helper Allowance, Academic or Research Allowance, and Uniform Allowance fall under this category. In the new tax regime, there are no exemptions for these items, regardless of how much you actually spent.

To be eligible to claim a deduction under the Old Tax Regime, you must provide sufficient documentation. Keep receipts, invoices, and anything else that supports how the allowance was used for official purposes. Without the required documentation, you will be taxed on the full amount of the allowance as if it were your income.

Category 3: Major Allowances with Conditional Exemptions

The most significant allowances that significantly influence a person’s tax liability are included in this sub-category. There are differing levels of tax treatment for the allowances between the old and new tax regimes, each of the allowances have certain conditions for the exemption.

I. The House Rent Allowance (HRA) is possibly the most valuable tax savings aid for salaried individuals who reside in rental properties. HRA was governed by Section 10(13A) of the Income Tax Act, 1961, however, the new tax regime is governed by Schedule V of Section 11 of the Income Tax Act, 2025.

To qualify for HRA exemption under the old tax regime, an employee must compute the lowest of three values:

1. The actual HRA amount received from the employer;

2. Fifty percent of the employee’s salary, if the employee resides in any of the four major metropolitan cities (Mumbai, Delhi, Kolkata and Chennai); or forty percent of the employee’s salary if they reside in any other city;

3. Rent actually paid minus 10 percent of the employee’s salary. Under the new tax regime, the HRA amount is 100 percent taxable with no exemptions available. An employee wishing to claim HRA exemptions under the old regime must maintain all appropriate records such as monthly rent receipts and the PAN of the landlord if the annual rent paid exceeds ₹1 lakh.

II. Under the old tax regime, you may be able to claim Leave Travel Allowance (LTA) two times in a 4-year block for personal travel purposes. Under the new tax regime, any LTA amount received becomes fully taxable with no exemptions or deductions that you can claim from your taxable income, irrespective of whether you actually travelled.

III. The Standard Deduction is a fixed amount that is allowed to all salaried individuals, even though they need not provide documentation or evidence of how much they spent on personal expenses. As per Section 16(ia) of the Income Tax Act 1961 and Section 19 of the Income Tax Act 2025, the Standard Deduction reduces the amount of Salary taxable to you each year. The amount of Standard Deduction offered under the previous tax regime was 50,000 rupees and 75,000 rupees under the new tax regime.

Old Tax Regime vs. New Tax Regime: The Difference

The new tax regime offers lower tax rates but eliminates most allowance exemptions. Allowances Available Under New Tax Regime are:

1. Standard Deduction - ₹75,000 (Section 19)

2. Conveyance/Daily/Travel Allowance - For official duties only (Schedule VI)

3. Transport Allowance for Specially-Abled - Up to ₹3,200/month (Schedule VI)

4. Armed Forces Special Allowances - Fully exempt (Schedule VI)

5. Professional Tax - Maximum ₹2,500/year (Section 19)

6. Employer's NPS Contribution - Up to 14% of salary (Section 80CCD(2))

7. Agniveer Corpus Fund - Section 80CCH(2)

8. Family Pension Deduction - Up to ₹25,000 (Section 21)

Major Exemptions NOT Available Under New Tax Regime

● House Rent Allowance (HRA)

● Leave Travel Allowance (LTA)

● Children Education Allowance

● Hostel Expenditure Allowance

● Transport Allowance (except for specially-abled)

● Helper, Uniform, Internet Allowances

● Hill/Tribal/Remote Area Allowances

● Entertainment Allowance (for government employees)

● All Chapter VI-A deductions except 80CCD(2), 80CCH(2), and 80JJAA

How to Calculate Taxable Special Allowance

Formula: Taxable Special Allowance = Total Special Allowance Received – Exempted Portion (if any)

Example: Monthly Salary Components:

● Basic Salary: ₹40,000

● Special Allowance: ₹10,000

● Transport Allowance (specially-abled employee): ₹3,200

● HRA: ₹15,000

Under Old Regime:

● Transport Allowance Exemption: ₹3,200 (fully exempt)

● HRA Exemption: ₹8,000 (assuming eligible conditions met)

● Taxable Special Allowance: ₹10,000 – ₹3,200 = ₹6,800

● Taxable HRA: ₹15,000 – ₹8,000 = ₹7,000

Under New Regime:

● Transport Allowance Exemption: ₹3,200 (fully exempt)

● HRA Exemption: Nil (no exemption available)

● Taxable Special Allowance: ₹10,000 – ₹3,200 = ₹6,800

● Taxable HRA: ₹15,000 (fully taxable)

Notable Changes

The transition from the Income Tax Act 1961 to the Income Tax Act 2025 results in significant changes in how employee allowances are classified, reported, and taxed.

1. Removal of the Entertainment Allowance Deduction: The Income Tax Act, 2025 eliminates the previous deduction for the entertainment allowance previously claimed by government employees under Section 16(ii) of the 1961 Act. The entertainment allowance is fully taxable for all employees moving forward even though there is no longer any deduction available.

2. New Term to Standardise Tax Year: The Income Tax Act, 2025 has introduced the new term of "Tax Year" to create consistency in terminology versus the conflicting terms of "Previous Year", "Assessment Year" and "Financial Year" which existed under the Income Tax Act, 1961.

3. Digital-First Provisions: The Income Tax Act, 2025 provides for the digital economy by allowing for digital solutions so as to enable faceless assessments and appeals, electronic documentation and verification, online filing and communication and the requirement to maintain digital records.

4. Allowances for Specially-Abled Employees Protected - The transport allowance for specially-abled employees is not lost to exemption from the new tax regime whereas many other transport-related allowances were. In Section 10(14)(ii) of the Income Tax Act, 1961, the monthly exemption limit of ₹3200 for transport for specially-abled employees will remain available to these employees under the new tax regime as set out in Schedule VI under Section 11 of the Income Tax Act, 2025.

5. Armed Forces Special Allowances Remain Exempt: All special allowances paid to members of the armed forces are exempt from taxation under the old and new tax regimes. The exemption for special allowances paid to members of the armed forces is provided for by way of Section 10(14)(ii) of the Income Tax Act, 1961 and is now included in Schedule VI of Section 11 of the Income Tax Act, 2025.

It is very important to understand how special allowances are taxed when planning to receive a salary. The Income Tax Act 2025 has improved how taxes are organized and simplified the way they are written but the principles for taxing income have not changed. The main impact of the new Income Tax Act 2025 is your ability to choose between the old tax regime and the new tax regime.