Is a golden handshake or early retirement package taxable, and can it be taxed at a lower average rate?

What does the law say?

Section 12(2)(e)(iii) of the Income Tax Ordinance, 2001 includes in salary any amount received “on termination of employment, whether paid voluntarily or under an agreement, including any compensation for redundancy or loss of employment and golden handshake payments”. A voluntary separation scheme (VSS) payment, an early retirement bonus or a negotiated exit sum all fit these words. Section 12(1) taxes it in the tax year it is received.

Section 12(6) gives the relief. An employee who received such an amount “may, by notice in writing to the Commissioner, elect for the amount to be taxed at the rate computed in accordance with the following formula”: A/B%, where

• A is the total tax paid or payable on the employee’s total taxable income for the three preceding tax years, and
• B is the employee’s total taxable income for those three years.

Section 12(8) says the election must be made by the due date for the return of income for the tax year in which the amount was received, “or by such later date as the Commissioner may allow”. Section 118(3) sets that due date at 30 September after the end of the tax year. A package received between 1 July 2026 and 30 June 2027 falls in tax year 2027, so the election is due by 30 September 2027 unless extended.

How do the parts of an early retirement package differ?

An early retirement package usually has several parts, and the Ordinance treats each one differently:

Part of the package	Where the Ordinance deals with it	Tax position
Golden handshake, VSS or exit compensation	Section 12(2)(e)(iii)	Salary; A/B% election available under section 12(6)
Gratuity	Section 12(2)(a) and Second Schedule clause (13)	Exempt up to the clause (13) limits; the rest is salary
Commutation of pension	Second Schedule clauses (12) and (13)	Fully exempt if from Government or a Board-approved scheme; otherwise clause (13) limits
Monthly pension afterwards	Section 12(2)(f) and 12(2A)	Final tax on pension; nothing from age seventy

Only the first row is covered by section 12(6). Labelling a payment “gratuity” or “handshake” in an offer letter does not change what it is; the Ordinance looks at what the payment is for.

Worked example (illustrative figures)

Nadia, 57, accepts early retirement from a textile company in Faisalabad in tax year 2027. All income figures are invented. The rates are the real ones from clause (2) of Division I, Part I of the First Schedule, and the earlier years’ tables printed in its footnotes.

• Ordinary salary received in tax year 2027 before leaving: Rs. 1,800,000
• Golden handshake: Rs. 4,000,000
• Taxable income, all salary, in the three preceding years: Rs. 3,000,000 (2024), Rs. 3,300,000 (2025), Rs. 3,500,000 (2026)

Step 1: A and B.

Tax year	Taxable income (Rs.)	Band in that year’s table	Tax (Rs.)
2024	3,000,000	165,000 + 22.5% of amount over 2,400,000	300,000
2025	3,300,000	430,000 + 30% of amount over 3,200,000	460,000
2026	3,500,000	346,000 + 30% of amount over 3,200,000	436,000
Total	9,800,000		1,196,000

Checks: 22.5% of 600,000 = 135,000; 30% of 100,000 = 30,000; 30% of 300,000 = 90,000.

A/B = 1,196,000 / 9,800,000 = 12.20% (rounded).

Step 2: without the election. All salary for tax year 2027 is taxed together on the tax year 2027 table.

1. Total: 1,800,000 + 4,000,000 = 5,800,000
2. Band above Rs. 5,600,000 and up to Rs. 7,000,000: 976,000 + 32% of the amount over 5,600,000
3. 32% of 200,000 = 64,000
4. Tax: 976,000 + 64,000 = Rs. 1,040,000

Step 3: with the section 12(6) election.

1. Tax on the handshake: 4,000,000 x 1,196,000 / 9,800,000 = Rs. 488,163 (rounded to the rupee)
2. Tax on ordinary salary of Rs. 1,800,000: 6,000 + 11% of 600,000 = 6,000 + 66,000 = Rs. 72,000
3. Total: 488,163 + 72,000 = Rs. 560,163

On these figures the election reduces Nadia’s tax year 2027 liability by Rs. 479,837 (1,040,000 minus 560,163).

Section 12(6) says “the amount”, meaning the termination payment, is taxed at the A/B rate. It does not spell out whether the handshake is left out when placing the rest of the year’s salary in a band. Step 3 follows the natural reading that ordinary salary is taxed on the table by itself.

What if …?

My average rate is higher than the slab rate? The election is optional (“may … elect”), so section 12(6) does not force a higher rate on anyone.

I had little or no income in one of the three years? The formula uses totals over “the three preceding tax years”. The Ordinance does not say how it works if a year had no taxable income, and this page does not assume a result.

The employer deducted tax at the full slab rate? Section 149 requires the employer to deduct at your average rate on estimated salary using the Division I rates. The election is made by you to the Commissioner, not by the employer. Tax deducted beyond your final liability is dealt with through your return.

I start drawing a pension straight away? The pension is taxed separately under section 12(2A), not at the A/B rate.

Common mistakes

• Treating the handshake as tax free because it is compensation. Section 12(2)(e)(iii) expressly makes it salary.
• Applying the A/B rate to gratuity or commutation. Those have their own exemptions in clauses (12) and (13) of the Second Schedule; section 12(6) is limited to termination payments.
• Missing the deadline. After the section 12(8) date, a later election depends on the Commissioner allowing it.

What to check in the official text

Read section 12(2)(e)(iii), 12(6) and 12(8) together, and section 118(3) for the return due date. The tax year 2024, 2025 and 2026 salary tables used for A are printed as footnotes under clause (2) of Division I, Part I of the First Schedule in the official PDF. A and B come from your own returns for those years, so the figures in them, not estimates, decide your rate.