Is commuted pension (the lump sum at retirement) taxable?

What does the law say?

Commutation means giving up part of your future monthly pension in exchange for a lump sum paid at retirement. Section 12(2)(f) of the Income Tax Ordinance, 2001 includes “any pension or annuity” in salary, and section 12(2) covers amounts “whether of a revenue or capital nature”. Section 12 does not use the word “commutation”, but the Second Schedule treats commutation as income and exempts it in two clauses of Part I.

Clause (12): full exemption. “Any payment in the nature of commutation of pension received from Government or under any pension scheme approved by the Board for the purpose of this clause.” There is no rupee limit in clause (12).

Clause (13): limited exemption. This clause covers “any payment received by way of gratuity or commutation of pension by an employee on his retirement or, in the event of his death, by his heirs” up to the following limits:

Sub-clause	Who	Exempt amount
(i)	Employee of the Government, a Local Government, or a statutory body or corporation established by law	The amount receivable under the rules and conditions of the employee’s service
(ii)	Payment from a gratuity fund approved by the Commissioner under Part III of the Sixth Schedule	Any amount receivable from that fund
(iii)	Any other employee, under a scheme applicable to all employees and approved by the Board for this sub-clause	Up to Rs. 300,000
(iv)	Any employee to whom (i), (ii) and (iii) do not apply	50% of the amount receivable or Rs. 75,000, whichever is less

Sub-clause (ii) refers to a gratuity fund, so it is relevant to gratuity rather than commutation.

How does it work in practice?

Start with clause (12). If the commutation comes from Government, or from a pension scheme the Board has approved for clause (12), the whole lump sum is exempt and clause (13) does not need to be used.

If clause (12) does not fit, move to clause (13). An employee of a statutory corporation is covered by sub-clause (i) up to what the service rules provide. A private sector employee is covered by sub-clause (iii) only if the employer’s scheme applies to all employees and has Board approval for that sub-clause. Everyone else falls into sub-clause (iv).

Clause (13) ends with a proviso that lists cases where “nothing in this sub-clause shall apply”: a payment not received in Pakistan, a payment from a company to a director who is not a regular employee, and a payment to an employee who is not a resident individual. The proviso also removes the exemption for “any gratuity received by an employee who has already received any gratuity from the same or any other employer”, which concerns gratuity, not commutation. The proviso is printed after sub-clause (iv), and the consolidated text does not make clear whether “this sub-clause” reaches sub-clauses (i) to (iii) as well.

Any part of the commutation that is not exempt stays income under the head “Salary”.

Worked example (illustrative figures)

All amounts are invented.

Case 1: Federal Government officer. Nasreen retires as a Grade 19 officer in Islamabad and commutes part of her pension for Rs. 4,000,000.

1. The payment is commutation of pension received from Government.
2. Clause (12) exempts it with no cap.
3. Taxable amount: Rs. 0

Case 2: Private company, Board-approved pension scheme. Kamran retires from a Karachi manufacturing company whose pension scheme is approved by the Board for clause (12). He commutes for Rs. 2,500,000.

1. The payment is under a pension scheme approved by the Board for clause (12).
2. Taxable amount: Rs. 0

Case 3: Private company, no approved scheme. Farhan retires from a Multan trading firm with no Board-approved scheme and receives Rs. 400,000 as commutation.

1. Clause (12) does not apply. Sub-clauses (i), (ii) and (iii) of clause (13) do not apply either.
2. Sub-clause (iv): 50% of Rs. 400,000 = Rs. 200,000. The alternative limit is Rs. 75,000.
3. The lesser is Rs. 75,000, so Rs. 75,000 is exempt.
4. Taxable amount: 400,000 - 75,000 = Rs. 325,000

What rate applies to the taxable part?

The Ordinance does not settle this. Section 12(2A)(i) and the pension table in the proviso to clause (2) of Division I, Part I of the First Schedule tax “pension” received from a former employer at 0% up to Rs. 10 million. Neither mentions commutation. If the taxable commutation is treated as pension, Farhan’s Rs. 325,000 would sit well inside the 0% band. If it is treated as ordinary salary for the year, it would be added to his other salary income and taxed on the clause (2) slab table for tax year 2027, where income up to Rs. 600,000 is taxed at 0% and the next band is 1% of the amount over Rs. 600,000. This page does not choose between the two.

Common mistakes

• Assuming all commutation is tax free. Clause (12) covers only Government and Board-approved schemes. Other commutation is capped under clause (13).
• Using the Rs. 300,000 limit without Board approval. Sub-clause (iii) needs a scheme applicable to all employees and approved by the Board for that sub-clause.
• Forgetting the proviso. A non-resident, or a director who is not a regular employee, may lose the clause (13) exemption entirely.

What to check in the official text

Read clauses (12) and (13) of Part I of the Second Schedule, including the proviso at the end of clause (13) and its footnotes, which show earlier versions of the clause. Section 12(2) sets out what counts as salary. If your employer says its scheme is Board-approved, check which clause the approval is for, because clause (12) and clause (13)(iii) each require approval “for the purpose” of that clause. The approvals themselves are not part of this corpus.