Home > Income Tax, Payroll, Statutory Compliance > Calculation of HRA exemption – Part II

Calculation of HRA exemption – Part II

February 15, 2010 Leave a comment Go to comments

In the previous post, we talked about the different methods followed by organizations for calculating the House Rent Allowance (HRA) exemption. According to us, the method that goes well with the letter and the spirit of Section 10 (13A) of the Income Tax Act, 1961, is the Period method, while the other methods such as the Annualized exemption method and the Monthly exemption method do not. Let us see why.

First, the Annualized exemption method.

Organizations using this method calculate the HRA exemption by determining the values of the different factors (Basic pay etc.) for the year and applying the “least of three” rule. In this method, employees are asked to submit the total rent amount paid during the year and specify if the location of the residence is in a metro city or a non-metro city/town. If an employee lives in a metro city or a non-metro city through the year, there is no problem. However, if an employee lives, say, for 6 months in a metro city and the other 6 in a non-metro city, should metro be considered or non-metro be considered for the sake of exemption calculation?

Considering just one of the two is in direct violation of the Income Tax Act, while  considering both is not feasible in this method since an employee submits a single amount as rent for the year.

Second, the Monthly exemption method.

Organizations using this method calculate HRA exemption for each month by determining the values of the different factors (Basic pay etc.) and applying the “least of three” rule. The monthly HRA exemption amounts are added to compute the annual HRA exemption amount. In this method, employees are asked to submit the total rent amount paid for each month and specify if the location of the residence is in a metro city or a non-metro city/town.

The Income Tax Act does not mandate calculation of monthly HRA exemption amounts and hence we wonder on what basis payroll managers look at the month as the period for HRA exemption calculation.

Let us illustrate the problem with the Monthly exemption method with an example.

An employee receives a monthly Basic salary of Rs 50,000 and a monthly HRA of Rs 25,000. In the month of June, the employee lives in his own house (and hence pays no rent) from June 1 to June 15 and moves into rent accommodation (in a metro city) from June 16 for a monthly rent of Rs 25,000. Further, the employee has loss of pay from June 16 to June 30, and hence receives no Basic salary and HRA for that period.

According to the Monthly exemption method, the HRA exemption for the month of June is Rs 10,000, by applying the “least of three” rule. However, for the period from June 1 to June 15, the employee does not live in a rented house and hence is not eligible for any HRA exemption, while for the period from June 15 to June 30, the employee has no Basic pay or HRA on account of loss of pay and hence is not eligible to claim HRA exemption. If one were to adopt the Period method, the HRA exemption for both June 1 to June 15 and June 16 to June 30 will be zero.

The Period method is the only method which stands the test of compliance with Section 10(13A) of the Income Tax Act.

Why many organizations do not follow the Period method?

1. Ignorance: Many payroll managers do not seem to be aware of the limitations of the other methods. The income tax department too does not seem to have given any specific instructions on how the exemption should be calculated. The manner in which HRA exemption is calculated in many organizations in India does not exactly fall in line with the Income Tax Act.

2. Limitations in payroll software: The Period method is not easy to implement. Whenever Basic salary, HRA, place of residence, and rent paid change, the HRA exemption has to be computed. Manual computation of HRA exemption for each period is cumbersome and prone to errors. We do not know of too many payroll software (other than Tandem’s HRWorks) in India which can automatically compute HRA exemption whenever any of the input parameters that drive the HRA exemption calculation, change.

We wonder which is worse: cumbersome law or incorrect practice of cumbersome law?

Maybe it is time for a total re-think on the need for HRA exemption itself. Even if the HRA exemption has to exist, the income tax department should provide specific instructions (with clear-cut examples) on how the exemption should be calculated.

We are hopeful of seeing changes in this regard in the proposed Direct Taxes Code.

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