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Considering TDS on Other Income while calculating tax on salary – Part II

April 11, 2010 2 comments

In the previous post, we said TDS on Other Income poses a problem to the employer from the point of view of issuing Form 16 and filing Form 24Q.

What is the problem?

In both Form 16 and the annexure in Form 24Q for the last quarter, the details of Other Income can be displayed, but there is no provision to display details of TDS on Other Income. As a result, in both Form 16 and Form 24Q, it would look as though there is a shortfall in tax deducted by the employer while in reality it is not the case. Let us take a look at an example to examine this.

A male employee receives an annual taxable salary of Rs 900,000 after all deductions. The employee has Other Income of Rs 100,000 and the TDS deducted on Other Income is Rs 10,000 (10% on Rs 100,000).

The total income including salary and Other Income is Rs 10,00,000 (Rs 900,000 plus Rs 100,000) for the year and the total tax on Rs 10,00,000 is Rs 158,620 for the year.

If the employer considers TDS on Other Income and deducts tax on salary accurately, the Form 16 issued by the employer will have the following amounts.

11. Total Income (8 – 10) Rs. 10,00,000
12. Tax on Total Income Rs. 154,000
13. Add Surcharge Rs. 0
14. Add Education Cess Rs. 4,620
15. Tax Payable (12+13+14) Rs. 158,620
16. Relief under section 89 (attach details) Rs. 0
17. Tax payable (15-16) Rs. 158,620
18. Less
(a) Tax deducted at source u/s 192(1) Rs. 148,620
(b) Tax paid by the employer on behalf of the
perquisites u/s 17(2)
19. Tax Payable/(Refundable) (17 – 18) Rs. 10,000

In the Form 16 excerpt presented above, the total income (No. 11) comprises both salary and Other Income while tax deducted (No. 18) contains only the amount deducted by the employer. There is no provision in Form 16 and Form 24Q to present TDS on Other income. As a result, No 19. above shows a Tax Payable amount of Rs 10,000. This, of course, is the TDS on Other Income and not the tax payable.

By taking a look at just Form 24Q — in its current format — the income tax department will not be able to figure out whether the Tax Payable figure is as a result of a genuine under deduction of tax by the employer, or due to TDS on Other Income.

If the tax department raises a query on the Tax Payable figure, the employer can always explain the same by submitting information on TDS on Other Income submitted by the employee. Instead of the tax department and the employer wasting time on raising and answering the query, why can’t the tax department simply modify the format of Form 16 and Form 24Q to include TDS on Other Income?

That way, the Tax Payable amount in Form 16 and Form 24Q will become zero and there will be no room for any doubt.

Considering TDS on Other Income while calculating tax on salary – Part I

April 8, 2010 2 comments

Section 192 of the Income Tax Act allows employers to consider employees’ Other Income and TDS on Other Income while calculating tax on employee salary. The relevant excerpt from Section 192 is presented as follows. Click here to see the source.

[(2B) Where an assessee who receives any income chargeable under the head “Salaries” has, in addition, any income chargeable under any other head of income (not being a loss under any such head other than the loss under the head “Income from house property”) for the same financial year, he may send to the person responsible for making the payment referred to in sub-section (1) the particulars of—(a)   such other income and of any tax deducted thereon under any other provision of this Chapter;

(b)   the loss, if any, under the head “Income from house property”,

in such form and verified in such manner as may be prescribed69, and thereupon the person responsible as aforesaid shall take—

(i)   such other income and tax, if any, deducted thereon; and

(ii)   the loss, if any, under the head “Income from house property”,

also into account for the purposes of making the deduction under sub- section (1) :

Provided that this sub-section shall not in any case have the effect of reducing the tax deductible except where the loss under the head “Income from house property” has been taken into account, from income under the head “Salaries” below the amount that would be so deductible if the other income and the tax deducted thereon had not been taken into account.]

Payroll managers have to keep in mind the following conditions imposed by Section 192 while considering Other Income and TDS on Other Income.

1. The employee should submit a declaration under Rule 26B with details of Other Income and TDS on Other Income, to the employer.
2. The employee cannot declare a loss under any “Other Income” other than “Income from House Property.”
3. The addition of TDS on Other Income should not reduce the tax deductible on salary.

The first two conditions are easy to understand. Let us take a look at the third condition by way of an example.

A male employee receives an annual taxable salary of Rs 200,000 after all deductions. As per the income tax rates prevailing for the financial year 2010-11, the total annual tax on salary, including Education Cess, is Rs 4,120. The employee has Other Income of Rs 200,000 and the TDS deducted on Other Income is Rs 40,000 (20% on Rs 200,000).

The total income including salary and Other Income is Rs 400,000 (Rs 200,000 plus Rs 200,000) for the year and the total tax on Rs 400,000 is Rs 24,720 for the year. Please note that the total tax including Education Cess (Rs 24,720) for the year is less than the TDS of Rs 40,000 deducted on Other Income. Just because the TDS on Other Income is higher than the total annual tax, the employer cannot ignore deducting the tax on salary.

According to Section 192, the TDS on Other Income should not have the effect of reducing the tax deductible under the head “Salaries” except where the loss under the head “Income from house property” has been taken into account, and hence the employer will have to deduct Rs 4,120 as TDS on salary.

Payroll managers can consider TDS on Other Income for the sake of calculating tax on salary. However, from the point of view of issuing Form 16 and filing Form 24Q, TDS on Other Income poses a problem to the employer. We will discuss that in the next post.

Section 192 of the Income Tax Act should be worded better

March 30, 2010 Leave a comment

The opening sentence of Section 192 of the Indian Income Tax Act is presented as follows. Please click here to see the source.

192. (1) Any person responsible for paying any income chargeable under the head “Salaries” shall, at the time of payment, deduct income-tax on the amount payable at the average rate of income-tax computed on the basis of the [rates in force] for the financial year in which the payment is made, on the estimated income of the assessee under this head for that financial year.

The section states that tax on salary shall be deductible at the time of salary payment. No problem about that.

It gets a bit confusing when one reads the phrase “….income-tax computed on the basis of the [rates in force] for the financial year in which the payment is made,…” in the above excerpt.

When salary payment is made within the same financial year, the tax rates in force for the financial year should be used for tax computation, according to Section 192. So far, so good.

But what if salary, which accrues on March 31 of a year, is paid out in the first week of April (the beginning of the next financial year)?

There are many organizations that pay salary — that accrues on the last day of a calendar month — in the first week of next month. If one were to go by the letter of Section 192, in such organizations, until February salary, employees’ salary should be taxed as per tax rates prevailing in that financial year. But the March salary paid in April will have to be taxed as per the rates for the next financial year (starting April).

Even if salary is paid on the last day of March, final settlements for employees who leave an organization in March may be processed only in April or later. In such cases too, the words that describe Section 192 give rise to confusion.

What is the confusion about?

The way Section 192 is worded puts it in conflict with Section 15 of the Income Tax Act which states that taxability on salary arises whenever salary is due/accrued or paid, whichever is earlier. In case of fixed heads of pay such as Basic pay, salary accrues on March 31, and taxability arises on March 31 according to Section 15. While the tax may be deducted in April or later, whenever the salary is paid, the amount of tax calculated should be as per the tax rates that prevailed in March.

Organizations tax salaries that accrue in March as per tax rates for that financial year ending March, in accordance with Section 15, whether the salary is paid in April or later. If one goes by the (poorly worded) section 192, such organizations can be viewed as deducting tax in contravention to Section 192.

Software developers, at the time of testing software, use what are called test cases to check if a software application works as per the functional specification the software is expected to meet. A test case is a set of rules/conditions which a developer applies to check if the software is functioning as expected. It is important for law makers to apply test cases while drafting a law in order to check if the words fully and accurately convey the intention of the law.

Section 192, the way it is currently worded, fails the test case of March salary paid in April.

A well worded law goes a long way in ensuring compliance with the spirit of the law. On the other hand, a poorly written law increases the cost of and lowers the likelihood of compliance.

Property under construction: Tax benefit from principal repayment

March 23, 2010 Leave a comment

The Indian Income Tax Act clearly specifies the conditions under which a salaried employee can claim tax rebate on interest payment for housing loan. Section 24 of the Income Tax Act states that no deduction is permissible on interest payment during the years in which construction of the property is still to be completed. Interest for pre-construction period is eligible for deduction in 5 equal installments (across 5 years) from the year construction is completed.

What about tax rebate on account of principal repayment? When the property for which a loan has been taken is under construction, can an employee claim rebate under Section 80C for principal repayment?

Some payroll managers opine that Section 80C doesn’t explicitly bar the rebate on account of principal repayment when the property is under construction. However, a look at the law suggests that tax rebate on principal repayment may not be allowed when the property is under construction.

The relevant clause under Section 80C is presented as follows. Click here to see the source.

80C. (1) In computing the total income of an assessee, being an individual or a Hindu undivided family, there shall be deducted, in accordance with and subject to the provisions of this section, the whole of the amount paid or deposited in the previous year, being the aggregate of the sums referred to in sub-section (2), as does not exceed one lakh rupees.

(2) The sums referred to in sub-section (1) shall be any sums paid or deposited in the previous year by the assessee—

(xviii) for the purposes of purchase or construction of a residential house property the income from which is chargeable to tax under the head Income from house property (or which would, if it had not been used for the assessees own residence, have been chargeable to tax under that head), where such payments are made towards or by way of

(a) any instalment or part payment of the amount due under any self-financing or other scheme of any development authority, housing board or other authority engaged in the construction and sale of house property on ownership basis; or

(b) any instalment or part payment of the amount due to any company or co-operative society of which the assessee is a shareholder or member towards the cost of the house property allotted to him; or

(c) repayment of the amount borrowed by the assessee from

(1) the Central Government or any State Government, or

(2) any bank, including a co-operative bank, or

(3) the Life Insurance Corporation, or

(4) the National Housing Bank, or

(5) ……………

A close look at clause (xviii) stated above suggests that for the principal repayment to be considered for tax rebate under Section 80C, there should be an income (or notional income) from the house property. When a property is under construction, there is no likelihood of income, and hence under Section 80C there is no provision for tax rebate on account of principal repayment. Only in the year in which the construction is completed can the principal repayment be considered for tax rebate. The same rule is applicable not only for principal repayment but also for stamp duty and registration charges.

Calculation of HRA exemption – Part II

February 15, 2010 Leave a comment

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.

Calculation of HRA exemption – Part I

February 9, 2010 1 comment

Organizations in India follow different methods for arriving at the House Rent Allowance (HRA) exemption, while calculating income tax on employee salary. Each method produces a different exemption amount. This begs the question, “which is the correct method?” Payroll managers have different opinions on how the exemption should be calculated. Let us examine the methods used for the HRA exemption calculation, and see which method goes well with the letters and spirit of Section 10(13A) of the Income Tax Act, 1961.

As per the Indian income tax law, the HRA exemption should be calculated as the least of the following.

1. Rent paid in excess of 10% of basic salary.
2. Actual HRA received by the employee.
3. Forty percent of basic salary, if the location of the residence is in a non-metro city/town or 50% of basic salary, if the location of the residence is in a metro city

From the above “least of three” rule, it is clear that HRA exemption amount is determined by a number of factors — Basic pay, location of the residence, rent paid by the employee, and the HRA paid to the employee.

So far, so good. The “least of three” rule looks easy to understand and implement. However, the same rule can be applied in different ways to create different methods of HRA exemption calculation.

Let us assume that an employee, who lives in a metro city, takes home a monthly Basic pay of Rs 50,000, monthly HRA of Rs 25,000, and pays a monthly rent of Rs 25,000. As long as everything remains constant throughout the year, there is no complication. The problem starts once any of the factors changes. Let us assume that the employee has a loss of pay for a month and half, say from August 1 to September 15, but the employee pays full rent in the months of August and September. Let us look at the different methods of calculating the exemption.

Method 1 – Annualized HRA exemption calculation

Organizations using this method calculate HRA exemption by determining the values of the different factors (Basic pay etc.) for the year and applying the “least of three” rule.

a. Basic pay for the year = Rs 50,000 x 10.5 months (on account of loss of pay) = Rs 525,000.
b. HRA paid to the employee = Rs 25,000 x 10.5 months (on account of loss of pay) = Rs 262,500.
c. Rent paid by the employee for the year = Rs 25,000 x 12 = Rs 300,000.

HRA exemption calculation

1. Rent paid in excess of 10% of Basic salary = Rs 300,000 – Rs 52,500 = Rs 247,500.
2. Actual HRA received by the employee = Rs 262,500.
3. Fifty percent of Basic salary (since the location of the residence is in a metro city) = Rs 262,500.

The HRA exemption for the year is the least of the above, which is Rs 247,500.

Method 2 – Monthly HRA exemption calculation

Organizations using this method calculate HRA exemption each month, and add the monthly HRA exemption values to arrive at the exemption for the year.

1. Monthly HRA exemption amount — after applying the “least of three” rule for each month — from April to July and from October to March = Rs 20,000 per month.
2. Monthly HRA exemption amount — after applying the “least of three” rule — for August = Rs 0.
3. Monthly HRA exemption amount — after applying the “least of three” rule — for September = Rs 12,500.

The total of HRA exemption amounts across all months = Rs 212,500 for the year.

Method 3 – HRA exemption calculation for each period of input change

As per this logic, whenever any of the input parameters (Basic pay, Rent paid, HRA, and Metro or Non-metro) changes for an employee during a year, the HRA exemption is calculated. In other words, the year is divided into as many periods as dictated by changes in any of the input parameters, and HRA exemption is calculated for each of the periods. Finally, the HRA exemption amounts for the different periods are aggregated to arrive at the HRA exemption amount for the year.

With regard to the illustration presented earlier, the year is divided into 3 periods, as follows.

Period 1: From April 1 to July 31  – when there is no change to any of the input factors.
Period 2: From August 1 to September 15 – when Basic pay and HRA change (became zero) on account of loss of pay.
Period 3: From September 16 to March 31 – when there is no change to any of the input factors.

HRA exemption calculation

HRA exemption for period 1– from April 1 to July 31 = Rs 80,000.
HRA exemption for period 2 — from August 1 to September 15 = Rs 0.
HRA exemption for period 3 — from September 16 to March 31 = Rs 130,000.

The total of HRA exemption amounts across all periods = Rs 210,000 for the year.

The 3 methods yield different annual HRA exemption amounts – Rs 247,500, Rs 212,500, and Rs 210,000.

Which is the correct method?

This is an important question to answer. Depending on the method an organization uses, the tax liability for the employee would be higher or lower, and in turn the government’s receipt from tax on salary income would be higher or lower.

The above illustrations present HRA exemption calculation in the event of changes in Basic salary and/or HRA. In the event of Basic salary or HRA not changing, but the rent amount changing or the location of the residence changing (say, from metro to non-metro), there will still be differences in HRA exemption calculation across the 3 methods.

While there is no explicit instruction from the income tax department as to which method should be used, we believe the “period” method (Method 3, described above) goes well with the provisions of Section 10(13A) of the Income Tax Act. We will explain how in the next post.