Calculation of loss of pay – Part II

May 25, 2010 2 comments

In the previous post, we talked about how some organizations make the mistake of presenting loss of pay as a deduction in payroll instead of reduction in pay. Let us examine some more issues pertaining to loss of pay in this post.

Loss of pay when pay calculation is on the basis of the calendar day logic

If your organization follows the calendar day logic, ensure that you record dates pertaining to the days for which loss of pay should be applied for an employee. For example, let us assume that the payroll manager wishes to apply 1 day loss of pay for an employee in July payroll. It is important for the payroll manager to know to which month the loss of pay pertains. Depending on the month, the loss of pay value would change. If the employee has a monthly salary of Rs. 31,000 on which loss of pay has to be applied, the value of one-day salary in July is Rs. 1,000 (Rs. 31,000/31 days) while the value of one-day salary in June is Rs. 1033 (Rs. 31,000/30).

In case the loss of pay pertains to a day in June, and if the payroll manager applies a 1 day loss of pay in July and reduces pay by Rs 1,033 instead of Rs. 1,000, he would be committing a mistake.

Hence, in the above example, the payroll software should have the capability to take the loss of pay input by way of dates, calculate the correct loss of pay amount and reduce pay accordingly. It may be noted that many of the payroll software applications in India simply take the loss of pay input by way of days without taking cognizance of the month in which the loss of pay days fall.

Taking cognizance of dates is important not only for calculation but also for reversal of loss of pay. There are occasions when loss of pay, applied in the previous month’s payroll, may be reversed in a subsequent month on account of loss of pay having been applied by mistake earlier. Again, if the dates pertaining to the loss of pay are not considered, the reversal of loss of pay may be done incorrectly and the employee may be credited with a loss of pay reversal amount which may be different from the actual loss of pay amount deducted earlier.

Impact of loss of pay on pay arrears

Whenever pay structure changes happen with retrospective effect, payroll managers should remember to make adjustments for loss of pay, if applicable, while calculating arrear pay. Here again, unless dates pertaining to loss of pay days are recorded, the payroll manager may be calculating arrear pay incorrectly.

For example, let us assume that an employee has 1 day loss of pay in June. If the organization hikes pay by revising the pay structure of the employee in August with effect from June 1, the payroll manager should ensure that the arrear pay is calculated after taking into the impact of the one-day loss of pay in June.

Clarity in loss of pay rules for non-statutory deductions in payroll

We find that in many organizations there is no clear-cut policy pertaining to application of loss of pay on deductions, particularly with reference to fixed deductions such as loan recovery and those on account of benefits such as accommodation, recreation club facility, and transport provided by the organization.

The organization’s policy should specify if there is a hierarchy among deductions with regard to applying loss of pay. For example, a loan recovery may come first and a deduction for recreation club may come later.

In case an employee has loss of pay for the whole month, the policy should specify if fixed deductions should be carried out, given the possibility of a negative net salary on account of 100% loss of pay. If deductions such as loan recoveries are deferred to subsequent months on account of 100% loss pay, the payroll manager should re-work perquisite valuation, if applicable, on loan deductions and re-calculate the income tax liability for the year.

Categories: Payroll

Calculation of loss of pay – Part I

May 21, 2010 7 comments

The basis of calculation of loss of pay for employees is fairly well established, yet, we come across many instances of incorrect calculation of loss of pay in organizations. The mistakes we are talking about here are not calculation errors but those on account of organizations adopting an incorrect basis for calculation of loss of pay.

Let us look at a common mistake committed by payroll managers while calculating loss of pay on employee salary.

Loss of pay amount as a deduction in payroll

Some payroll managers view loss of pay as a deduction in payroll instead of a reduction in pay. For example, an employee receives a monthly Basic salary of Rs. 10,000 in April and is entitled to no other head of pay. The Provident Fund (PF) contribution is Rs.  1,200 per month (12% of Rs. 10,000). The company in which the employee works follows the calendar day basis for pay calculation. If the employee has no loss of pay in April, his salary statement will read as follows.

Earning
Basic Salary : Rs. 10,000
Deduction
Provident Fund : Rs. 1,200
Net Pay : Rs. 8,800

If the employee has 15 days loss of pay for April, the company calculates the loss of pay to be Rs. 5,000 for April, shows this as a deduction, and calculates the net pay as follows.

Earning
Basic Salary : Rs. 10,000
Deduction
Provident Fund : Rs. 1,200
Loss of Pay Deduction : Rs. 5,000
Net Pay : Rs. 3,800

The above method is wrong since PF is calculated on “fixed” Basic instead of “earned” Basic for the month. Instead of presenting the loss of pay amount as a deduction, the company should reduce the pay to arrive at the net pay. For the above example, the net pay should be calculated as follows.

Earning
Basic Salary : Rs. 5,000
Deduction
Provident Fund : Rs. 600
Net Pay : Rs. 4,400

In the above example, the company ends up paying a lower net salary — Rs. 3,800 instead of Rs. 4,400 for the month — on account of incorrect loss of pay calculation.

Specifying loss of pay as a deduction in payroll leads to incorrect income tax, PF, and Employee State Insurance (ESI) deduction calculation.

When loss of pay is stated as a deduction, the income tax, if the employee has taxable income,  is calculated on full pay and hence the employee ends up paying income tax on salary he doesn’t receive. While for PF and ESI, both employer contribution and employee deduction are overstated.

Presenting loss of pay as a deduction (instead of reduction in pay) may look like a silly mistake. But you would be surprised to know that there are many companies that commit this silly mistake while processing payroll each month.

We will examine some more issues pertaining to loss of pay calculation in the next post.

Enhancement of wage limit for ESI coverage

May 2, 2010 Leave a comment

The Ministry of Labour and Employment, Government of India, has notified that the wage-limit for coverage of employees under the Employee State Insurance (ESI) scheme will be Rs 15,000 per month effective May 1, 2010, as against Rs 10,000 earlier.

Click here to read the government notification.

The new rule could bring in more employees under ESI in your organization from May 2010. If your organization is still to come under ESI, check if the number of additional employees that would be eligible for ESI on account of the wage-limit enhancement will require your organization to go for mandatory ESI registration.

In addition, keep in mind to apply the new wage-limit while including employees for ESI calculation from May 2010 payroll onwards.

Categories: ESI

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.

Definition of pay period: Let “month” mean “calendar month”

April 5, 2010 Leave a comment

In India, the most frequently used pay period (the length of time for which salary is calculated) is monthly.

How does one define “monthly?”

Some organizations define monthly as calendar month, while other organizations specify their own dates to define month – for example, from 21st of a month to the 20th of next month. In addition, in some organizations, some heads of pay may be calculated for a calendar month, while some other heads may be calculated for a different monthly period, i.e. 21st t0 20th. Whatever the month definition, salary payments typically happen on the same day, for example, the last working day of the calendar month.

Why do organizations specify their own dates while defining month for salary computation? Here are the reasons we have come across.

1. “Greater hold” over employees

A business process outsourcing company, known to us, defined 21st to 20th as its salary month, while the salary payment happened on the last working day of the month. When we asked them why they adopted 21st to 20th as the period for salary computation, the company said they wished to “retain” 10 days’ (from 21st till the day salary is paid) salary and this would discourage employees from leaving the company without any notice since their 10 days’ salary was with the company.

Whatever happened to values such as employee friendliness and trust!

2. Administrative convenience

Payroll managers typically process payroll by the 26th or 27th of a month and by specifying 20th as the last day of the month, they can receive all the inputs on time for payroll processing. In case the month is defined as calendar month, payroll managers, when they process payroll, may not know, for example, if there will be loss of pay for an employee after the 26th, the date of payroll processing. The payroll in such cases may be processed with the assumption that there will be no loss of pay for the month after the date of payroll processing.

We believe defining the month as anything other than calendar month leads to problems in salary processing and statutory compliance. It is best if month is defined as calendar month whenever salary is paid monthly.

Let us take a look at the problems faced by payroll managers when they do not follow calendar month but define their own month for salary computation.

1. Difficulty in salary computation

When the pay period is spread across 2 calendar months, what should be the base number days for pay computation? We described the different bases of pay computation here and here. The calendar day logic will not work if the salary month is different from calendar month, while adopting a standard number of base days — such as 30 or 25 — for salary computation could lead to flawed salary calculation as described here.

Of course, one can always write a formula in a payroll software, input the exact number of worked days for employees and the total number of pay days and calculate pay, if the salary month is defined as 21st to 20th or 26th to 25th for that matter. However, in such cases, implementing an automated arrear calculation, by way of formula, in the payroll software may not be possible and the payroll manager adopting 21st to 20th as the salary month may have to compute arrear salary manually. In addition, non-calendar salary months may lead to incorrect computation of loss of pay amounts and loss of pay reversals.

2. Issues with income tax calculation

The tax year is April 1 to March 31 as per the tax law. If a company defines its pay period as, say, 25th to 24th, compliance with the tax law may be difficult. In the month of March, the company’s salary month would end on March 24 (for the month February 25 to March 24). If salary for the period March 25 to March 31 accrues in the books of accounts of the company for the March month, the company will have to calculate income tax on salary for that period as per the rates prevailing for the year ending March 31. If for the salary paid for the period March 25 to April 24, tax rates are applied as per the rates prevailing in the new tax year starting April 1, the company may be calculating tax in contravention to Section 15 of the Income Tax Act. As a consequence, the Form 16 may present incorrect data regarding salary paid and income tax deducted.

3. Issues with provident fund/ESI calculation

Month, as specified by the laws governing Provident Fund (PF)/ESI, is the calendar month. If a company follows 21st to 20th as salary month, the amount remitted to the PF/ESI department may be different from the PF/ESI amount which should be accrued in the books of accounts since the PF/ESI amount for a calendar month could be different from the PF/ESI amount payable for the month, from 21st to 20th.

If new PF or ESI deduction rates are mandated by the respective departments from a certain month, computation of PF/ESI deductions may be incorrect if a company follows non-calendar month for pay computation. For example, let us assume that a new PF deduction rate, say, 15% of Basic pay comes into effect from March 1 of a PF year. If a company follows January 21 to Feb 20 as the salary month, the PF amount for salary paid for Feb 21 to Feb 28 may be calculated at 15% (the new rate) in March payroll run while the new PF rate comes into existence only from March 1 (and not February 21).

Using the calendar month is fine, but what if the payroll inputs are not available by the time payroll is run?

This is a valid issue. The only way to tackle this is to make certain assumptions while running the payroll and make adjustments, if required, in the next month’s payroll run or final settlement. For example, payroll is run on the 26th of a month for the entire calendar month and the salary is credited on the last day of the month with the assumption that there is no loss of pay for an employee. If in the first week of next month, an input that there is a one day loss of pay for an employee for the previous month is received, then the one day loss of pay could be deducted in the next month’s payroll run.

Despite the administrative inconvenience, it is best to use calendar month for the sake of computing monthly pay.

Categories: Payroll

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.

PF contribution – company policy cannot overrule the law

February 22, 2010 8 comments

According to Section 6 of the Employees Provident Fund and Miscellaneous Provisions Act, 1952, the provident fund (PF) contribution is to be calculated as 12% of the sum of basic pay, dearness allowance, cash value of food concession and retaining allowance, if any, subject to a maximum of Rs 6,500 per month.

Let us see how employer and employee PF contributions should be calculated.

a. Rate of contribution: Should be 12%. The law allows a 10% contribution under specific conditions. However, for most organizations, the rate is 12%.

b. Basis of calculation: The 12% rate should be applied on the basic pay, dearness allowance, cash value of food concession and retaining allowance, if any.

What constitutes salary for the purpose of PF calculation is an interesting question by itself. There are many court judgments which clarify this. The 2008 judgment by the Supreme Court of India (Citation: CASE NO.: Appeal (civil) 1832 of 2004, PETITIONER: Manipal Academy of Higher Education, RESPONDENT: Provident Fund Commissioner, DATE OF JUDGMENT: 12/03/2008, BENCH: Hon’ble Dr. ARIJIT PASAYAT & Hon’ble P. SATHASIVAM) in which the court clarified that earned leave is not a part of basic salary for the purpose of PF computation, is a must read for payroll managers. The judgment specifies how Section 2b and Section 6 of the Employees Provident Fund and Miscellaneous Provisions Act should be read together in order to determine what constitutes salary.

We can choose to ignore cash value of food concession and retaining allowance, since very few organizations provide those. In most cases, it safe to conclude that the 12% rate should be applied on the basic pay and dearness allowance, if any.

The PF contributions can be calculated on either “full” basic (total basic pay paid to employees) or “restricted” basic (limited to basic pay amount of Rs 6,500 per month).

Organizations in India should fully adopt the rate and the basis of calculation as specified in the law. However, we come across organizations which follow their own business rules — which are not in line with what the law mandates — for calculating the employer and employee contribution to PF.

A multinational company in India, until recently, was deducting and remitting PF amounts at 5% of the gross compensation paid to employees. When we had a discussion with the company as to whether this was in compliance with the PF rules, we were informed that a leading law firm had vetted this management policy and hence the company was comfortable following it. This company some time ago received a notice from the PF department that the PF contribution was less than 12% of basic pay — on account of the company following its own business rule — and the company should remit the difference to the department along with penal interest. The company recently changed its PF calculation rule to 12% of basic pay.

We wonder what was the need for the company to follow its own basis for PF calculation when the basis of calculation is clearly specified in the law.

In addition to calculating PF contribution incorrectly, organizations make mistakes in calculations in the bank challan used for remitting PF contribution each month. Calculations for Accounts 1, 2, 10, 21, and 22 are presented incorrectly in the challan on account of incorrect PF calculation. Payroll managers should appreciate the nuances of PF calculation and the linkages among the underlying components such as contribution to pension fund, provident fund, administration charges etc. It is not difficult for the PF department to figure out mistakes in the PF challan.

It is also important for payroll managers to understand how income tax calculation gets impacted when they follow their own business rule for PF calculation. Some companies add earned leave amounts to the basic pay for PF calculation even though as per law the basic pay does not comprise earned leave. Such companies claim that they do it for the sake of employee welfare (a higher amount of PF saving for the long-term). When heads of pay such as earned leave are added to the basic pay, the employer PF contribution goes beyond 12% of basic pay and any amount under employer contribution to PF beyond 12% is chargeable under the Income Tax Act.

Payroll managers should strive to comply with laws governing statutory deductions to the fullest extent. Ignorantia juris non excusat.

Categories: Provident Fund

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.