Calculation of HRA exemption – Part I
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.
Basis of pay calculation – Part II
In our previous post, we said calculating pay on the basis of a fixed number of days such as 26 or 30 leads to logical inconsistencies. Here is an illustration to describe the problem with the 26 day basis; the below illustration holds good even for 30 or any other fixed number of days.
Let us assume that the monthly salary for an employee is Rs 26,000 — which translates into Rs 1,000 per day due to the 26 day basis. For employees who join the organization in the month of July — which has 31 days — the salary calculation shall be as follows.
For those who join in early July, the number of days paid must be as per the number of days not worked in July. For example, employees who join on July 1 will have zero “not worked” days and hence will get paid Rs 26,000 as salary. Employees joining on July 2 will have 1 “not worked” day and hence will get paid Rs 25,000 as salary and so on. The “not worked” days logic will not work till the end of the month since as per this logic anyone who joins on the 26^{th} of July will have 26 “not worked” days and hence will get Rs 0 as salary.
Hence, for those who join towards the end of the month, one should use “worked” days instead of “not worked” days for salary calculation. For example, employees who join on July 31 will get salary for 1 day (Rs 1,000), employees joining on July 30 will get salary for two days (Rs 2,000) and so on.
The problem in using 26 as the basis of pay calculation is that at some point in time during the month the payroll manager should switch from the “not worked days” basis to the “worked days” basis, and whenever the switch is made, there will be a problem of logical inconsistency. Let us assume that the switch is made on July 16. A simple calculation shows that a person who joins on July 15 would get paid Rs 12,000 as salary for the month of July (on the basis of the “not worked days” method) and another person who joins one day later on July 16 gets paid Rs 16,000 (on the basis of the “worked days” method) — please see the table below. This is neither logical nor fair to the person who works for more number of days. Please see the table below for salary calculations for different dates of joining.
Table – Salary in July for employees with a monthly salary of Rs 26,000
Standard days – 26, Monthly salary – Rs 26,000, Month – July, and No of calendar days – 31
N W Days (in the Calculation Method column) refers to “Not Worked” days
Join date | Total days | Calculation method | Not worked days | No of salary days | Salary (Rs) | Calculation method | Worked days | Salary (Rs) | |
1 | 26 | N W days | 0 | 26 | 26000 | Worked days | 31 | 26000 | |
2 | 26 | N W days | 1 | 25 | 25000 | Worked days | 30 | 26000 | |
3 | 26 | N W days | 2 | 24 | 24000 | Worked days | 29 | 26000 | |
4 | 26 | N W days | 3 | 23 | 23000 | Worked days | 28 | 26000 | |
5 | 26 | N W days | 4 | 22 | 22000 | Worked days | 27 | 26000 | |
6 | 26 | N W days | 5 | 21 | 21000 | Worked days | 26 | 26000 | |
7 | 26 | N W days | 6 | 20 | 20000 | Worked days | 25 | 25000 | |
8 | 26 | N W days | 7 | 19 | 19000 | Worked days | 24 | 24000 | |
9 | 26 | N W days | 8 | 18 | 18000 | Worked days | 23 | 23000 | |
10 | 26 | N W days | 9 | 17 | 17000 | Worked days | 22 | 22000 | |
11 | 26 | N W days | 10 | 16 | 16000 | Worked days | 21 | 21000 | |
12 | 26 | N W days | 11 | 15 | 15000 | Worked days | 20 | 20000 | |
13 | 26 | N W days | 12 | 14 | 14000 | Worked days | 19 | 19000 | |
14 | 26 | N W days | 13 | 13 | 13000 | Worked days | 18 | 18000 | |
15 | 26 | N W days | 14 | 12 | 12000 | Worked days | 17 | 17000 | |
16 | 26 | N W days | 15 | 11 | 11000 | Worked days | 16 | 16000 | |
17 | 26 | N W days | 16 | 10 | 10000 | Worked days | 15 | 15000 | |
18 | 26 | N W days | 17 | 9 | 9000 | Worked days | 14 | 14000 | |
19 | 26 | N W days | 18 | 8 | 8000 | Worked days | 13 | 13000 | |
20 | 26 | N W days | 19 | 7 | 7000 | Worked days | 12 | 12000 | |
21 | 26 | N W days | 20 | 6 | 6000 | Worked days | 11 | 11000 | |
22 | 26 | N W days | 21 | 5 | 5000 | Worked days | 10 | 10000 | |
23 | 26 | N W days | 22 | 4 | 4000 | Worked days | 9 | 9000 | |
24 | 26 | N W days | 23 | 3 | 3000 | Worked days | 8 | 8000 | |
25 | 26 | N W days | 24 | 2 | 2000 | Worked days | 7 | 7000 | |
26 | 26 | N W days | 25 | 1 | 1000 | Worked days | 6 | 6000 | |
27 | 26 | N W days | 26 | 0 | 0 | Worked days | 5 | 5000 | |
28 | 26 | N W days | 27 | -1 | -1000 | Worked days | 4 | 4000 | |
29 | 26 | N W days | 28 | -2 | -2000 | Worked days | 3 | 3000 | |
30 | 26 | N W days | 29 | -3 | -3000 | Worked days | 2 | 2000 | |
31 | 26 | N W days | 30 | -4 | -4000 | Worked days | 1 | 1000 |
Of course, in order to solve the above problem, the organization could simply say that anyone who works for 26 days or more will get full salary, while anyone who works for less than 26 days will get a reduced salary. Here the problem is that someone who joins on the 1^{st} will get paid Rs 26,000 which is equal to what a person would get even if he joins only on the 2^{nd} (due to the same 26 days). Here again the method of calculation is not fair to the person who joins on the 1^{st} since another person (with the same monthly salary) who joins on the 2^{nd} gets paid the same salary.
The above problem exists — whether the basis is 26 or 30 days — for pay calculation in the first or last month of service when an employee works for less than full month, and in cases of loss of pay. The problem ceases to exist only when the calendar day basis or its variant is used for pay calculation.
Why do organizations use the fixed day basis?
Arguments in favor of the fixed days method are fallacious. Here are the typical arguments.
1. Let us maintain consistency across 30 and 31 day months. Whether an employee joins on June 21 or July 22 (and hence works for the same 10 days) they should be paid the same compensation.
As users of the Gregorian calendar system, we have chosen to live with the idea of paying the same amount as salary whether it is a 28 or 30 or a 31 day month. What about the issue of consistency there?
2. Indian laws mandate salary payment on the basis of a fixed number of days such as 26.
We haven’t received a satisfactory reply to the question of which statute (Factories act, Payment of wages act, etc.) mandates it, from anyone. If any such a mandatory requirement exists, it would be safe to say that many organizations are not following it.
We wonder how organizations that follow the fixed days logic resolve the problem inherent in the method. Or maybe they don’t, and just pay employees whatever comes out of using the method.
Basis of pay calculation – Part I
When an employee works for a part of a month – in their first or last month of employment — on what basis should their pay for that month be calculated? Should the pay be calculated on the basis of the total number of calendar days in the month, or should it be on the basis of a fixed number of days such as 26 or 30? As a payroll service provider, we receive this question quite often from organizations.
Organizations in India follow a variety of methods for pay calculation.
1. Calendar day basis
The monthly pay is calculated as total number of pay days multiplied by pay per day. In a calendar month, the per day pay is calculated as the total compensation for the month divided by the total number of calendar days.
For example, if the total monthly compensation of an employee is Rs 30,000, and if the employee joins the organization on June 21, they would be paid Rs 10,000 for the 10 days in June. Since June is a 30 day month, the per day pay is calculated as Rs 30,000/30 = Rs 1,000.
In the calendar day method, an employee — depending on whether they join or leave the organization in a 30 day or a 31 day month — will receive different pay amounts for the same number of pay days. In the above example, if the same employee joins the organization on July 22 (instead of June 21), even though they work for 10 days in July, they would receive only Rs 9,677 (after rounding off) in July. Since July is a 31 day month, the per day pay is calculated as Rs 30,000/31 = Rs 967.74.
2. Calendar days adjusted for Sundays
The monthly pay is calculated as total number of pay days multiplied by pay per day. In this method, pay per day is calculated as the total compensation for the month divided by the total number of calendar days minus Sundays.
Let us assume that an employee joins work in June which happens to have 4 Sundays. If the employee’s total monthly compensation is Rs 26,000, and if the employee joins on June 21, they would be paid Rs 10,000 for the 10 days in June. Since June has 26 pay days (30 minus 4 Sundays), the per day pay is calculated as Rs 26,000/26 = Rs 1,000.
Some organizations add public holidays to the total number of Sundays in order to arrive at the total pay days for the month.
In this method, the total number of pay days each month varies from one month to another depending on the number of calendar days, Sundays, and other holidays.
3. Fixed number of days, such as 26 or 30
The monthly pay is calculated as total number of pay days multiplied by pay per day. In this method, pay per day is calculated as the total compensation for the month divided by 26 or 30, as specified by the organization.
If an organization uses 26 as the fixed number of pay days each month, an employee who joins on June 21 and whose total monthly compensation is Rs 26,000, will get paid Rs 10,000 for the 10 days in June; the per day pay is calculated as Rs 26,000/26 = Rs 1,000.
In the fixed days method, an employee whether they join or leave the organization in a 30 day or a 31 day month, will get the same pay amount for the same number of pay days. In the above example, if the same employee joins the organization on July 22 (instead of June 21), he would be paid the same amount of Rs 10,000 (for 10 pay days) since both July and June are 26 day months from a payroll perspective.
Of course, the discussion on the method of pay calculation is relevant only for employees who have to be paid for less than a month – due to loss of pay or in their first or last month of service. For employees who have to be paid full salary for the month, the method of pay calculation is of no consequence.
Which is the best method?
Given the many methods of pay calculation that are being followed, is there is a particular method which stands out as the best?
From a statutory standpoint, labor laws in India do not seem to mandate the method which should be used by organizations; this is evident from the different methods that are in vogue. However, from the standpoint of logic, we recommend the use of calendar day logic or its variant, instead of the fixed day logic. The use of a fixed number of days such as 26 or 30 each month leads to inconsistencies in pay calculation and organizations should consider not using the method.
We will present our views on why the fixed day logic should not be used for pay calculation, in the next post.