CALCULATION OF HTA EXEMPTION

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 From April 1 to July 31 when there is no change to any of the input factors. 1: Period From August 1 to September 15 when Basic pay and HRA change (became zero) on 2: account of loss of pay. Period From September 16 to March 31 when there is no change to any of the input factors. 3: HRA exemption calculation HRA exemption for period 1 from = Rs 80,000. April 1 to July 31 HRA exemption for period 2 from = Rs 0. August 1 to September 15 HRA exemption for period 3 from = Rs 130,000. September 16 to March 31 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 governments 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.

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 thePeriod method, while the other methods such as the Annualized exemption method and theMonthly 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 Tandems 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.