Section 10 (13A) of the Income Tax Act along with Rule 2A of the Income Tax Rules provides for income tax exemption on House Rent Allowance (HRA) paid to employees. While HRA is one of the most widely used head of pay in Indian organizations, we find many payroll managers not calculating the exemption on HRA as per what the statutes specify. According to Section 10 (13A), any allowance paid for the purpose of an employee meeting house rent expenses is exempted, specified as follows:
any special allowance specifically granted to an assessee by his employer to meet expenditure actually incurred on payment of rent (by whatever name called) in respect of residential accommodation occupied by the assessee, to such extent as may be prescribed having regard to the area or place in which such accommodation is situate and other relevant considerations.
Explanation.—For the removal of doubts, it is hereby declared that nothing contained in this clause shall apply in a case where—
(a) the residential accommodation occupied by the assessee is owned by him ; or
(b) the assessee has not actually incurred expenditure on payment of rent (by whatever name called) in respect of the residential accommodation occupied by him ;
An employee should have lived in a house property which was not owned by him/her and the employee should have made payments towards rent in order to avail tax exemption on the HRA received.
Rule 2A of the Income Tax Rules specifies how HRA exemption should be calculated –
2A. The amount which is not to be included in the total income of an assessee in respect of the special allowance referred to in clause (13A) of section 10 shall be—
(a) the actual amount of such allowance received by the assessee in respect of the relevant period; or
(b) the amount by which the expenditure actually incurred by the assessee in payment of rent in respect of residential accommodation occupied by him exceeds one-tenth of the amount of salary due to the assessee in respect of the relevant period; or
(c) an amount equal to –
(i) where such accommodation is situate at Bombay, Calcutta, Delhi or Madras, one-half of the amount of salary due to the assessee in respect of the relevant period; and
(ii) where such accommodation is situate at any other place, two-fifth of the amount of salary due to the assessee in respect of the relevant period,]
whichever is the least.
Explanation : In this rule –
(i) “salary” shall have the meaning assigned to it in clause (h) of rule 2 of Part A of the Fourth Schedule;
(ii) “relevant period” means the period during which the said accommodation was occupied by the assessee during the previous year.]
In other words, the exemption on HRA, as per Rule 2A, should be the least of the following. Let us call it the Least of Three rule.
Least of Three rule for HRA exemption calculation
The least among the below shall be the exemption on HRA.
1. The actual HRA pay amount received by the employee.
2. The house rent paid by the employee which is in excess of 10% of the salary, i.e. rent minus 10% of salary.
3. 50% of salary if the rented house is located in a metro city (Delhi, Mumbai, Kolkata or Chennai) or 40% of salary if the rented house is located in any place other than Delhi, Mumbai, Kolkata or Chennai.
Note: According to the Income Tax Act, “salary” for the purpose of HRA exemption calculation “includes basic salary as well as dearness allowance if the terms of employment so provide. It also includes commission based on a fixed percentage of turnover achieved by an employee as per terms of contract of employment but excludes all other allowances and perquisites.”
For all illustrations in this blog post, we will assume that “salary” includes only Basic and employees in the illustrations are not paid Dearness Allowance or Commission.
On the face of it, the Least of Three rule looks easy to understand. However, as we will soon see, the rule is not so easy to implement. The tax exemption is determined by Basic pay, HRA, location (metro or non-metro) of the house, and the rent paid and when any of the input factor changes, the HRA exemption amount can change. We find organizations following different methods to arrive at HRA exemption and many calculate the exemption incorrectly.
Methods of HRA exemption calculation
a. Annualized HRA exemption calculation
Some organizations use the annual amounts of Basic, HRA, and rent paid, and calculate the HRA exemption by applying the Least of Three rule.
b. Monthly HRA exemption calculation
Some organizations use the monthly amounts of Basic, HRA, and rent paid, and calculate the monthly HRA exemption by applying the Least of Three rule. The total HRA exemption for the year is the sum of all monthly HRA exemption figures.
c. Period method
In this method, the HRA exemption is calculated (by applying the Least of Three rule) for a period in which the input factors (Basic, HRA, rent paid and location) remain the same. If any of the input factors changes, the HRA exemption should be calculated for the new period with the new input figures. The annual HRA exemption is the sum of the HRA exemptions for the different periods.
For example, an employee pays the same monthly rent (metro city) of Rs 10,000 per month from April to September in a year and from October to March he lives in a different house (metro city) and pays Rs 12,000 per month. The employee’s monthly Basic salary and monthly HRA remain constant throughout the year.
As per the Period method, the HRA exemption shall be calculated for 2 periods during which the input factors remain the same.
HRA exemption for the year (Apr to Mar) = HRA exemption for Period 1 (from Apr to Sep) + HRA exemption for Period 2 (from Oct to Mar).
Does the method of calculation matter?
Yes, it does. The HRA exemption amount from the three methods will be the same only when all input factors remain constant throughout the year. If any of the input factors changes during the year, the HRA exemption as calculated by one method will be different from that calculated by other methods. Let us illustrate this with an example.
An employee, who lives in Chennai (metro city), receives Basic pay (monthly) of Rs 50,000, HRA (monthly) of Rs 25,000, and pays a monthly rent of Rs 25,000. The employee has loss of pay from October 1 to November 15, but pays full house rent in the months of October and November. Let us calculate the HRA exemption using the different methods.
Annualized HRA exemption calculation
This method calculates HRA exemption by using the annual figures.
- Basic pay for the year = Rs 50,000 x 10.5 months (due to loss of pay for 1.5 months) = Rs 525,000.
- HRA for the year = Rs 25,000 x 10.5 months (due to loss of pay for 1.5 months) = Rs 262,500.
- Rent paid by the employee for the year = Rs 25,000 x 12 = Rs 300,000.
HRA exemption calculation
- HRA received by the employee = Rs 262,500.
- Rent paid in excess of 10% of salary = Rs 300,000 – Rs 52,500 = Rs 247,500.
- 50% 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.
Monthly HRA exemption calculation
As per this method, HRA exemption is calculated each month, and the monthly HRA exemption values are added to arrive at the exemption for the year.
- Monthly HRA exemption amount, after applying the Least of Three rule for each month – from April to September and from December to March = Rs 20,000 per month.
- HRA exemption amount for October, after applying the Least of Three rule = Rs 0.
- HRA exemption amount for November, after applying the Least of Three rule = Rs 12,500.
The total of HRA exemption amounts across all months = Rs 212,500 for the year.
HRA exemption calculation for each period of input change (Period method)
As per this method, whenever any of the input factors (Basic pay, Rent paid, HRA, and Metro or Non-metro) changes for an employee during the year, the HRA exemption is re-calculated. In other words, the year is divided into as many periods as dictated by changes in the input factors, and HRA exemption is calculated for each of the periods. Finally, the HRA exemption amounts for the different periods are added 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 September 30) – when there is no change in any of the input factors.
- Period 2 (from October 1 to November 15) – when Basic pay and HRA change (became zero) on account of loss of pay.
- Period 3 (from November 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 September 30) = Rs 120,000
- HRA exemption for Period 2 (from October 1 to November 15) = Rs 0
- HRA exemption for Period 3 (from November 16 to March 31) = Rs 90,000
The total of HRA exemption amounts across all periods = Rs 210,000 for the year.
The 3 methods yield different annual HRA exemption amounts:
Annual exemption method: Rs 247,500
Monthly exemption method: Rs 212,500, and
Period method: Rs 210,000.
Which is the correct method?
Depending on the method used, 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 illustration presents 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 on which method should be used, we are of the view that the “Period” method described above complies with the letter and the spirit of Section 10 (13A) of the Income Tax Act, 1961. The other methods such as the Annualized Exemption method and the Monthly Exemption method are not in line with the law. Let us see why.
The problem with the Annualized HRA Exemption method
Organizations using this method ask employees to submit the total rent amount paid during the year and use the annual rent amount for calculation. If an employee has a full month loss of pay in a month, say, September, the rent for September is also included in the annual rent figure. If in September, the employee received zero HRA on account of loss of pay, how can the September rent be included for HRA exemption calculation? In other words, how can rent be considered for a period in which there is no HRA and consequently no HRA exemption?
The problem with the Monthly HRA Exemption method
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. If within the same calendar month, an employee lives in rented accommodation in 2 cities, one metro and the other non-metro, this method would fail since both locations cannot be considered for exemption calculation for that month.
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 September, the employee lives in his own house (and hence pays no rent) from September 1 to September 15 and moves into a rented accommodation (in a metro city) from September 16 for a monthly rent of Rs 25,000. Further, the employee has loss of pay from September 16 to September 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 September is Rs 10,000, by applying the Least of Three rule. However, for the period from September 1 to September 15, the employee does not live in a rented house and hence is not eligible for HRA exemption, while for the period from September 16 to September 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 use the Period method, the HRA exemption for both the periods in the month (from September 1 to September 15 and from September 16 to September 30) will be zero.
The Period method is the only method which is compliant with the Income Tax Act under all possibilities.
Please note that, as per the Income Tax Act, the salary, for the purpose of HRA exemption calculation, is to be determined on “due” basis and hence the Period method should be used for HRA exemption calculation including for situations such as salary arrear payments and loss of pay.
Why is the Period method not followed widely?
1. Lack of awareness: Many payroll managers are unaware of the limitations of annualized exemption and monthly exemption calculations. Given that the Monthly Exemption method is widely used in India, one can safely say that the manner in which HRA exemption is calculated in many organizations in India is not in line with the Income Tax Act.
2. Payroll software limitations: The Period method is difficult to implement. Whenever Basic pay, HRA, residence location, or the rent paid change, the HRA exemption has to be re-computed. There aren’t too many payroll software (other than Hinote’s HRWorks) in India which can automatically re-compute HRA exemption whenever the input factors change. Manual computation of HRA exemption for each period is cumbersome and prone to errors.
We request the Income Tax Department to provide instructions (with numerical examples illustrating complex situations such as salary arrears, loss of pay etc.) on how HRA exemption should be calculated.