1. Rent paid in excess of 10% of basic salary.
2. Actual HRA received by the employee.
3. 40% 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.