The new wage definition under the Code on Wages, 2019 will change the way gratuity and provident fund calculations are done on salary. As per current rules, gratuity and provident fund is calculated on the basic salary. However, under new rules, it will take into account basic and other allowances except those that are excluded. These changes will impact your income tax liability.
The four new Labour Codes enacted in 2019 and 2020 are awaiting notification by the central government and are expected to be notified in 2022. As many as 29 States and Union Territories have already issued the Draft Rules for one or more of the four Labour Codes.
One of the key changes under the new Labour Codes is the introduction of a uniform definition of the term ‘wage‘ across all the four Codes., The uniform definition of ‘wage’ includes all monetary payments and any benefits provided in kind except for the specified exclusions. Specified exclusions consist of components such as conveyance allowance, house rent allowance (HRA), amounts paid to defray special expenses (e.g., telephone reimbursements etc.) and contribution to pension and Provident Fund (PF).
Under the new definition of wages, the specified exclusions are to be capped at 50% of the total remuneration. This means that for the purpose of social security contributions such as PF, gratuity (accrual and payout), etc. at least 50% of the ‘total remuneration’ shall be considered. This ‘total remuneration’ includes wages (as defined in the paragraph above) plus specified exclusions (e.g HRA, conveyance).
Generally, employers identify a basket of allowances and leave the choice to the employee to pick and choose specific components which are relevant to them for inclusion in their salary structure, within the overall CTC. This helps employees to optimize their taxes. However, a flexible salary structure could result in complexity in determining “Wages” under the labour codes, impact retirals such as PF, Gratuity and thereby the take-home pay of employees.
Impact on income tax payable due to new wage definition
Here is an example of an employee with a CTC of Rs 12 lakh (monthly Rs 1 lakh), with 40% as basic salary. There are two situations, one where the HRA is covered under the flexible components and an employee decides not to avail the same (Situation A), and another where HRA is a fixed salary component (Situation B).
|Components||Reference||Under the existing law||Under the new Labour Codes|
|Monthly Amounts (Rs) – Situation A||Monthly Amounts (Rs) – Situation B||Monthly Amounts (Rs) – Situation A||Monthly Amounts (Rs) – Situation B|
|HRA (40% basic for situation B)||B||–||16,000||–||16,000|
|Retirals – Employer’s Contribution to PF||C||4,800||4,800||10,273||8,629|
|Retirals – Gratuity||D||1,924||1,924||4,118||3,459|
|Special allowance (i.e., balancing figure)||E||53,276||37,276||45,609||31,912|
|Total Monthly Salary||F||100,000||100,000||100,000||100,000|
|Income Tax *||G||10,055||7,457||7,220||5,545|
|Take Home Pay (F – C- D- G – employee PF contribution)||H||78,421||81,019||68,116||73,738|
|Retiral Benefit (C +D)||I||6,724||6,724||14,391||12,088|
|Wages as per the new Labour Codes (Total salary – exclusions i.e., gratuity accrual, PF contribution and HRA)||J||85,609||71,912|
*Income tax calculated as per the old tax regime assuming rent payment of Rs 16,000 p.m. and that PF contribution is the only eligible deduction under section 80C of the Income Tax Act.
Essentially, the employer is required to consider “wages” as per the new Labour Codes (once notified) as the basis for determining gratuity, coverage under ESI, statutory bonus, etc.
In the example tabulated above, wages as per the new Labour Codes is determined by excluding HRA, gratuity accrual and PF contribution from the total monthly salary.
The above table clearly indicates that there is an increase in the allocations towards retiral benefits and a decrease in the take home pay. This is consequent effect of “wage” (including other allowances) being considered for the purpose of PF and gratuity as opposed to basic salary currently. There is also a corresponding decrease in the tax outflow as taxable salary is reduced to the extent of increased allocations to PF and gratuity.
From the table above, one would also notice that wage determined is different in Situation A and in Situation B, despite the monthly salary remaining constant at Rs 100,000. Having HRA as a fixed component results in a lower impact on gratuity (see Row D) i.e., gratuity amount is lower. This consequently results in a higher take-home pay (see Row H), once the Labour Codes are made effective in situation B (HRA as a fixed component).
It may, therefore, be beneficial for organisations as well as employees to move into a fixed structure to the extent possible. The increase in gratuity benefits, flowing in on account of the new definition of wages is certainly attractive to employees.
However, significant increase in gratuity accruals (payable if a person resigns after 5 years by organisations covered under the Gratuity Act) and PF could impact their take-home pay. Further, moving into a fixed structure would mean that some flexibility in availing tax benefits may be reduced, however, it would provide certainty in arriving at the take-home pay.
Overall, moving to a well-balanced compensation structure under the new Labour Codes may prove to be beneficial for both employer and employee – by lowering the employer costs as well as being tax efficient for an employee.
To conclude, there are significant areas where more clarity is expected from the government, such as – (i) can variable pay be considered as an exclusion, and (ii) can we expect a specific definition of “last drawn wages” for the purpose of gratuity. It would be interesting to watch out for the final Rules or any changes to the definition of wages that may have an impact on both the employer and employee.
(Saraswathi Kasturirangan is a Partner with Deloitte India. Ratna K is a Director and Ankit Agarwal is a Manager with Deloitte Haskins and Sells LLP )