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Compensation structuring should be in line with tax law

Compensation structuring with a view to minimizing tax in the hands of employees is not a bad thing. However, we find a number of organizations not adhering to the Income Tax Act while including allowances and reimbursements in their employees’ salary structure. A typical practice adopted by many organizations is to define a portion of the compensation as “variable” or “flexi” and not tax such components as long as employees submit supporting bills in proof of certain expenses having been incurred. The typical heads of pay we come across in this regard include Petrol Reimbursement, Uniform Allowance, Books and Periodicals Reimbursement, Professional Development Allowance, Grooming Allowance, and Soft Furnishing Allowance. The list goes on, limited only by the creativity of payroll managers in coming up with names for heads of pay. While we have no problem with organizations creating new heads of pay or having flexible pay components, we are concerned that some payroll managers may be committing mistakes with regard to the tax treatment of such heads of pay.

Let us take a look at some examples of heads of pay which are not taxed as per the Income Tax Act in some organizations.

1. Petrol / Fuel Reimbursement

Many organizations provide tax free compensation under this head as long as employees submit petrol/diesel bills. Senior managers in some organizations receive thousands of Rupees each month under this head. Many payroll managers are not aware that there are documentation requirements to be met if any amount is paid tax free under this head.

There is no direct reference to petrol/fuel reimbursement in the income tax law. Rule 3 of the Income Tax Rules, which pertains to valuation of perquisites, provides guidelines on how to tax an amount paid to employees for the purpose of meeting the “running and maintenance charges” of their motor car or other vehicles. The term running and maintenance charges includes expenses incurred on petrol/diesel.

According to Rule 3, for any payment made for meeting the running and maintenance expenses of an employee’s vehicle to be fully tax free, the following conditions should be met.

a. If fuel reimbursement is sought for an employee’s vehicle, it is imperative that the employee owns the vehicle and as part of documentation, the employer should store a copy of the vehicle’s documents (such as the RC book). In case the vehicle is provided by the employer (owned or leased), the supporting ownership or lease document should be maintained.

b. The vehicle should be used wholly and exclusively for official purposes and the employer should give a certificate to the effect that the expenditure was incurred wholly and exclusively for the performance of official duties. In other words, if the employee uses the vehicle for personal purposes, even if partly, the fuel expenses reimbursed shall not be tax free.

c. The employer should maintain complete details of journey undertaken for official purpose which may include date of journey, destination, mileage, and the amount of expenditure incurred. In other words, the employer should maintain a travel log book at the individual employee level and be able to justify that the expenses reimbursed were incurred only for official purposes.

As per Rule 3, submission of fuel bills alone is not adequate for making the reimbursement amounts non-taxable. We find many organizations not adhering to the income tax rules (stated above) in this regard.

2. Uniform Allowance

According to Rule 2BB of the Income Tax Rules, “any allowance granted to meet the expenditure incurred on the purchase or maintenance of uniform for wear during the performance of the duties of an office or employment of profit” is tax free. Many organizations ignore the term uniform and make payments under this head tax free as long as employees submit some clothing bills.  This, in our view, is not in line with Rule 2BB. The term uniform refers to the distinctive clothing worn by members of the same organization. In case an organization does not have the practice of asking its employees to wear uniform to work, the organization cannot have a tax free head of pay called Uniform Allowance.

3. Books and Periodicals Reimbursement

There is no direct reference to books or periodicals in Rule 2BB of the Income Tax Rules. Many organizations reimburse employees the money they spend on buying books and periodicals under this head of pay. Payroll managers argue that employees need to keep abreast with the latest happenings relating to their profession and hence spending money on books and periodicals is justified. While the Income Tax Department would have no objection to employees keeping themselves abreast of the developments around them by reading books and periodicals, it could well object to making the payment tax free.

We can add many more heads of pay (which are commonly adopted by organizations) to the above, the taxation of which is not strictly in line with law.

Avoid liberal interpretation of law

Whenever you decide to create a head of pay which is tax free, please ensure that the taxation of the head of pay is as per Section 10(14) of the Income Tax Act, Rule 2BB and Rule 3 of the Income Tax Rules which refer to tax free allowances and valuation of perquisites. Section 10(14)(i) states that any “special allowance or benefit, not being in the nature of a perquisite within the meaning of clause (2) of section17, specifically granted to meet expenses wholly, necessarily and exclusively incurred in the performance of the duties of an office” can be tax free. We find payroll managers taking refuge under this section and arguing that some of the allowances and reimbursements (such as Books and Periodicals Reimbursement) are not to be taxed because such expenses are required for the performance of official duties. For example, in case of Books and Periodicals Reimbursement, unless one can establish that the books or the periodicals can be established to be “wholly, necessarily and exclusively” required for official work, the reimbursement cannot be tax free. We find employees submitting bills for daily newspapers and generic news magazines which are readily accepted by many organizations. Surely, a daily newspaper cannot be stated to be “wholly, necessarily and exclusively” required for official work.

In short, we suggest that payroll managers do not take liberties which are not explicitly provided by law.

Keeping it outside of payroll does not matter

A payroll manager once informed us that he keeps the payments under certain heads of pay (such as fuel reimbursement) outside of payroll and the monthly salary register since he wanted to keep it tax free. It is quite strange that some payroll managers believe that if a payment is kept outside monthly payroll process, the payment can be made tax free. The Income Tax Department does not recognize the formality of payroll processing. Whenever a salary payment is made to an employee, whether within or outside of payroll, payroll managers should ensure that the tax calculation is as per the Income Tax Act. If a tax free payment does not have a clear-cut basis in the Income Tax Act, there is a likelihood that it may be construed as tax evasion by the Income Tax Department.

Make sure that the documentation is complete

Finally, please ensure that you collect all the required documents for tax free allowances and reimbursements from employees. Please make a salary payment tax free only after a careful scrutiny of the bills submitted by employees. Please ensure that all the required underlying documents (bills etc.) are stored carefully. In case of any queries from the Income Tax Department, you will need to submit the documents to the department while justifying the reasons for tax free payouts.