Definition of Allowance
Allowance is a fixed amount of financial or monetary benefit offered by the employer to its employee to meet the required expenditures over and above the basic salary. Allowances are pre-determined and are given irrespective of the actual expenditure.
Example: The company provides employees with additional benefits like overtime allowance if they work extra working hours. The company can also give a travel allowance if the employee is travelling from home to the workplace. There are many such examples for which allowances can be provided to employees.
Companies provide the allowances as a part of the salary of the employee and are taxable, except for those specifically exempted under the Income Tax Act.
Types of Allowances
Depending upon the application of tax treatment, allowances can be divided into three categories:
- Taxable Allowances
- Non-Taxable Allowances
- Partially Taxable Allowances
1. Taxable Allowances
Taxable allowances are treated as a part of the salary and are not fully or partially exempted under any section or provision of the Income Tax Act.
Some major taxable allowances are:
i) Dearness Allowance (DA)
All public sector employers pay basic salaries according to the pay scale. Several other components are calculated and added in respect to the basic salary to calculate the take-home amount. One such important component is Dearness Allowance (DA).
What is Dearness Allowance?
Dearness Allowance is paid by the government to its employees and pensioners to offset the impact of inflation. The effective salary of government employees requires constant enhancement to help them cope with the increasing prices. Despite several measures by the government to control inflation, only partial success has been achieved because prices move according to the market. It, therefore, becomes essential for the government to shield its employees from the adverse effects of inflation.
As the impact of inflation varies according to the location of the employee, dearness allowance is calculated accordingly. Thus, DA varies from employee to employee based on their presence in urban, semi-urban, or rural sectors.
Calculation of Dearness Allowance
DA is calculated twice every year — in January and July. The formula was changed in 2006 by the government. Presently, DA is calculated as per the following formula:
- Central Government Employees: - % of DA = {(Average of the All-India Consumer Price Index (Base year -2001=100) for the last 12 months -115.76)/115.76} x 100
- Central Public Sector Employees: - % of DA = {(Average of the All-India Consumer Price Index (Base year -2001=100) for the last 3 months -126.33)/126.33} x 100
Treatment under Income Tax:
As per the latest updates, DA is fully taxable for salaried employees. If the employee has been provided with unfurnished rent-free accommodation, it becomes part of the salary up to which it forms the retirement benefit salary of the employee, provided that all other pre-conditions are met. The Income Tax rules in India require the DA component to be mentioned separately in income tax returns.
Types of Dearness Allowance
For calculation, DA is divided into two categories:
- Industrial Dearness Allowance (IDA): Applies to public sector employees of the Central Government. IDA undergoes quarterly revision depending on the Consumer Price Index to offset the impact of inflation.
- Variable Dearness Allowance (VDA): Applies to Central Government employees. Revised every six months according to the CPI.
Components of VDA:
- Base Index: Remains fixed for a particular period
- Consumer Price Index: Changes every month and impacts VDA
- Variable DA amount: Fixed by the Government unless the basic minimum wages are revised
Role of Pay Commissions
Pay Commissions evaluate and change salaries of public sector employees based on various components that make up the final salary. DA is considered by Pay Commissions while preparing subsequent reports. It is their responsibility to review and update the DA multiplication factor periodically.
Dearness Allowance for Pensioners
Pensioners are retired employees of the central government eligible for individual or family pension. Whenever the Pay Commission rolls out a new salary structure, DA adjustments are reflected in pensions.
Changes in Dearness Allowance as per Budget 2018
Over 50 lakh central government employees receive salaries, and 55 lakh retired employees receive pensions. As per Budget 2018, DA was hiked by 2%, from 5% to 7%, benefiting both employees and pensioners.
Dearness Allowance Merger
DA for public sector and central government employees has been consistently rising. It presently stands at 50% of the basic salary. When DA crosses 50%, it is merged with the basic salary, resulting in a significant salary increase, as all other components of salary are calculated based on the basic. A decision from the Government is expected on this matter.
ii) Entertainment Allowance
Entertainment allowance is paid for hospitality services, including hotels, client meetings, drinks, business outings, and more.
- Private-sector employees: Fully taxable
- Government employees: Exemption under Section 16(ii) up to: 20% of gross salary (excluding other allowances), Actual entertainment allowance, Rs 5,000
iii) Overtime Allowance
Overtime allowance is provided to employees working beyond agreed working hours due to urgent tasks or project deadlines. Fully taxable.
iv) City Compensatory Allowance
City compensatory allowance is given to employees in major or metropolitan cities with high living costs. It is paid to retain employees in certain locations. Fully taxable under Section 10(14). There is no minimum or maximum limit.
v) Cash Allowance
Cash allowance is paid for incidentals such as marriage or holiday expenses. Fully taxable.
2. Non-Taxable Allowances
Non-taxable allowances are fully exempted from taxes and mostly provided to government employees.
Examples include:
- Allowances paid to government employees abroad
- Allowances paid to UNO employees
- Allowances for Supreme Court and High Court judges (sumptuary allowances)
- Allowances for retired Chairman or Members of UPSC
- Compensatory allowances for judges
3. Partially Taxable Allowances
Partially taxable allowances are exempted up to a limit under the Income Tax Act. Only some parts are taxable.
i) House Rent Allowance (HRA)
HRA is provided for accommodation expenses if the employee lives in a rented house. Fully taxable if living in own house.
Exemption under Section 10(13A):
Least of:
- Actual rent paid minus 10% of basic salary
- 50% of basic salary (metro) or 40% (non-metro)
- Actual HRA received
ii) Conveyance Allowance
Conveyance allowance (Transport Allowance) compensates for commuting costs if employer does not provide transport.
- Exemption limit: Rs.19,200 per year or Rs.1,600 per month
- Special cases: - Blind/orthopedically handicapped: Rs.3,200 per month, UPSC members: fully exempt under Section 10(45)
iii) Special Allowances
Special allowances are paid for performance of duty. Examples:
- Children education allowance: Rs.100 per month per child, max 2 children
- Children hostel allowance: Rs.300 per month per child, max 2 children
- Exceeding amounts are taxable
iv) Special Compensatory Allowance (Hilly Areas)
Paid to employees working in hilly or high-altitude areas. Exemption ranges: Rs.300 – Rs.7,000 per month. Example: Employees in Siachen area are eligible for Rs.7,000/month.
v) Underground Allowance
Paid to employees working in unfavorable underground conditions. Exemption: Rs.800/month. Excess is taxable.
