Summary: The implementation of the labour codes necessitates a comprehensive review of compensation paid to employees. The compensation structure of employees will also see an impact from an income tax perspective, which cannot be ignored easily. Through this blog, we have analysed some of the positive as well as negative consequences that would need to be understood and analysed by employers as well as employees at the earliest.
The much-awaited labour reforms have finally been implemented. The Government of India’s rollout of the four new labour codes; namely, the Code on Wages, the Industrial Relations Code, the Code on Social Security, and the Occupational Safety, Health and Working Conditions Code, marks a transformative step in consolidating and modernising the nation’s labour regulations. These codes not only harmonise definitions and compliance procedures, but also introduce a fresh perspective on how compensation is structured and delivered to employees across the organised sector. Crucially, the new codes redefine the concept of ‘wages’, which has a direct bearing on statutory deductions, benefits, and, ultimately, the calculation of individual tax liabilities. Through this note, we will elucidate the multifaceted impacts of these changes, delving into both the positive and negative ramifications for an employee’s financial planning and tax obligations.
Overview of the New Salary Structure Under the Labour Codes
The reimagined definition of ‘wages’ under the new labour codes brings much-needed uniformity. The term now encapsulates basic pay, dearness allowance, and retaining allowance, while carefully excluding elements such as house rent allowance (HRA), statutory bonus, overtime, commissions, and certain other benefits. One of the most significant mandates is that the ‘wages’ component must constitute at least 50% of the total remuneration provided to the employee. This will compel organisations to revisit their salary frameworks and restructure compensation packages more efficiently, in light of the new “wages” definition under the Labour Codes.
This alteration is not merely cosmetic; it fundamentally shifts the base income on which statutory benefits like provident fund (PF), gratuity, and other retirement related contributions are calculated. The ripple effect will be felt in every aspect of an employee’s remuneration, from monthly take-home salary to long-term savings and tax exposure.
Impact on Tax Liability: Positive Implications
Greater Transparency and Simplification
The standardisation of wage definitions across all organisations brings clarity and transparency to salary slips. Employees gain a clearer understanding of which pay components are taxable, which are exempt, and how statutory benefits are calculated. This makes personal tax planning and compliance easier, reducing the likelihood of inadvertent errors or disputes with authorities.
Enhanced Gratuity Benefits
With “wages” comprising a larger share of total salary, the gratuity payout at the time of cessation of employment, computed as a percentage of “wages”, increases substantially. Under the Income Tax Act, gratuity is subject to tax exemption up to a prescribed limit. Larger gratuity accruals improve financial security after employment and may further reduce taxable income at the time of encashment, provided the gratuity amount does not exceed the statutory limit, which is currently Rs 20,00,000 (Rupees Twenty Lakh).
Increased Provident Fund and Retirement Savings
As PF (when the relevant portions of the Code come into effect) and gratuity are now required to be calculated on the newly defined ‘wages’ under the Codes, a heightened base translates to higher mandatory contributions to these funds. Under Section 80C of the Income Tax Act, an employee’s contribution toward PF (up to 24% of monthly basic salary, including both an employee’s contribution as well as an equivalent amount contributed by the employer, subject to an overall limit of Rs 1,50,000 (Rupees One Lakh Fifty Thousand) is exempt from income tax. This not only augments the quantum of an employees’ retirement corpus, but also enables employees to optimise tax savings through higher deductible amounts. In effect, a greater portion of income is shielded from taxation by being channelled into long-term savings mechanisms. However, it is relevant to note that this deduction is not available in the new tax regime.
Promotion of Long-Term Financial Discipline
The new codes inherently promote a savings culture by raising the mandatory contribution to recognised retirement benefits. This can help employees build a more robust safety net for the future, aligning with the wider objective of enhancing social security coverage.
Impact on Tax Liability: Negative Implications
Reduction in Take-Home Pay
With a higher proportion of the total compensation now earmarked as “wages” and forming the basis for statutory deductions, employees may notice a decrease in their net monthly income. Although these deductions benefit employees in the long term, they also reduce the disposable income available for immediate needs, budgeting, and lifestyle choices.
Decreased Scope for Tax-Exempt Allowances
Previously, salary structures often included a variety of allowances — such as HRA, leave travel allowance (LTA), meal vouchers, and reimbursements — that could be partially or entirely exempt from income tax. The new codes restrict their proportion in the overall pay package, leading to a situation where a larger part of the salary is taxable. For employees who heavily relied on allowances for tax planning, this change can result in an increased effective tax burden.
Possibility of Moving to a Higher Tax Bracket
Since “wages” and, hence, the taxable component of income is now higher, some employees may be pushed into a higher income tax slab. This escalation in taxable income can lead to a proportionally higher outflow in taxes, depending on one’s overall annual earnings and the prevailing personal tax rates.
Reduced Flexibility in Salary Structuring
The new codes significantly reduce the ability of both employers and employees to optimise salary structures for tax efficiency. Where previously tailored distributions of allowances and reimbursements could be leveraged to reduce taxable income, the minimum ‘wages’ requirement and restrictions on the share of allowances now put strict boundaries on such practices.
Potential Complexity in Transition Period
During the initial period of transition to the new codes, there may be confusion and complexity in recalculating statutory contributions and taxable income, both for HR departments and employees. Mismatches between old and new structures might result in temporary discrepancies or misunderstandings about net salary and tax deductions.
An illustration
Consider the case of an employee whose total fixed cost to company (CTC) is Rs 10 lakh (Rupees Ten Lakh) per annum. Previously, basic salary might have constituted 35% (Rupees Three Lakhs Fifty Thousand), with the remainder split among various allowances many of which offered tax exemptions or rebates.
Under the new regime, ‘wages’ will effectively constitute 50% (Rupees Five Lakh). This adjustment increases the base for calculation of PF and gratuity, boosting tax-exempt savings and future benefits. However, as allowances are reduced, the portion of the salary subject to tax rises. For instance, if HRA and LTA are reduced or reclassified, the overall taxable income grows, possibly pushing the employee into a higher tax slab.
While the employees’ retirement savings are enhanced, their monthly net salary could decrease due to higher PF and gratuity deductions. The net effect on annual tax liability will depend on an individual’s total income, eligible exemptions, other deductions, and specific tax slab.
Conclusion
The changes brought about by the four new labour codes introduce a nuanced set of outcomes for employees. On the positive side, they foster greater savings, boost social security benefits, and streamline salary structures for clarity and compliance. Conversely, they can reduce immediate disposable income, increase overall taxable salary, and limit options for tax-efficient pay structuring.
Employees are encouraged to closely review their revised salary breakdowns, understand the implications for both short-term budgeting and long-term savings, and consult tax professionals to make the most informed decisions possible. A proactive approach to tax planning — considering both statutory deductions and available exemptions — will ensure that the transition to the new salary structure is as beneficial as possible, given the evolving regulatory landscape.
Employers are equally required to consider the impact of these new codes from their cash flow as well as compliance perspective, especially because “wages” now will comprise at least 50% of the total remuneration paid by the employer to the employees. This may necessitate revising salary structures, which can adversely impact cash flows of concerned employees. Once the outcome and impact of these changes are determined, employers will have to conduct special sessions to educate employees regarding changes and consequential impact.
For further information, please contact:
S.R. Patnaik, Partner, Cyril Amarchand Mangaldas
sr.patnaik@cyrilshroff.com
