The Payment of Bonus Act, 1965, stands as a cornerstone of Indian labour legislation, designed to regulate the payment of bonus to employees in certain establishments based on the profits of the employer or on their productivity. Far from being a mere gratuitous payment, bonus under this Act is considered a statutory right, representing an equitable sharing of the prosperity of an establishment. The genesis of this legislation lies in the need to ensure industrial peace and harmony by providing a structured framework for employers to distribute a share of their profits, thereby motivating employees and acknowledging their contribution to the enterprise’s success. This Act transcends traditional wage structures, aiming to bridge the gap between capital and labour by establishing a principle of deferred wage linked to the employer’s economic performance.

At the heart of the bonus computation mechanism lie the critical concepts of “available surplus” and “allocable surplus.” These terms are not merely accounting constructs; they are the legal and financial determinants of how much an employer can and must set aside for bonus payments in a given accounting year. The accurate calculation of these surpluses, along with the sophisticated mechanism of “set-on” and “set-off,” ensures that bonus payments are both sustainable for employers and predictable for employees. This intricate system balances the employer’s need for financial stability and reinvestment with the employee’s legitimate expectation of sharing in the fruits of their collective labour, thereby mitigating disputes and fostering a more cooperative industrial environment.

The Payment of Bonus Act, 1965: A Framework

The Payment of Bonus Act, 1965, mandates the payment of bonus to employees by certain establishments and specifies the method for its computation. It applies to every factory and every other establishment in which twenty or more persons are employed on any day during an accounting year. The Act defines “employee” broadly to include any person employed on salary or wage not exceeding a prescribed limit, currently Rs. 21,000 per month, for doing any work. The objective is clear: to ensure that employees who contribute to the generation of profits receive a share, thereby fostering motivation and acknowledging their efforts. The Act also provides for minimum and maximum bonus limits, ensuring that employees receive a bonus even in times of loss, and conversely, preventing excessive payouts that might destabilize the employer.

Computation of Available Surplus

The concept of “available surplus” is the foundational step in determining the total pool from which bonus can potentially be paid. It represents the net financial capacity of an establishment to pay a bonus after accounting for essential deductions and prior charges. The computation of available surplus is meticulously laid out in Section 4 read with Section 6 and the Schedules of the Payment of Bonus Act, 1965.

Calculation of Gross Profits

The starting point for determining available surplus is the computation of “gross profits.” The Act provides two separate schedules for this purpose: Schedule I for non-banking companies and Schedule II for banking companies. The underlying principle is to adjust the net profit (or loss) as shown in the profit and loss account, adding back certain items and deducting others, to arrive at a standardized figure of gross profit for bonus calculation purposes.

For non-banking companies (as per Schedule I), the following adjustments are typically made to the net profit shown in the profit and loss account:

  • Additions:

    • Depreciation: Any depreciation deducted from the gross profits in the profit and loss account must be added back. This is because depreciation for bonus computation is treated as a prior charge under Section 6 and is calculated as per the Income-tax Act, not necessarily as per company accounts.
    • Development Rebate/Investment Allowance/Investment Deposit Account Reserve: Any provision for these reserves must be added back. These are typically provisions for future investments or tax benefits, not actual expenses, and therefore enhance the profit available for bonus.
    • Bonus paid to employees: Any bonus paid to employees in respect of previous accounting years, if debited to the profit and loss account, must be added back. This prevents double counting and ensures the current year’s bonus is calculated on the actual profit before this specific distribution.
    • Donations: Any donations made by the employer must be added back. These are considered discretionary expenditures, not directly related to profit generation for bonus purposes.
    • Income tax and other direct taxes: Any provision for income tax, super tax, wealth tax, or other direct taxes payable by the employer for the accounting year must be added back. These are prior charges under Section 6 and are deducted later, notionally, after considering the bonus payment itself.
    • Losses of previous years and arrears of depreciation: If these are provided for in the profit and loss account, they must be added back. These are generally adjusted against future profits, not treated as current year’s deduction for bonus purposes.
    • Capital receipts/profits from the sale of fixed or other capital assets: These are typically non-recurring gains and are added back to ensure that the bonus calculation reflects the operating profitability.
    • Amounts carried to any reserves: Any amounts transferred to reserves (other than those specified for deduction) must be added back.
    • Expenditure on account of commission paid to directors: If not otherwise excluded, this may need to be added back as it’s an appropriation of profit.
    • Other items: Any other amounts which are not allowed as deductions for the purpose of bonus calculation under the Act.

  • Deductions:

    • Capital losses: Any capital losses incurred during the year, not provided for elsewhere, may be deducted.
    • Any profit from sale of goodwill or any assets on which depreciation is not allowed: These are typically non-operating profits and are deducted.

The result of these additions and deductions from the net profit (or loss) as per the profit and loss account yields the “gross profits” for the purpose of bonus calculation.

Deduction of Prior Charges (Section 6)

Once gross profits are computed, the next step involves deducting certain “prior charges” as specified in Section 6 of the Act. These are essential expenses or provisions that must be accounted for before determining the final “available surplus” for bonus distribution. The concept of prior charges ensures that the employer’s financial stability and continuity are protected, and that certain statutory obligations and returns on capital are met.

The prior charges include:

  1. Depreciation: This is calculated as per the provisions of Section 32 of the Income-tax Act, 1961, or as the case may be, the agricultural income-tax law. It represents the allowance for the wear and tear of assets and their gradual loss of value. The Act explicitly requires the Income-tax Act method, even if the company’s books use a different method. This ensures uniformity and prevents manipulation of bonus figures through accounting policy changes.

  2. Direct Taxes: This refers to income tax, super tax, wealth tax, and any other direct tax legally leviable by the Central Government or any State Government on the employer in respect of his income, profits, or gains during the accounting year. A crucial point here is that this deduction is for the notional tax payable on the gross profits after allowing for all other deductions (including the bonus itself, conceptually). This means a complex calculation often involving a “bonus-before-tax” and “bonus-after-tax” iteration to arrive at the correct tax figure. The Act specifies that the tax should be computed as if the bonus, which is finally determined, had been allowed as a deduction from the gross profits. This ensures that the employer gets the tax benefit for the bonus payment.

  3. Development Rebate/Investment Allowance/Investment Deposit Account Reserve: In respect of the accounting year, the sums deductible from the gross profits under the Income-tax Act or the agricultural income-tax law by way of development rebate or investment allowance or investment deposit account or any other similar deduction are considered. These are incentives for capital investment and are treated as prior claims on profits.

  4. Return on Capital (for Companies): This is a critical prior charge for companies and varies based on the type of capital:

    • Paid-up Equity Share Capital: A percentage (currently 8.5%) of the paid-up equity share capital at the commencement of the accounting year. This compensates shareholders for their investment.
    • Paid-up Preference Share Capital: A percentage (currently 7.5%) of the paid-up preference share capital at the commencement of the accounting year. This covers the fixed dividend payable to preference shareholders.
    • Reserves: A percentage (currently 6%) of its reserves (excluding any sums debited from the gross profits to the balance of profit and loss account) shown in its balance sheet at the commencement of the accounting year. This acknowledges the retained earnings that contribute to the company’s operational capacity.

  5. Return on Capital (for Other Employers): For employers other than companies (e.g., sole proprietorships, partnerships, or other establishments), different rates apply:

    • Interest on Capital Invested: 8.5% on the capital invested by the employer in the establishment or on the net worth (paid-up capital plus reserves) shown in the balance sheet.
    • Remuneration to Partners/Proprietor: An amount equal to 25% of the gross profits after deducting depreciation and prior charges, but subject to a maximum of Rs. 50,000 for each partner or proprietor. This allows for a reasonable return for their direct involvement in the business.

  6. Any Other Sums: Any other sums as may be specified by the Central Government by notification in the Official Gazette, having regard to the nature of the industry and other relevant circumstances.

The formula for Available Surplus thus becomes:

Available Surplus = Gross Profits - (Depreciation + Direct Taxes + Development Rebate/Investment Allowance + Return on Capital + Any Other Sums specified)

The available surplus represents the maximum amount that an employer can potentially utilize for bonus payments in a given year, after ensuring the solvency and basic returns required for the business.

Understanding Allocable Surplus

The “available surplus” is the total financial pool, but not all of it is distributed as bonus. The Payment of Bonus Act, 1965, introduces the concept of “allocable surplus” (Section 2(4)), which is a specific percentage of the available surplus earmarked for bonus distribution to eligible employees. This distinction is crucial as it ensures that while employees receive a share of profits, the employer also retains a portion for reinvestment, business expansion, or to build reserves for future contingencies.

The Act prescribes different percentages for allocable surplus based on the type of employer:

  • For employers other than companies (e.g., sole proprietorships, partnerships, other establishments): The allocable surplus is 67% (sixty-seven per cent) of the available surplus in that accounting year.
  • For companies: The allocable surplus is 60% (sixty per cent) of the available surplus in that accounting year.

The rationale behind this differentiation is often attributed to the distinct financial structures and obligations of companies versus other forms of business entities. Companies typically have shareholders who expect a return on their investment (dividends), and they also often need to retain a larger portion of profits for significant capital investments, research and development, and building reserves to sustain growth and face market challenges. The slightly lower percentage for companies (60% vs. 67%) allows them to retain a larger share for these strategic purposes, while still ensuring a significant portion is distributed as bonus.

The allocable surplus is the actual amount from which the bonus is paid to the eligible employees. It is this figure that is compared against the minimum and maximum bonus limits prescribed by the Act.

Minimum and Maximum Bonus Context

While not directly part of the surplus computation, the minimum and maximum bonus provisions are intrinsically linked to the allocable surplus.

  • Minimum Bonus (Section 10): Every employer is bound to pay a minimum bonus of 8.33% of the salary or wage earned by the employee during the accounting year, or Rs. 100/-, whichever is higher, even if there is no available surplus or if the allocable surplus is insufficient to cover this minimum. This provision underscores the social welfare aspect of the Act, guaranteeing a floor for bonus payments. If the allocable surplus is less than the minimum bonus payable, the deficit is covered by the “set-off” mechanism.
  • Maximum Bonus (Section 11): The maximum bonus payable is 20% of the salary or wage earned by the employee during the accounting year. If the allocable surplus is so high that it allows for a bonus exceeding 20% of the aggregate wages of eligible employees, the excess is not distributed but is carried forward under the “set-on” mechanism.

The allocable surplus, therefore, acts as the definitive pool. If it’s less than the minimum bonus obligation, the “set-off” comes into play. If it’s more than the maximum bonus obligation, the “set-on” mechanism is triggered.

Set-on and Set-off of Allocable Surplus (Section 15)

The provisions for “set-on” and “set-off” are arguably among the most ingenious features of the Payment of Bonus Act, 1965. They introduce a smoothing mechanism that ensures consistency in bonus payments over multiple years, thereby promoting industrial harmony and stability. This mechanism addresses the natural fluctuations in an employer’s profitability from year to year. Without it, employees might face wildly varying bonus payments, leading to dissatisfaction in lean years despite high performance in previous periods.

The primary objective of set-on and set-off is to stabilize bonus payments. In years of high profits, excess allocable surplus is carried forward (“set-on”) to compensate for potential shortfalls in future years. Conversely, in years of low profits or losses, past surpluses (“set-on”) or future profits (“set-off”) are utilized to ensure the payment of minimum bonus or to make up for deficits.

Set-on of Allocable Surplus

When does “set-on” occur? Set-on happens when the allocable surplus in an accounting year exceeds the maximum bonus amount (20% of the aggregate salary/wage of eligible employees) that could be paid in that year.

How does it work? If the allocable surplus is more than the amount of bonus that would be payable at the maximum rate of 20% of the aggregate salary/wage of all employees, then the excess amount, up to the limit of 20% of the total annual earnings of employees, is carried forward to the immediately succeeding accounting year. This carried forward amount is then treated as “allocable surplus” for that succeeding year.

Example: If in Year 1, the allocable surplus is ₹1,00,000, and the maximum bonus payable at 20% is ₹60,000, then ₹40,000 (₹1,00,000 - ₹60,000) will be “set-on” for the next year. This ₹40,000 will be added to the allocable surplus of Year 2.

Duration: Any amount thus set-on can be carried forward and utilized for up to four subsequent accounting years. If not utilized within this period, it lapses.

The set-on provision prevents the entire excess profit from being distributed in a single year, thus building a reserve for future bonus payments. It acts as a buffer, ensuring that employees are likely to receive a good bonus even if the company’s performance declines temporarily.

Set-off of Allocable Surplus

When does “set-off” occur? Set-off occurs under two primary scenarios:

  1. When there is no available surplus in an accounting year (i.e., a loss year or break-even).
  2. When the available surplus, and consequently the allocable surplus, is insufficient to cover the minimum bonus of 8.33% of the aggregate salary/wage of eligible employees.

How does it work? If the allocable surplus is zero or less than the minimum bonus payable (8.33% of the aggregate salary/wage), then the deficit amount is carried forward to the immediately succeeding accounting year. This deficit is then “set-off” against the allocable surplus of that succeeding year. Essentially, it reduces the allocable surplus of the future year.

Example:

  • Scenario 1 (No Available Surplus/Loss): If in Year 1, the company incurs a loss, resulting in no available surplus. However, it is still obligated to pay the minimum bonus of, say, ₹20,000. This entire ₹20,000 becomes a deficit to be “set-off” in Year 2.
  • Scenario 2 (Insufficient Allocable Surplus): If in Year 1, the allocable surplus is ₹15,000, but the minimum bonus payable is ₹20,000. The deficit is ₹5,000 (₹20,000 - ₹15,000). This ₹5,000 will be “set-off” in Year 2.

In both scenarios, the deficit amount is treated as a charge against the allocable surplus of the next year. So, in Year 2, if the allocable surplus is, say, ₹50,000, and there was a ₹20,000 set-off from Year 1, the net allocable surplus available for distribution in Year 2 will be ₹30,000 (₹50,000 - ₹20,000).

Duration: Any amount thus set-off can be carried forward and utilized for up to four subsequent accounting years. If not adjusted within this period, it lapses.

The set-off provision ensures that the employer’s obligation to pay the minimum bonus, even in lean years, is accounted for against future profitability. It prevents the employer from bearing the entire burden of minimum bonus payment from current cash flows in a loss-making year, by allowing them to recover it from future surpluses.

Rules for Set-on and Set-off

The Act specifies the order and rules for these adjustments. Schedule VI of the Act provides a tabular representation of how available surplus, amount of bonus payable, and set-on/set-off are calculated for different scenarios. The key principle is that the amount of bonus actually paid in a given year is compared with the allocable surplus.

  • If the allocable surplus (including any set-on from previous years) is greater than the maximum bonus payable (20%), the excess is set-on.
  • If the allocable surplus (including any set-on from previous years) is less than the minimum bonus payable (8.33%), the deficit is set-off.
  • If the allocable surplus falls between the minimum and maximum bonus payable, the exact amount of allocable surplus is distributed as bonus.

The set-on and set-off amounts are adjusted chronologically. An amount set-on or set-off in an earlier year will be utilized before an amount set-on or set-off in a later year. This mechanism provides a fair and predictable system for both employers and employees, preventing abrupt changes in bonus payouts and promoting long-term financial stability for the employer while ensuring the employee’s share.

The detailed computation of available surplus, involving meticulous adjustments to gross profits and the deduction of various prior charges, forms the bedrock of bonus determination. From this, a defined percentage is carved out as allocable surplus, which is the actual fund from which bonus payments are made. The brilliance of the Payment of Bonus Act, 1965, lies not just in these calculations but in the sophisticated mechanism of set-on and set-off. This intricate system allows for the carrying forward of excesses or deficits of allocable surplus over multiple years.

This carry-forward mechanism plays a pivotal role in maintaining consistency in bonus payments, irrespective of annual fluctuations in an establishment’s profitability. In years of high profits, the surplus is “set-on” and acts as a reserve, ensuring that employees can still receive a bonus in subsequent lean years, even when the current year’s profits are insufficient. Conversely, in years of losses or marginal profits, the deficit required to pay the statutory minimum bonus is “set-off” against future surpluses, preventing undue financial strain on the employer in a single year. This balanced approach protects the employer’s financial health by allowing recovery of minimum bonus payouts from future earnings, while simultaneously assuring employees of a stable, albeit varying, income supplement.

Ultimately, the comprehensive framework encompassing available surplus, allocable surplus, and the set-on/set-off provisions under the Payment of Bonus Act, 1965, serves a dual purpose. It ensures an equitable distribution of profits, reflecting the employees’ contribution to the prosperity of the enterprise. Simultaneously, it provides a structured and predictable financial obligation for employers, contributing significantly to industrial peace and reducing the scope for disputes related to bonus payments. This statutory framework fosters a sense of shared destiny between management and workforce, promoting long-term industrial harmony and stability.