Background
The implementation of the labour codes in November 2025 has created a material financial impact for many companies, especially in relation to gratuity and leave encashment. In several cases, actuarial valuations have resulted in a one-time charge in the books, and a substantial portion of that charge relates not to the current year’s service, but to employee service rendered over earlier years.
This has raised a practical question under Section 198 of the Companies Act, 2013: While computing net profits for CSR and/ or managerial remuneration, should such a one-time charge be excluded to the extent it pertains to past periods?
At first glance, the question seems reasonable. If the liability relates to service already rendered in earlier years, should the entire expense really be considered while computing profits of the current year?
The answer, however, may lie less in the period to which the service relates and more in the nature of the liability itself.
Nature of the Liability
The first distinction that matters is between a hypothetical provision and a crystallised business obligation. Many disallowance issues arise in relation to doubtful debts, anticipated losses, or other provisions where the existence or quantum of the liability is uncertain. Those are estimates of possible future losses.
Gratuity and leave encashment are different. These liabilities arise from a definite statutory and contractual obligation owed by the employer to its employees. The obligation is not speculative. Employees have already rendered service, and the employer has already accrued the liability. The actuarial valuation only determines the present value and timing of its discharge.
So, even though the accounting entry is described as a “provision”, the substance is not hypothetical. It represents recognition of a real employee cost.
Effect of Labour Code Changes
This becomes even more relevant in the context of the labour code implementation. The one-time impact recognised during the year is not an amount created at management’s discretion, nor is it a prudential reserve. It arises because the legal framework governing employee benefits has changed, requiring companies to reassess and recognise obligations already embedded in the employment relationship.
In other words, the expense does not arise because the company chose to create a provision. It arises because the law altered the measurement of an existing obligation.
That is why excluding the amount merely because it relates to past service may not reflect the commercial reality of the transaction.
Section 198 Perspective
Section 198 permits deduction of “usual working charges” while arriving at net profits. Employee benefit costs, including gratuity and leave encashment, are part of the normal operating expenses of a business. The section does not distinguish between current service cost and past service cost, nor does it suggest that an expense should be ignored simply because it is recognised in one year due to a statutory change.
The trigger for recognition is also important. Although the underlying service may have been rendered over earlier years, the impact crystallises in the current year because of the implementation of the new law. The charge recognised in the books is therefore not a prior-period adjustment arising from error or omission, but a current-year recognition of an enhanced statutory obligation.
If a company is required during the year to recognise an increased employee benefit obligation because of a change in law, that expense assumes the character of an actual business charge incurred in that year, even if part of the underlying service relates to earlier periods.
Practical View
Viewed in this light, excluding such expense from Section 198 computation merely because it relates to past service may create an artificial divide between accounting recognition and legal obligation. More importantly, it would treat a genuine employee welfare cost as if it were a notional or contingent provision, which does not sit well with the nature of gratuity and leave encashment liabilities.
The better view, therefore, is that the one-time impact arising from the implementation of the labour codes should be allowable while computing net profits under Section 198, even where a substantial portion of the amount relates to past service periods as the expense represents a real statutory employee cost recognised pursuant to a change in law and forms part of the ordinary working charges of the company, rather than a hypothetical or contingent adjustment.
The discussion, therefore, is not merely about recognising an employee benefit expense, but about understanding how a statutory change in one area of law can influence outcomes under another. Companies would therefore be well advised to consider these implications while assessing the impact of the new labour code regime.
Since both managerial remuneration and CSR expenditure are determined on the basis of net profits computed under Section 198 of the Companies Act, 2013, any increase in employee benefit costs arising from the implementation of the labour codes would ordinarily have a corresponding impact on these computations. As a result, the one-time impact of the labour code changes is likely to reduce both the ceiling available for managerial remuneration and the amount required to be spent towards CSR.