Gratuity is the payment of the lumpsum amount to an employee of the company, by the company after a certain length of service has been completed. This is paid to the employee for the completion of a certain length of service in the company which generally is 5 years.
The company which is paying the employee with such gratuity can claim the same as expense thereby availing tax benefit while paying the taxes for the particular or the relevant year. And this is the major topic of discussion of this article.
Payment of Gratuity
Gratuity payment is governed by the Payment of Gratuity Act, 1972 in India. This will be paid in a lump sum in addition to the salary paid to the employee upon his exit from the company. It is to be noted that gratuity shall be paid after rendering of services by the employee for a period of not less than 5 years:
– on his superannuation, or
– on retirement or resignation, or
– on death or disablement due to a certain accident or disease.
So, it should be noted and understood as well that the need for the completion of continuous service of 5 years in the company shall not be necessary where such exiting of the employee or termination of employment is due to his disablement or death arising out of an accident or disease. In the case of an employee who leaves the company on completion of 5 years of rendering service, the receipt of gratuity is a statutory right and is terminal.
Gratuity which is to be paid or paid to an employee shall be determined on the basis of the monthly terminal wages paid to the employee on exit from the company after the completion of 5 continuous years of service. So, this cannot be treated as Cost-to-Company (CTC) like other benefits of insurance or such other fringe benefits paid to the employee.
Say, Mr. Kuldeep Singh is working for XYZ Ltd. with a basic pay of INR 40,000 per month and a monthly CTC of INR 70,000. The expected increase in salary on an annual basis is 10%, and based on this, the computation of gratuity payment for the next five years shall be as follows:
Formula = (15*Last Drawn Salary*Working Tenure)/30 days
On completion of;
– 1st Year = (15*[40000+10%] *1)/30 = INR 22,000
– 2nd Year = (15*[44000+10%] *2)/30 = INR 48,400
– 3rd Year = (15*[48,400+10%] *3)/30 = INR 79,860
– 4th Year = (15*[53,240+10%] *4)/30 = INR 1,17,128
– 5th Year = (15*[58,564+10%] *5)/30 = INR 1,61,051
Now, to pay Mr. Singh this gratuity amount, the company can take two ways, which are discussed below:
(i) Pay-As-You-Go Option
Under this option, the company will make a provision for gratuity in the Balance Sheet on an accrual basis. For this, the company will also take an actuarial report from an actuary on the date of the Balance Sheet. Now, when Mr Singh, referred to in the example, leaves the company, it shall pay him the gratuity he is entitled to from these resources and claim the tax benefit for such amount being paid in the form of gratuity.
Keeping in light the same example, the tax benefit computation in the case of the Pay-As-You-Go option shall be as follows:
– Provision to be made for 1st Year = Nil
– Provision to be made for 2nd Year = Nil
– Provision to be made for 3rd Year = Nil
– Provision to be made for 4th Year = Nil
– Provision to be made for 5th Year = INR 1,61,051
When Mr Singh leaves the company after the completion of the 5th year, the company shall pay him INR 1,61,051 and claim the same as an expense, which will, in turn, give the company a tax benefit.
(ii) Funding Option
Under this option, the company would decide to set up an Approved Gratuity Trust. The investment to be made by the company in this trust shall be either self-managed by the company or managed by the insurance company. The company here will make yearly or annual contributions to this trust, for which they would also claim tax benefits. In the case of Mr. Singh, who leaves the company on completion of the 5th year of continuous service, now the payment will be made from this trust or fund.
The expected tax benefit here shall be computed as per section 36(1)(v) of the Income Tax Act, and such contribution shall be made on an annual basis at the rate of 8.33% of the Annual Basic Salary of the particular employee.
In the case of Mr Singh, it shall be as follows:
– Contribution for 1st Year = INR (40,000+10%) *12*8.33% = INR 43,982
– Contribution for 2nd Year = INR (44,000+10%) *12*8.33% = INR 48,381
– Contribution for 3rd Year = INR (48,400+10%) *12*8.33% = INR 53,219
– Contribution for 4th Year = INR (53,240+10%) *12*8.33% = INR 58,541
– Contribution for 5th Year = INR (58,564+10%) *12*8.33% = INR 64,395
When added together, this will result in INR 2,68,518, but Mr Singh shall be eligible for only INR 1,61,051. However, the company can claim a tax benefit of INR 2,68,518 for the annual contribution made by them to the fund or Gratuity Trust.
So, we can conclude that a company can claim tax benefits for gratuities paid to employees for rendering longer years of service. This should not be treated as a CTC to the company like other benefits paid to the employees.
