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Encyclopedia on Gratuity

Chintan Shah 
Updated on 01 August 2020

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  1. Gratuity – Meaning of –

Gratuity refers to the gracious payments made to the employee in appreciation of the prolonged services rendered by the employee to the employer and is normally payable at the time of termination of employment or retirement or death of employee.

  1. Gratuity funds

Gratuity fund is generally established in the form of a trust. A few employees become the trustees of such fund.

The contributions made towards the Gratuity fund generally depends on the Actuarial Valuation. However, an employer may approach a life insurer in order to purchase a group gratuity plan. The Gratuity trust can invest its funds by making a contribution under a Group Gratuity Scheme of an insurer.  Thus, the employer has to pay annual contributions to the insurance company as decided by the insurance company. The gratuity will be paid by the insurance company based upon the terms of the group gratuity scheme.

  1. Approved Gratuity Funds

Section 2(5) of the Act defines an ‘approved gratuity fund’ as ‘a gratuity fund which has been and continues to be approved by the Chief Commissioner or  Commissioner in accordance with the rules contained in Part C of the Fourth Schedule’. In order to get the approval of the chief commissioner or commissioner, an application needs to be made under Rule 109, including prescribed particulars regarding the employer, nature of business of the employer, employees eligible to participate in the fund and verified in the prescribed manner.

However, as per circular dated 3-11-1951 if the rules of a gratuity fund, duly constituted under an irrevocable trust, satisfy certain prescribed conditions (mentioned in table below), the contributions made by the employers may be allowed as a deduction in their income-tax assessments and the rules need not be forwarded for approval.

A

the benefit of the fund shall be open to only those persons who are whole-time bona fide employees of the employer, having no substantial shareholding interest;

B

the trust money shall be invested in such trusted securities as are payable both as regards capital and interest in India;

C

the gratuity shall be made payable and shall be paid only in India;

D

the trustees shall be responsible for deduction of tax from the gratuities and crediting the tax so deducted to the Government revenue;

E

the contributions shall be made on a reasonable basis acceptable to the Income-tax Department, i.e., either on actuarial basis or any other basis having regard to the length of service of each employee concerned;

F

so much of the contribution as cannot properly be treated as ordinary annual contributions shall be treated by the Commissioner of Income-tax in the same manner as is adopted by the Central Board of Revenue to deal with similar contributions to an approved superannuation fund.

Rule 4(1) of Part C of the Fourth Schedule to the Income Tax Rules specifically lays down that an application for approval of a gratuity fund shall be accompanied by two copies of the accounts of the fund for the last three years for which such accounts have been made up. This provision contemplates that an application for approval may be made 3 years after the establishment of a gratuity fund. However the board has clarified that, in order that the benefits of approval for the intervening period may not be denied to bona fide gratuity funds, the Commissioners may, after considering all the relevant facts of the case, accord approval to a gratuity fund with effect from the date from which it satisfies the conditions laid down in rule 3 of Part C of the Fourth Schedule. Hence if the fund satisfies the conditions for approval laid down in Rule 3 than such a fund can make an application for approval.

Rule 2(2) of Part C of the Fourth Schedule to the Income-tax Act, provides that the Commissioner shall communicate to the trustees of a gratuity fund the grant of approval with the date on which the approval is to take effect.

  1. Appeal against the order of chief commissioner or commissioner refusing approval

An employer, objecting to an order of the Chief Commissioner or Commissioner refusing to accord approval to a gratuity fund or an order withdrawing such approval may appeal, within sixty days of such order, to the Board in Form No. 44 verified in prescribed manner and accompanied with a fee of one hundred rupees.

  1. Contributions to the Fund

  1. Initial Contributions

When a new fund has been formed and approved, the employer may make contribution to such fund in respect of the services rendered in the past years by the existing employees. Such contribution however shall not exceed 81/3 per cent of the employees’ salary for each year of his past service with the employer.

  1. Annual contributions

The ordinary annual contribution by the employer to a fund shall be made on a reasonable basis as may be approved by the Chief Commissioner or Commissioner having regard to the length of service of each employee concerned so, however, that such contribution shall not exceed 81/3 per cent of the salary of each employee during each year.

6. Contributions by employer, when deemed to be income of employer.

Where any contributions by an employer (including the interest thereon, if any) are repaid to the employer, the amount so repaid shall be deemed for the purposes of income-tax to be the income of the employer of the previous year in which they are so repaid.

7.Winding up or amalgamation of the fund

Winding up or amalgamation of the fund with another fund shall require the prior approval of the Chief Commissioner or commissioner.

8.Winding up of business of employer

At the time of winding up of the business of the employer, the employer shall make satisfactory arrangements for payment of benefits to existing beneficiaries of the fund.

  1. Variation to the rules of the fund

Rule 110 of the Income tax rules lays down that any amendment to the rules of the fund requires the prior approval of the Chief commissioner or commissioner.

  1. Deduction of contribution made to approved gratuity funds

Under section 36(1)(v) of the Act, any sum paid by the assessee as an employer by way of contribution towards an approved gratuity fund created by him for the benefit of his employees under an irrevocable trust is allowable as a deduction in the computation of income from business/profession.

However, no allowance shall be made in respect of a payment to a provident or other fund established for the benefit of employees unless the employer has made effective arrangements to secure that tax shall be deducted at source from any payment made from the fund which are taxable under the head “Salaries”.

11. Deduction of contribution made to other than approved gratuity funds

Section 40(A)(7) places a bar on deduction of any provision made for payment of gratuity by the employer except where the same is for contribution to approved gratuity fund or if the gratuity is payable in the previous year in which such provision is made.

  1.  Income of an approved Gratuity Fund

Income of an approved gratuity fund is exempt under Section 10(25)(iv).

  1.  Taxability of gratuity in the hands of employees

Gratuity payable to an employee is taxed as part of the employee’s salary income under Section 17 (i) (iii). However, Gratuity is tax free up to half months’ (15/26 of last drawn salary for each year of service for employees covered by payment of gratuity Act) average salary of last 10 months for each completed year of service, subject to a maximum of Rs. 3, 50,000 (in both cases) under Section 10(10). 




Category Income Tax
Other Articles by - Chintan Shah 




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