Gratuity is a lumpsum amount paid by an employer to its employees at the time of their retirement, superannuation or death. It is one of the means by which an employer expresses its gratitude to its employees for rendering their services.
The Gratuity Act, inter alia, specifies:
(i) 'Employees' eligible for receiving Gratuity [Sec 2(e)].
(ii) the method for computing the gratuity amount [Sec. 4(2)].
(iii) the time when gratuity becomes payable [Sec. 4(1)].
(iv) the maximum amount which can be paid under the Act [Sec 4(3)].
The Gratuity Act further states the manner in which the gratuity liability of an organization should be provided for. Under section 4A of the Gratuity Act, the following methods have been prescribed:
(i) Obtain a Gratuity Insurance from Life Insurance Corporation of India [Sec. 4A(1)]
(ii) Establish an Approved Gratuity Fund and contribute periodically [Sec. 4A(2)]
Reference to Accounting Standards, Provisions and Rules under Income Tax Act,1961.
- Gratuity is accrued in the books based on AS-15 based on the actuary valuation. The actuarial report provides the closing value of defined benefit obligation and fair value of planned assets. It also includes the amount to be recognized in financial statements as per Accounting Standard 15.
- Provision made in the books for gratuity is disallowed under section 40A (7) of the Income Tax Act.
- Section 43B allows the payment of Gratuity either to the employee or to the gratuity fund on cash basis. Only the payment done till the due date of furnishing the return is eligible to claim deduction.
- Section 10(25)(iv) provides for exemption of income received by approved gratuity fund.
- Alteration to constitution, rules etc. not be done without the permission of CCIT (Rule 110).
- Winding up/merger with the approval of CCIT (Rule 107).
- TDS provisions to be adhered for making the Gratuity Payments.
- Annual audits to be conducted for the trust.
- No right of employer on Trust's fund in any circumstances (Rule 106).
- Rule 103 states that contribution cannot exceed 81/3 per cent of the annual employee's salary.
- Section 40(a)(iv) provides for disallowance of deductibility u/s. 36(1)(v) in case the Approved Gratuity Trust does not deduct taxes at source from payment of Gratuity to employees
- Investment of Funds (Rule 101) provides for investment of funds to-
- Post office SB/SB or CA of Scheduled Banks
- Policy with LIC or any other approved Insurance company
- Investment in terms of Rule 67(2) for funds which are not invested in the above 2 options
Formation of Approved Gratuity Trust - Noteworthy points
- Section 2(5) of the Income Tax Act, 1961 defines an approved gratuity fund as a gratuity fund which has been and continues to be approved by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner in accordance with the rules contained in Part C of the Fourth Schedule.
- Conditions for the formation
- Establish 'XXXX Ltd. Employee Gratuity Fund Trust (the Trust)' exclusively for meeting the Gratuity liability of its employees by executing a duly registered Trust Deed. The Trust should be an irrevocable trust.
- Appointment of at least two Trustees is mandatory. Trustees should be resident in India. A Company can also be appointed as a Trustee only on approval of Chief Commissioner or Commissioner. Further the directors of the company can also be made trustees of the Trust.
- All employees should me made member/ beneficiary of the Trust.
- Not less than 90% of the employees should be employed in India.
- A director may be admitted as a member/beneficiary of the Trust only if he is a Whole Time Director or Managing Director and does not hold shares in the Company carrying more than 5% of the total voting power.
- Trust Deed along with rules and regulations mentioned in the Income Tax Act, 1961 needs to be duly signed by the trustees.
- Application has to be made with jurisdictional Income Tax Office for granting approval. The form for application is specified in Rule 109 of Part C of Fourth Schedule to Income Tax Act, 1961. This application has to be made in the name of the Trust and to be signed by the trustees.
- On fulfillment of all the conditions along with executed documents would form the basis of approval/ disapproval from the Income Tax Office.
- Contribution to the Trust can be made once approval has been granted in writing.
- In case the approval has been refused, an appeal may be made to CBDT in the prescribed form and manner provided in the Act.
An approved gratuity fund has been accorded a separate legal entity under the Income Tax Act, 1961. The trust would have following characteristics-
- The trust would have own PAN card in its name.
- The trust would have a separate bank account preferably with a scheduled bank (See rule 101 of Income Tax Rules, 1962).
- The trust must maintain its own books of accounts (see rule 109(1)(c) of Income Tax Rules, 1962).
- Trust would have to get its books audited.
Since an approved gratuity fund is a private discretionary trust, it would be assessable as an Association of Persons (AOP) for Income Tax purpose - Clause (iv) of first proviso to section 164(1).
- Minimum of 2 Trustees to be appointed by the Company to administer the Trust and the Trustees should be Indian Resident.
- The Company can decide the appointment/removal of Trustees.
- The Trustees would ensure all Gratuity Investments and Pay-outs in a timely manner.
- The Trustee would make decisions regarding any amendment to the Trust.
- The Trustees would be responsible for maintaining the Trust Accounts.
- The Trustees would meet on a periodic basis to discuss key issues.
- The Trustees shall comply with and carry out all such direction as evidence by a resolution of the Directors of the Company as may be given to them by the Company from time to time in relation to any matter with respect to which the Company has power under this deed or under the Rules to determine or decide and certificates from the Company as to the admission to membership of an employee or as to the death of any member or his retirement, resignation or dismissal from the service of the Company or as to any other relevant matters shall constitute a good and sufficient an authority to the Trustees and shall be conclusive as to all facts stated therein.
Advantages of forming Gratuity Trust
- Tax benefit for the financial year in which the contribution is made. The company/ assessee must make the contribution to approved Gratuity Fund on of before the due date of furnishing the return in order to claim deduction u/s 36(1)(v) else it will be disallowed u/s 43B for the relevant financial year.
- The funds invested with LIC or other securities mentioned in rule 67(2) would fetch returns in the form of dividend, interest, appreciation in NAV etc.
- Income earned by the Trust is fully tax exempt under section 10(25)(iv).
- Post tax rate of return from investment with chosen insurance player in the range of 7%-9% depending on the fund option chosen vis-à-vis post tax return on interest of less than 4%. In that way it reduces the gratuity expense for the company.
- Minimal compliances in respect of accounting and audit matters.
- There is no need for full funding of the gratuity liability. There is no minimum contribution which needs to be made for a financial year. Corpus can be built considering cash flow position over a period of time.
- Merger of Trust with necessary approvals is possible in case of merger of legal entities.
Disadvantages of forming Gratuity Trust
- Trust is irrevocable - Company does not have the right on the funds post the contribution.
- Trust to be formed for each legal entity as one trust for all group companies (in case of more than one legal entity under the same group) is not allowed.
Formation of gratuity trust entails many benefits and can be utilized to have an appropriate cover for the mandatory gratuity liability provided in the Income Tax Act, 1961. Since there are many insurance companies who does offer formation of the trust, an exercise can be made on understanding the nitty gritty before having the same implemented.
Disclaimer: Indian Accounting Standards and Income Tax Act, 1961 has been referred while preparing this article. This article is meant for understanding purposes only and in no way be deemed to be an advice or solicit any marketing whatsoever. Any decisions based on this article would not held me liable for any action whatsoever. Please get in touch with your legal consultants to understand the scope and impact pertaining to your industry.
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