Tax Benefits to Companies under Pay-As-You-Go and Gratuity Trust
Income Tax

Tax Benefits to Companies under Pay-As-You-Go and Gratuity Trust Formation Option for Payment of Gratuity

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  Posted on December 28, 2021

Tax Benefits to Companies under Pay-As-You-Go and Gratuity Trust Formation Option for Payment of Gratuity

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 and in addition to the salary which is paid to the employee on his exit from the company. And 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. And 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 next 5 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 for paying 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 as 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 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

And when Mr. Singh leaves the company after 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 tax benefit also.

(ii) Funding Option

Under this option, the company would decide to set up an Approved Gratuity Trust. And 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. And taking the case of Mr. Singh who leaves the company on completion of 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 Annual Basic Salary of the particular employee.

In 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

This when added together will result in INR 2,68,518, but Mr. Singh shall be eligible for only INR 1,61,051. But 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 gratuity paid to employees for rendering longer years of service. And this should not be treated as a CTC to the company like other benefits which are paid to the employees.


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