Overview on Employee Provident Fund & Gratuity Trust Taxation

Tax Benefits on Formation of Employee Provident Fund & Gratuity Trust

Tax Exemption on Income of the Gratuity Trust: Income received from the gratuity trust is exempt under Section 10(25)(iv) of the Income Tax Act, 1961. A tax-free return of 10% p.a. is equivalent to a pre-tax return of 13-14% p.a., making it a highly efficient investment for the company

Investment & Return Optimization:

• Gratuity Trust Investments: The gratuity trust can invest in approved financial instruments, and the returns earned are tax-free. Companies can compare the returns from the trust with alternative investments to ensure the best utilization of funds.
• Employee Trust & Retention: A well-structured gratuity scheme enhances employees’ financial security, building a trustworthy relationship between the company and its workforce.
• Once the Gratuity Trust is established, the contributions received are invested in various financial instruments. These investments are typically managed by insurance companies, offering a mix of Debt Instruments (for stability and fixed returns) and Equity Products (for long-term growth potential).

Tax deduction on contributions to the Gratuity Trust:

• Annual Contributions: Employers are expected to contribute a certain amount annually to the Gratuity Trust. There is no mandatory minimum contribution required. The employer can claim a tax deduction on the amount contributed under Section 36(1)(v) of the Income Tax Act, 1961.

• Contributions made to an approved gratuity fund are deductible u/s 36(1)(v) of the Income Tax Act, 1961. This results in a tax benefit of approximately 25.17% of the amount contributed. The contribution made by the employer to a gratuity trust is treated as an allowable expense under the Income Tax Act, 1961.
• Surplus and Deficit Handling: If the trust fund exceeds the gratuity payments in a financial year, the excess remains invested in the fund. If the gratuity payout exceeds the available balance, the employer must cover the shortfall.

Applicability of Certain Income Tax Provisions on Approved Gratuity Funds

When an employer contributes to an approved gratuity fund, certain income tax provisions impact the deductibility of such contributions. Income taxpayers (employers) ensure contributions are made to an “Approved Gratuity Fund” for deduction eligibility. Employers must make payments before the ITR filing deadline to claim the deduction. Employers must Comply with TDS provisions to avoid disallowances. Employers should avoid contributing to unapproved funds, as they won’t qualify for tax benefits. Below is a summary of the key provisions:

Section 40A(7) – Disallowance of Gratuity Provisions : General Rule: Any provision for gratuity is disallowed as an expense. Exceptions: Deduction is allowed only if The contribution is made to an Approved Gratuity Fund and The gratuity has actually become payable to employees in the same financial year.

Under Section 40(a)(iv) – TDS Requirement for Employee Benefit Funds : No deduction is allowed for contributions to an employee benefit fund unless:

• The employer has made arrangements for TDS deduction on payments from the fund that are taxable under “Salaries”.
• This ensures that any gratuity payout from the fund is taxed appropriately before being given to employees.

Section 40A(9) – Restrictions on Contributions to Other Funds : Contributions to any other trust, fund, or institution are disallowed, unless:

• They fall under Section 36(1)(iv), (iva), or (v), or
• In ncase its is required by law.
• This prevents companies from arbitrarily setting up funds for tax benefits.

Under Section 43B(b) – Deduction Only on Actual Payment: Contributions to an Approved Gratuity Fund are deductible under Section 36(1)(v) only if they are paid before the due date of filing the Income Tax Return. Any unpaid contribution is disallowed and can only be claimed in the year of actual payment.

Allowable deduction for the employer’s initial contribution to the gratuity fund: As per Rule 104 of the Income Tax Rules, an employer can claim a deduction for the initial contribution made toward past service benefits of employees, limited to 8.33% of the employee’s salary per year of past service.

When shall the gratuity become payable? The gratuity becomes payable when an employee leaves the organization for any of the following reasons:

• Retirement or superannuation
• Termination or resignation
• Disablement or death due to an accident or disease
• Layoffs or retrenchments
• Voluntary Retirement Scheme

Financial Planning Advantages—Funded vs. Unfunded Approach:

• Unfunded Gratuity Plan: The company must pay gratuity as and when an employee leaves, leading to uncertainty in yearly cash outflows.
• Funded Gratuity Plan (via Trust): The company makes regular contributions to the trust, ensuring there is no sudden financial burden at the time of an employee’s retirement or resignation. This provides certainty in financial planning.
• Better Cash Flow Management: Instead of making large lump sum payouts, companies replace increasing gratuity liabilities with a stable and predictable funding strategy.

Tax Implications on Employees’ Contributions to Approved Superannuation Fund

Tax Deduction for Employee Contributions: As per Section 80C of the Income Tax Act, an employee can claim deductions up to ₹1,50,000 for contributions made to an Approved Superannuation Fund, Recognized Provident Fund, and National Pension System while computing taxable income.

Taxation of Annual Accretion to ASF, RPF & NPS

• Annual accretion to these funds is considered a taxable perquisite u/s 17(2)(viia).
• The computation of such taxable perquisites is governed by Rule 3B of the Income Tax Rules.

Tax Exemption on Payments from ASF (Section 10(13))

Payments from an approved superannuation fund are exempt from tax in the following cases:

• On Death of the Beneficiary: Entire amount is tax-free.
• In case Retirement or Incapacitation: If received as an annuity or in commutation of an annuity, it is exempt.
• Refund of Contributions on Death: Tax-free if paid to legal heirs.
• In case Refund of Contributions on Leaving Service: Tax-exempt up to contributions made before the commencement of the Income Tax Act (along with interest).
• Transfer to NPS (Section 80CCD): If the amount is transferred to an employee’s NPS account, it is fully exempt from tax.

Income Tax Exemption U/s 10(25) of the Income Tax Act, 1961

• Exemption for Income of Approved Funds: As per Section 10(25), any income received by the trustee on behalf of the following funds is fully exempt from tax i.e Recognized Provident Fund , Approved Superannuation Fund, Approved Gratuity Fund. This means that interest, dividends, and other investment income earned by these funds are not taxable in the hands of the trust or fund.
• Assessment U/s 164(1) (First Proviso, Sub-clause iv) :  These funds are not subject to the general tax provisions for trusts u/s 164(1). Instead, they are covered by sub-clause (iv) of the first proviso to Section 164(1), which ensures that their income is exempt from tax when earned within the trust.
• Contributions to these funds enjoy tax benefits for both employers and employees. Income earned within these funds is exempt from tax u/s 10(25). The funds are not subject to trust taxation under Section 164(1), ensuring tax-free status.

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