Taxation & Withholding Tax Issues on Gratuity Payments & Provisions against Liab

People are debating all around in Nepal about the withholding tax rate while making payment of gratuity and other retirement benefits that is of non contributory in nature. The Income Tax Act has clearly prescribed the tax rate of 15% for all retirement payments from non-contributory funds. In this article, we will be highlighting the provisions of Income Tax Act to conclude that the applicable rate of tax for retirement payments of non-contributory in nature is 15% discussing in the practice gap in the industry.

The article also highlights the tax treatment of provision for Defined Benefit Plan Liability and the loss sustained by the shareholders of the company and the government due to the practice adopted by entities as “Tax Planning Tools” in lack of clarity legal provisions in revenue authority.

Contributory and Non-Contributory Fund:
In a single sentence, contributory funds are funds that mobilize the resources obtained from the contribution of each beneficiary from such income that has already been included while calculating the tax liability of such beneficiaries. The contributor and the beneficiary are same in case of Contributory Funds. 

Non contributory Funds mobilize such resources that are maintained for the payment to a separate individual than the person making the contribution in the Fund, i.e. the beneficiary and the contributor of the funds are different. 

The only difference exists in these two types of fund is that the contributory fund mobilizes such resources that have been made taxable at any point of time in the hands of employee. The non-contributory fund mobilizes such resources that are not made taxable in the hand of employee till when the actual payment is made from the fund. 

The matter of deduction/reduction in case of contribution to approved retirement fund is separate matter of facility to taxpayer as per the other provisions of the Act so as to encourage the social security contribution from taxpayer’s point of view.

Gratuity: A Defined Benefit Plan
Nepalese Labour Act, 2048 requires every enterprise having 10 or more employees to provide certain amount as gratuity at the time of retirement from the enterprise after completing certain years of service (See box for the amount of benefit).  
Rule 23 of labor Rule:The enterprises shall provide a lump sum amount as follows as gratuity to every employee who is retired from the office due to any reason (except for disciplinary actions that makes ineligible to make such payments) if the employee has served more than three years continuously for such enterprise:For employee completing three years of service and retiring before seven years of service- Amount equivalent to half months’ salary drawn at the end of service for each year of serviceFor employee completing seven years of service and retiring before 15 years of service- Amount equivalent to two-third of a month’s salary drawn at the end of service for each year of serviceFor employee completing 15 years of service and retiring after 15 years- Amount equivalent to a month’s salary drawn at the end of service for each year of service

The rule has precisely mentioned that the amount is contingent upon the salary drawn by the employee at the end of his service. Thus, the amount of benefit can be determined only at the retirement of the employee, construing that the gratuity is a defined benefit employee liability.

Charge to Income Statement

Requirement of Accounting Standard
According to IAS 19 “Employee Benefits”-Accounting for defined benefit plans is complex because actuarial assumptions are required to measure the obligation and the expense and there is a possibility of actuarial gains and losses. Moreover, the obligations are measured on a discounted basis because they may be settled many years after the employees render the related service (Para 48). The accounting by an entity for defined benefit plans involves the following steps:

Using actuarial techniques to make a reliable estimate of the amount of benefit that employees have earned in return for their service in the current and prior periods. This requires an entity to determine how much benefit is attributable to the current and prior periods and to make estimates (actuarial assumptions) about demographic variables (such as employee turnover and mortality) and financial variables (such as future increases in salaries and medical costs) that will influence the cost of the benefit;

  1. discounting that benefit using the Projected Unit Credit Method in order to determine the present value of the defined benefit obligation and the current service cost; 
  2. determining the fair value of any plan assets;
  3. determining the total amount of actuarial gains and losses and the amount of those actuarial gains and losses to be recognised; 
  4. where a plan has been introduced or changed, determining the resulting past service cost; and
  5. Where a plan has been curtailed or settled, determining the resulting gain or loss

After applying the steps mentioned above, an entity shall recognize the net total of the following amounts in profit or loss, except to the extent that another Standard requires or permits their inclusion in the cost of an asset for any accounting year:

  1. current service cost;
  2. interest cost;
  3. the expected return on any plan assets and on any reimbursement rights;
  4. actuarial gains and losses, as required in accordance with the entity’s accounting policy;
  5. past service cost;
  6. the effect of any curtailments or settlements; and
  7. the effect of the limit in paragraph 58(b), unless it is recognised outside profit or loss in accordance with paragraph 93C (See IAS 19 for further explanations)

The standard requires recognizing expenses for Defined Benefit Plans after considering the effect of expected return on any plan assets and on any reimbursement rights, i.e. the employers are required to account for the returns on plan assets and any other reimbursement rights.

Practice in Nepal
As Nepal is yet to implement the IFRS on adoption modality- the applicability of new accounting standards drafted in conformity with IFRSs and IASs is still not known and the prevailing Nepal Accounting Standard on Employee Benefits is under voluntary compliance, the employers are calculating the gratuity liability such that the amount covers such outflow of resources as if all the employees of the entity opt for retirement.

The amount, so calculated, is compared with the previous year liability balance and the additional amount is recognized as expenses for the year along with any additional payments made during the year for any retired employee.

Defined Benefit Plan Asset- Deposit of Gratuity Liability in an Approved Retirement Fund
The management of various employers has started to deposit the liability provision for Defined Benefit Plan (say, gratuity and accrued compensated absences) in an Approved Retirement Fund. Large employers, such as Banks and Financial Institutions, have Retirement Funds controlled by Management Committee (the members of the management committee are the employees of the organization that manages fund) after registering a by-law in Inland Revenue Department (IRD). The legality of operation of retirement fund and approval of such retirement fund by IRD is a separate legal question when Sec. 12 of Companies Act does not allow any entity except for a public company to operate a retirement Fund and is not discussed in this article. The liability of such retirement fund is not limited and the legal status of such retirement fund is still not clear. 

Interestingly, the practice of the employers depositing such plan liability in approved retirement fund is that they do not expect the return on the plan asset and account for such return. The additional liability is computed without considering such return (either it may be a malicious negligence or lack of knowledge) and indirectly passing on the accrued benefit on such investment to the beneficiaries of the retirement fund through a unique mechanism in most of the cases. 

One such mechanism that might have been used by employers (the modality is finalized by the management and the Board of the entities are less concerned about such modality and in most of the cases this has been happening without the knowledge of Board, or even if the Board has information- they are unknown about the financial impact of the modality developed by the management) is deposit the Defined Benefit Liability (say, gratuity) in approved retirement fund (ARF). As stated earlier, the management committee of the fund is composed of the employees of the organization. The same retirement fund also manages other defined contribution plan investment from part of each employee maintaining the individual account of the employees (termed as beneficiary in other part of this article). The ARF invests both the funds (i.e. Defined benefit Plan Liability Fund and Fund accumulated through individual contribution from beneficiaries) at its own discretion. The employers never charge interest on Defined Benefit Plan assets. As such, total return from the investment explained above is passed on to the beneficiaries either as interest at higher rate than return in proportion to the fund accumulated through their contribution or in the form of bonus.

Loss to Shareholders & Revenue Loss

As explained in paragraph 10 above, the Defined Benefit Plan asset is asset of the entity and as such, the entity shall expect return on such plan asset. It is also a matter of prudence to expect return on any investment. Every rational investor expects the return on any investment made by it so that the goal of maximization of shareholder’s wealth is achieved. Such return on Plan Asset decreases the employer’s expenses with regard to the Benefit Plan.

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