Revisiting the world of Investment & Opportunity
Private Gratuity Trust a Vehicle worth exploring

We propose to discuss an interesting issue, known to all of us, but conveniently ignored owing to our other priorities. After seeing the impact, it will be an eye opener and will certainly merit attention of the professionals.

It is, considering setting up a private – employer managed gratuity trust.

The concept is well known to us from the tax angle. The provision for gratuity liability to the extent funded within the stipulated time to an irrevocable (Income-tax) approved Gratuity Trust, is allowable as a deduction in the tax computation for the year.

The simple tax arbitrage is the primary concern for the employer. But, the commercial aspect is not less important. It is, to create a safety nest, when the entity makes profit, for rainy days. It also inspires confidence among the sensible employees that the employer cares for them and they will be taken care of when the employer is in financial crunch. At the same time, on day-to-day basis, for gratuity, the employer is not bound by legal compliance or is answerable to the employees as would be in case of the provident fund applicability.

We do not think it necessary to go into the technical aspects of the Payment of Gratuity Act, 1972, the relevant accounting standards, the income tax provisions, etc. Here we wish to share our experience, observations, reservations/criticism of the people who opposed the same and later fell in line when saw the actual working and the benefits.

The basic features of a private gratuity trust are :

• A Simple Irrevocable (Private) Trust

• Created by the Employer

• Exclusively for payment of Gratuity

• To his Employees

• Managed by the Employer

• Approved by the Commissioner of Income Tax

It is Ideal for ….

• Corporates

• Trading Houses

• Large Co-operative societies

• Small and Medium Enterprises

• Associations

• Trusts with taxable commercial activities

Basic Objective may be to save on the current Tax.
Incidental Benefits

• Creating a hidden Strength

• Creating buffer for rainy day

• Safety nest for employees

• Comfort for the Employer

How does it work!

• Contribution to the Trust is an expense, Tax deductible

• Income on investment of corpus – Tax exempt

Commercial Pre-Requisites for Cost Benefit Criteria

• Reasonably good Profits

• Corresponding Taxability

• Reasonable cost of Borrowing

• Reasonably large Work Force — say 30 or more

Before going into further details, let us look at a Simplified Illustration that will answer our so many queries. For this we take a simple case study of a small/medium size unit engaged in manufacturing / trading/service activity

Basic Details/Assumptions :

• Five year old Unit

• 100 Employees, constant during next five years

• Average Salary (Basic + DA) — Rs. 5,000 per month in the base year

• Annual Increase/Increment to staff – 10%

• Yield on investments assumed Tax free @ 7% p. a., as per the current investment pattern under the Income-tax Act and taking long-term view of the interest rate scenario – Minimum that should be expected and achievable with minimum/reasonable risk levels.

In this exercise, the wage bill is more relevant than the number of employees.

It is a Conservative Hypothesis

The Gratuity Liability is assumed as per the Payment of Gratuity Act, @ 15 days per year and month of 26 working days — i. e., 4.808% of the relevant Annual Wage Bill.

The Actuarial Valuation is assumed to be @ 80% of Actual Gratuity Liability

The management expenses, not significant, are ignored for this exercise

The concept develops like this :

First Year of the Trust (Fifth Year of the Entity)

Second Year of the Trust (Sixth Year of the Entity)

Third Year of the Trust (Seventh Year of the Entity)

Fourth Year of the Trust (Eighth Year of the Entity)

Fifth Year of the Trust (Ninth Year of the Entity)

Objectives Achieved

• Saving on Current Income-Tax

• Creating Hidden Strength

• Creating Buffer for Rainy Day

• Safety Nest for Employees

• Comfort for the Employer

The entire process of fund management, custodial function, accounting and monitoring can be simplified and made as cost effective as possible with minimum efforts in setting the system in the initial period. By being conservative in the initial years in the fund investment function, we should attempt to ensure a stable base for the future. The risk levels should be raised steadily year after year. In this process, by being conservative, we ensure safety/protection of the principal (a basic fiduciary function of a trustee) and may even enhance the yield on consistent basis in future.

In the competitive business environment, cost saving of this kind does add tremendous value in the medium term onwards. For the Employer, it does not add any further labour law compliance, as gratuity trust is governed only under the Income-tax Act and needs to comply with the provisions of the Payment of Gratuity Act (as regards payment of gratuity at stipulated rate within stipulated time and maintenance of some basic records). It is different from management of a private (exempt) provident fund trust.

When we talk of saving for a rainy day, we should be more prepared for the worst than we needed to be so in past ! In the good old days, there was

• less of
  — competition

and

• more of
  — protection,
  — certainty of business continuity

and hence, the margins were little better. Now, what we have is, a competition led business and the level of uncertainty is very high. The pattern of consumption, customer preference, fashion, etc. change very fast. Even though we may remain alert to this, the cost and risk of obsolescence is always on our head. Further, we can save on the tax, only when we have a taxable income, profitability. Conversely, when we pass through adverse business cycle, obviously the business is bad, the financial crunch increases every month – realisations are less than costs and also there may be negative mismatch of cash flows. In this situation, the worst happens, There is an exodus of staff leaving the company. If the gratuity liability is funded in past relatively good years, the continuing staff has the comfort of being taken care of and this ensures continuity of staff at least to some extent. The importance of this is realised only when we don’t have it.

Going forward, we will have the luxury of professional fund managers under the PFRDA. This may simplify the process. Still, for smaller entities, it may remain economic to have own self managed gratuity trust, subject to the legal provisions that will follow.

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