Monday 26 January 2015

Income Tax Exemption on Gratuity

Gratuity may be one of the components of your CTC.  It is taxed under the head Income from Salaries. Some portion of gratuity received is exempt from tax as per Section 10(10) of the Income Tax Act and we will see how exemption is calculated.
Rules relating to Gratuity which are applicable to an Employer are set out in Payment of Gratuity Act 1972.
When is Gratuity Payable as per Payment of Gratuity Act 1972
Gratuity is payable to an employee when an employee leaves employment after completing at least five years in service with an employer – so this is payable –
  • On superannuation (means an employee who attains the age of retirement is said to be in superannuation)
  • On retirement or resignation
  • On death or disablement due to accident or disease (the time limit of 5 years shall not apply in the case of death or disablement of the employee)
Gratuity is not paid as part of your regular monthly salary; it is only payable on the occurrence of any of the above events.
Gratuity Applicability as per Payment of Gratuity Act 1972
Every person working in a factory, mine, oil field, port, railways, plantation, Shops & Establishments, or educational institution having 10 or more employees on any day in the preceding 12 months is entitled to Gratuity. It is applicable for only permanent employees and not for trainees/interns.
Once the Act becomes applicable to an employer – even if the number of employees goes below 10, gratuity is still applicable.
Income Tax Exemption on Gratuity payment to an employee as per Income Tax Act
In case of Gratuity received by a Government Employee
Any gratuity received by an employee of the Central Government, State Government or local authority, on death or retirement is fully exempt from tax.

In case of Gratuity received by an employee where Employer is covered by the Payment of Gratuity Act
The least of the following is exempt from Tax
  • 15 days salary based on the salary last drawn for every completed year of service or part thereof in excess of 6 months. Therefore the amount that shall be exempt from total Gratuity paid is calculated as
last drawn salary x number of years in employment x 15/26.
Last drawn salary is Basic salary and DA. Number of years in service is rounded off to the nearest full year. For example – if you have worked in an organization for 12 years and 2 months, the number of years in employment shall be considered to be 12 years. And in case you have worked for 12 years and 7 months, the number of years in employment shall be considered to be 13 years.
  • Rs 10,00,000
  • Gratuity actually received
Let’s understand this by way of an example – Rahul worked for a company for 18 years and 7 months. His company is covered by the Payment of Gratuity Act. At the time of his retirement, his salary was Rs 20,000. He received Rs 8,00,000 as Gratuity from his employer.
Calculation of amount which is exempt from Rs 8,00,000 – lower of the following 3
  • 20000 x 19 x 15/26 = Rs 2,19,230
  • Rs 10,00,000
  • Rs 8,00,000
The amount that is exempt from Gratuity payment for Rahul is Rs 2,19,230 and remaining amount of Rs 8,00,000 – Rs 2,19,230 = 5,80,769 is taxable for Rahul.

In case of Gratuity received by an employee where Employer is not covered by the Payment of Gratuity Act
The least of the following is exempt from Tax
  • Half month’s salary for each completed year of service. While calculating completed years, any fraction of a year shall be ignored. For example – if you have worked in an organization for 14 years and 9 months, the number of years in employment shall be considered to be 14 years. Here salary is taken as average salary of the 10 months immediately before the month in which the person retires.
  • Rs 10,00,000
  • Gratuity actually received
For example – Sunil who works for XYZ Ltd. Retires after 30 years and 9 months of service. He receives Rs 8,00,000 as gratuity. His average monthly salary of 10 months immediately preceding month of retirement is Rs 50,000.
For Sunil the minimum of these amounts shall be exempt from Tax
  • 50,000 x ½ x 30 = 7,50,000
  • 10,00,000
  • 11,00,000
Therefore for Sunil Rs 7,50,000 shall be exempt from Tax and he will pay tax on Rs 8,00,000 – 7,50,000 = Rs 50,000. Rs 50,000 shall be taxed and included under the head ‘Income from Salaries’.
Few notable points
The employer can pay a Gratuity of more than Rs 10,00,000, the exemption shall be calculated in the same manner as listed above.
If the employee’s services have been terminated due to any misconduct, the employer has the right to reject payment of Gratuity to the employee.
In case of death of the employee, the Gratuity can be paid to the nominee or the legal heir of the employee. In this case, the exemption is calculated in the same manner as above and is taxed for the receiver under the head ‘Income from Other Sources’.

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