4 Things to Consider While Funding a Gratuity Scheme

It calls for long-term strategic planning and research to decide whether to fund gratuity liabilities. There are sundry issues that need to be taken into account. Here’s a rundown of 4 key “generic” issues, which actuarial companies in India believe are relevant to most companies as they contemplate funding their gratuity schemes. 

1.    Tax Benefits

When an employer funds its gratuity scheme, it can get the following three benefits.

·       An amount equal to 8.33 percent of the sum total of all basic salaries paid by the company into its gratuity fund will be considered as a tax-deductible expense.

·       In case, the company is funding its gratuity liabilities for the first time, a dispensation amounting to 8.33 percent can be paid into the gratuity fund in the form of tax-deductible outlay for all the past years of an employee’s service.

·       The income earned as an interest or through an investment within the gratuity fund is exempted from any tax deduction.

According to experts from leading actuarial companies in India, a meticulously outlined gratuity funding strategy can markedly reduce the tax liability of a company. But it’s not only the tax benefits that are to be thought about while settling on whether to fund a gratuity scheme. There are other factors.

2.    Opportunity Cost

With intent to fund gratuity obligations, companies need to siphon cash from inside their business and entrust to a gratuity scheme. In this context, a critical concern lies in finding out alternate ways by which companies can utilize cash and the amount and duration of the profits which this cash would generate.

While studying and comparing such scenarios, one particular thing needs to be remembered that the interest accrued in a gratuity fund is tax-free. Hence if the company expects a return of 10 percent, the amount is equivalent to an annual pre-tax return of 14 percent, considering tax deduction at 30 percent.

Dividends can be paid out to the shareholders with the excess generated cash. But this alternative will be less financially rewarding than stashing the gratuity scheme in view of the tax benefits.

3.    Liquidity Management

In case the company stays away from funding liabilities, it’s accountable to pay gratuity to every employee as and when they leave the organization. Consequently, the amount which a company pays as gratuity will diverge by a substantial margin on a yearly basis as there’s no way to predict the number leaving employees.But, when a gratuity scheme is actuarially funded, the accumulation builds up, especially in those years when no major discernible payouts are compensated which can then be remunerated in the other years that demand sizeable payoffs.

4.    Cash flow Stability

For newly emerged companies, the payments disbursed to employees as gratuity would be, by and large, insignificant. However, as employees start aging and working longer, the gratuity payouts show a nearly exponential rise. Thus, when companies fund their liabilities, they can supplant the swiftly increasing gratuity payouts with a comparatively stable flow of payments made into the fund.