Gratuity Expenses as per Labor Act
Defined Contribution Plan: Employer’s obligation is to contribute to the plan & actuarial and investment risk fall on employee. Accounted for as Service Cost and Contribution Payable.
Defined Benefit Plan: Employer’s obligation is to provide agreed benefits & actuarial and investment risk fall on employer. Accounted for as Plan Asset and Plan Liability.
Para 14 of IAS 26: Accounting and Reporting by Retirement Benefit Plans: Under a defined contribution plan, the amount of a participant’s future benefits is determined by the contributions paid by the employer, the participant, or both, and the operating efficiency and investment earnings of the fund. An employer’s obligation is usually discharged by contributions to the fund. An actuary’s advice is not normally required although such advice is sometimes used to estimate future benefits that may be achievable based on present contributions and varying levels of future contributions and investment earnings.
Labor Act 2048 (Defined Benefit Plan)
Labor Act 2048 had not defined employer’s contribution towards the Gratuity. It had only defined how Gratuity Plan should be. So, it is in the nature of Defined Benefit Plan. Rule 23 of the Labor Rules, 2050 had provided that any permanent employee who has served for 3 or more years and retires from service due to age bar or tendering resignation or is relieved from service of the enterprise due to any reason, such worker or employee shall be given lump sum gratuity at the following rate:
- An amount equivalent to 1/2 of the current monthly remuneration for every year of service rendered for the service of first 7 years,
- An amount equivalent to 2/3 of the current monthly remuneration which he was receiving lastly for every year of service rendered, to a worker or employee who has served between 7 to 15 years.
- An amount equivalent to a 1 month’s remuneration which he was receiving lastly for every year of service rendered, to a worker or employee, who has served for more than 15 years.
Labor Act 2074 (Defined Contribution Plan)
Labor Act 2074 has however defined employer’s contribution rate towards the Gratuity. So, it is in the nature of Defined Benefit Plan. Section 53 of the Labor Act 2074 provides that the employer shall deduct an amount equivalent to 8.33% of the basic remuneration of each employee each month and deposit it for the purpose of gratuity and such amount shall be deposited in the Social Security Fund in the name of the concerned employee with effect from the date on which the employee begins to work.
Recognition of Gratuity Liability under IFRS
At the outset it should be noted that IAS 37 Provisions, Contingent Assets and Contingent Liability doesn’t apply in the recognition of the liability under IAS 19 Employee Benefits. So, Gratuity Liability under Defined Benefit Plan or Defined Contribution Plan are recognized and measured under IAS 19 Employee Benefits.
This begs additional questions:
A. Are the management estimates actuarial valuations regarded as reliable measurement of the employee benefit liability?
B. Is the employee benefits liability recognized and measured under IAS 19 qualify to be recognized as liability under Income Tax Act?
Are the management estimates actuarial valuations regarded as reliable measurement of the employment benefit liability?
Para 60 of IAS 19: In some cases, estimates, averages and computational short cuts may provide a reliable approximation of the detailed computations illustrated in this Standard.
Para 59 of IAS 19: This Standard encourages, but does not require, an entity to involve a qualified actuary in the measurement of all material post-employment benefit obligations. For practical reasons, an entity may request a qualified actuary to carry out a detailed valuation of the obligation before the end of the reporting period. Nevertheless, the results of that valuation are updated for any material transactions and other material changes in circumstances (including changes in market prices and interest rates) up to the end of the reporting period.
So as per IAS not just professional actuarial valuations but even management estimates and averages are an reliable measurement of the employment related liabilities.
Does the employment benefits liability recognized and measured under IAS 19 qualify to be recognized as liability under Income Tax Act?
Let’s look at the tests for recognition of Liability under Income Tax Act:
Recognition test for Tax Accounts:
- There should be opposite entitlement and obligation as a result of “the other payment” being received
Yes, the company is not contractually / legally obliged to distribute such employment benefits. Further the company has received the opposite employment services from the employees and as a result “the other payment” has been received
- The amount of the obligation can be quantified with reasonable accuracy
Conclusion: Yes, Recognize for Tax Purpose
But why isn’t Gratuity Liability related expense allowed for deduction in Tax?
Rule 23(3) of Labor Rules 2050 provided that any worker or employee who has been terminated from service pursuant to Section 52(4) or Section 54 of the Act shall not be entitled to receive gratuity.
The provision under Section 52(4) of the Labor Act, 2048 was related to the misconduct by the employee: (i) In case of any bodily harm or injury or fetters or detains to the proprietor, manager or employee of the enterprise with or without use of arms or injury or causes any violence or destruction or assault within the enterprise in connection with the labor dispute or on any other matter; (ii) in case steals the property of enterprise; (iii) remains absent in the enterprise more than a consecutive period of 30 days without notices; (iv) is imprisoned on being convicted on a criminal offence involving moral turpitude; (v) performs any activity with a motive of causing damage to secrecy relating to special technology of the Enterprise, Production Formula. Similarly, Section 54 of the Labor Act 2048, provided that the department of labor may impose any punishment to any worker or employee who causes violence illegally in the enterprise, other enterprises or in any government office, or directly or indirectly encourages others to do so. In these circumstances, the Laborer would not be eligible to receive the Gratuity entitled under Labor Act 2048.
However, such a restriction in receiving the Gratuity is not present in the current Labor Laws of Nepal; Labor Act 2074 and Labor Rules 2075.
Thus, the fact that Labor Act 2048 had the provision to manage Gratuity under a Defined Benefit Plan was not the reason why the Gratuity Liability maintained under Labor Act 2048 was not recognized for tax purposes as and when accrued. The reason for the non-recognition of the Gratuity Liability under Labor Act 2048 was due the presence of a likelihood that the employee could be disqualified / ineligible to receive the Gratuity benefits under Rule 23(3) of the Labor Rules, 2050 which could mean that: the employee could be far from having the “opposite entitlement” to the gratuity obligation of the employer.
The provision under Rule 23(3) of the Labor Rules, 2050 limited the virtual certainty of the gratuity liability tax authorities in Nepal has been treating this limitation of virtual certainty as a disqualifier for expense recognition for tax purpose.
Coming to the present Labor Laws; Labor Act 2074, the contribution by employer is also defined, it has to be deposited in approved fund and also because the employee who receive the gratuity under the Labor Act 2074 are now not limited to not receive the Gratuity by the disciplinary or other action of the law. This certainly is allowable for deduction in tax purpose.