It is very difficult to wrap the concept of gratuity, pension and retirement compensation as it is. Considering you usually receive these three after you leave your employment, working around the taxation surrounding the same can become quite tedious.
Gratuity is a lump-sum amount given to an employee after he retires from his work, having been in employment for a fixed amount of time, which is five years, as provided under Section 4 of the Payment of Gratuity Act, 1972. However, this minimum time does not apply in case the employee dies or has to be terminated from service arising from disablement.
As the name implies, gratuity is a payment that is provided to an employee by the employer to denote that his service has been appreciated. Contrary to this, pension is a sum of money paid in periodic (monthly) installments to a person after having retired.
Now, in case of receipt of pension, a person has the option of receiving the sum on a monthly basis, which will be subject to tax as per the usual rates. But, the person can also choose to receive the pension on a lump-sum basis, in which case, a portion of his / her pension will be commuted.
Any Government or local authority employee who receives gratuity owing to death or retirement shall be exempt from having to pay taxes. In the case of Ram Kanwar Rana v. ITO (cited in ITA No.1307/Del/2016), it was held that a professor or teacher at a University that was set up via a statute or a college affiliated to such an university was to be treated as a Government employee and therefore the gratuity received by such professor would be exempt from taxation.
For employees working in the private sector and receiving gratuity by virtue of the Payment of Gratuity Act, 1972 (which will be subsumed by the upcoming labour laws) would be exempt from income tax upto the lowest of the following limits-
1. 15 days’ salary for every year of completed work (or part thereof, provided it is more than six months) based upon the last-drawn salary;
2. Gratuity that was actually received by the employee;
For the purpose of the calculation, one should note that the term salary in this case, only means the basic salary and the dearness allowance. That said, the lowest of the three would be exempt from taxation and the rest of the gratuity, if any, would be taxed subject to any relief laid out under Section 89 of the Income Tax Act, 1961.
If the employee is not covered under the provisions of the Payment of Gratuity Act, 1972, then the gratuity received by him / her would be exempt from taxation upto the lowest of the following three-
1. Half month’s salary for every completed year of work. (Uncompleted years, that is months, even if 11 would be ignored.);
2. Gratuity that has been received by the employee;
The least of the above is exempt from taxation, but any amount above it would be subject to taxation on a due or receipt basis, even if the gratuity is received from more than one employer. The average salary needs to be computed taking the last ten months’ salary into consideration. The term salary would include only the basic salary and the dearness allowance, if any.
For more FAQs on taxation of gratuities, read this.
Now, in the case of taxation of pensions, if the employee chooses to receive uncommuted pension on a periodic basis, then he / she would be subject to taxation.
But, if the employee chooses commuted pension and works for the Central or State Government or local authority, statutory corporation, or is a judge at the Supreme Court or the High Court, then they would be entitled to have their pensions exempted from taxation.
For employees who do not work in the aforementioned list, they would be entitled to receive a tax exemption of half their commuted pension if they have not received gratuity, but if they have received gratuity, then they are entitled to an exemption of one-third of the sum of their pension. Any pension that is above the exempted limits would be subject to taxation. However, relief can be sought under Section 89 of the Income Tax Act.
It should however be noted that in case pension is received by a person from the United Nations, then it shall not be subject to tax. Also, if the family members of the deceased from armed forces receive the pension then it may be exempt from taxation as laid under Section 10(19).
Further, computation of pension received by family members would be taken up in the head – income from other sources, as is, in the case of gratuity.
It should be carefully noted that the sum received in cases of compensation should not be mixed with either of pension or gratuity.
Compensation that is received by employees due to voluntary retirement or separation from an authority established via statute or a local authority, university or certain institutes, as mentioned in Section 10(10C), companies or co-operative societies would be exempt from taxation upto a maximum of Rs. 5,00,000.
However to take the exemption, Rule 2BA of the Income Tax Rules need to be adhered to, which provides that the scheme which provides the compensation need to provide for-
1. The employees (of all types) need to have worked at the place for at least 10 years or be 40 years of age,
2. The scheme has been created to reduce the number of employees and the vacancy is not filled up,
3. The employee should not take up work under the same management,
4. The amount to be received by the employee does not exceed more than three months’ of salary for every year of work completed or the monthly emoluments when the employee retires multiplied by the months left till the employee superannuates, whichever may be more.
To know, whether you fall within this, it is best to search for the business policy of the organization, which are usually found after the vision and mission statements (but it may vary depending upon the organization).
These interplay between gratuity, pension and retirement compensation needs to be kept in mind when calculating for taxation.