Superannuation trust

An employer who promises a pension has created a liability. The question is where the money to meet it will sit.

There are two possible answers. The employer pays the pensions out of its own revenue when they fall due. Or the employer sets money aside in a trust.

The workbook rules out the first. If the employer has a bad year, the pensioners may not get paid. If the employer goes bankrupt, they certainly will not. So that method is not allowed.

That leaves the trust. The employer creates a trust for funding the pension liability and appoints trustees.

Two conditions define it. The trust must be irrevocable. And it must be distinct from the employer.

The employer then transfers the contributions into the trust fund, year by year, as the liability accrues.

The two arrangements, and why the first fails. Section 4.5 allows superannuation benefits to be provided through (1) payment by the employer or (2) funding through a trust. Direct payment out of current revenue fails on three grounds the workbook states:

• payment depends on the employer's financial health in the year the pension falls due;
• the payout liability keeps increasing year after year as the number of pensioners grows;
• worse still if the employer goes bankrupt and winds up the establishment.

The workbook's conclusion is blunt: this method is not allowed.

Two rules that force funding. Accounting Standard 15 of the ICAI does not allow companies to provide for retirement benefits at the time they become due; it insists that all retirement benefits be provided for in the respective year of accrual. And Section 2(11) of the Insurance Act defines life insurance business so as to include the payment of superannuation allowances and annuities out of a fund applicable solely to the relief and maintenance of persons engaged in a particular profession, trade or employment, or their dependents. The workbook reads that as making it obligatory for employers to arrange for payment of superannuation benefits only through a life insurance company registered with IRDAI.

So what the employer must do in the meantime. Create a fund for paying the superannuation benefits and set aside the funds required for meeting the liability on an accrual basis every year.

The trust itself, under section 4.5.2. The employer creates a Trust for funding the pension liability and appoints Trustees. The Trust should be irrevocable and should be distinct from the employer. The employer transfers the contributions for the superannuation benefit - both its own and the employees', if the scheme is contributory - to the Trust Fund.

The trustees' responsibilities, under section 4.5.4. The workbook lists eight:

1. hold periodical meetings to review the performance of the Trust and keep minutes;
2. keep in touch with the company and inform the employer of decisions taken;
3. collect contributions from the employer as per the rules of the scheme, or have them calculated by an Actuary in a defined benefit scheme and then request payment;
4. invest the Trust money as per the prescribed pattern of investment given in the IT Rules;
5. realise the interest earned and re-invest it as per the prescribed pattern;
6. make or enter into an arrangement to ensure pension benefits as per the options exercised;
7. deduct tax at source from annuity payments where applicable and remit it, or advise the life insurance company to deduct it;
8. prepare the annual accounts, get them audited and submit them to the IT authorities.

Trust first, tax approval second. Creating the trust does not by itself deliver the tax benefits. For those the employer must have the fund approved by the Commissioner of Income Tax, which makes it an approved superannuation fund - and one of the Fourth Schedule conditions is that the fund be established under an irrevocable trust in the first place.

Illustrative figures.

Case A - the method the workbook disallows. Vidarbha Engineering Ltd promises its senior staff a pension and sets nothing aside. In the first year two retirees draw Rs 6,00,000 between them, paid out of that year's revenue. Ten years later there are 24 pensioners drawing Rs 78,00,000 a year. That year the company makes an operating loss.

The liability grew every year while the ability to pay did not. That is exactly the objection the workbook raises, and it is why the method is not allowed.

Case B - funding through a trust. The company instead creates the Vidarbha Engineering Superannuation Trust, irrevocable and distinct from the company, and appoints three trustees.

The company's bad year no longer touches the pensioners, because the Rs 61,00,000 and everything before it sits in a trust that is not the company's.

What the trust does not give on its own. Until the fund is approved by the Commissioner of Income Tax, the company cannot treat its Rs 52,00,000 contribution as a business expense. The trust is the vehicle; the approval is what switches on the tax treatment.

Chapter 4 (Retirement Planning Basics), section 4.5, sets out the two arrangements for providing superannuation benefits; 4.5.1 explains why payment by the employer is not allowed, citing AS 15 and Section 2(11) of the Insurance Act; 4.5.2 creates the trust and states the irrevocable and distinct requirements; and 4.5.4 lists the eight trustee responsibilities. Section 4.5.3 on approved superannuation funds is the tax layer above it. Expect a question on the two requirements of the trust, on why direct payment by the employer is not permitted, or on which body prescribes the pattern of investment - the Income Tax Rules, not IRDAI or PFRDA.

• Two arrangements are described; only one is allowed. The workbook sets out payment by the employer and then says the method is not allowed. Do not offer it as a valid option.
• Irrevocable AND distinct from the employer. Both conditions, and a question may test either.
• The trust is the vehicle; approval is the tax status. Creating a superannuation trust does not by itself give the employer a deduction. That needs approval by the Commissioner of Income Tax under the Fourth Schedule.
• AS 15 is about the YEAR of provisioning. It requires retirement benefits to be provided for in the year of accrual, not when they become due.
• Section 2(11) is of the Insurance Act, not the Income Tax Act. It is what the workbook uses to require arrangement through an IRDAI-registered life insurance company.
• The Actuary appears only in a defined benefit scheme. In other schemes the trustees collect the contribution as per the rules of the scheme.
• The pattern of investment is prescribed in the IT Rules. Trustees do not choose it, and reinvestment of interest follows the same pattern.
• Contributory means employees pay in too. The employer then transfers both sides' contributions to the Trust Fund.