PROCEDURE FOR COMPUTATION OF TAX ON LUMPSUM PAYMENTS (GRATUITIES, BONUSES, ETC.)
A. NOTIFICATION
Every Employer has an obligation under section 37 of the Income Tax Act to recover appropriate tax from any lump sum amount before releasing the difference/balance to the employee. The following is a Guide to Employers on how to compute tax on lump sum payments:-
Employment Income Treatment – General
Employment income is assessable on accrual basis; that is, over the period it has been earned and become due for payment. The time the Income is received is, therefore, immaterial.
Income from employment or services rendered is chargeable to tax under section 3(2)(a)(ii) of the Income Tax Act. This is expounded by section 5(2) which spells out that gains or profits from employment includes: wages, salary, payment in lieu of leave, fees, commission, bonus, gratuity, subsistence, travelling, entertainment or any other allowance received in respect of employment or services rendered.
Where an amount is received in respect of employment or a service rendered in a year of income different from the year of accrual, such income is deemed to be income of the year of accrual. However, there is a provision which states that where the year of accrual is earlier than 4 years prior to the year of receipt, the income is to be treated as that of year of income which expired 5 years prior to the year in which the income is received or prior to the year of income in which employment ceased.
Example (Terminal Dues):
Mr. Peter Bakari left employment in September 2016 after 30 years of service and was paid severance pay/service gratuity of Kshs. 660,000; three months’ notice pay Kshs. 90,000 and Kshs. 25,000 for his 20 leave days not taken for the year 2015. For the purposes of calculation of tax payable, the service gratuity amount is to be spread backwards and taxed together with income earned in the relevant years but notice pay is assessable in the period immediately after date of leaving employment and pay in lieu of leave should be taxed in the year to which the leave days relate (i.e. 2014, 2015 e.t.c).
The procedure on how tax should be calculated is outlined below:-
Breakdown of Lump sum payment
Year: Taxable Amount: Kshs.
2016: Notice Pay: 90,000
2015: Leave pay: 25,000
2015: Service gratuity: 22,000
2014: Service gratuity: 22,000
2013: Service gratuity: 22,000
2012: Service gratuity: 22,000
2011: Service gratuity: 22,000
2010 & Prior: Service gratuity: Kshs. 550,000
Calculation of Tax on Lump Sum
i. Take total taxable pay for the year as per the Tax Deduction Card (P9A).
ii. Add Lump Sum amount for that year
iii. Calculate tax chargeable on the revised total taxable income – (i) + (ii).
Use annual individual rates of tax.
iv. Deduct personal relief for the year
v. Deduct total PAYE deducted and already paid – (per P9A)
vi. The balance is tax payable on the Lump Sum.
This method of calculating the tax should be followed for all the years involved so as to arrive at the total tax due and payable on the terminal dues.
IMPORTANT
– Pay in lieu of notice (i.e. notice pay) is assessable in the period immediately after the date of termination of employment.
– Leave pay should be assessed in year to which it relates.
– If termination of employment occurs in the course of the year, the portion of lump sum payment for that period is taxable in that particular year.
– Calculate the tax for each year using annual rates of tax and then add up tax for all the years involved to arrive at total tax to be deducted from the lump sum payment.
It should be noted that any lump sum payment relating to the year of income 2010 and prior years is assessable in 2011 being the 5th year prior to the year of receipt (2016) as per example in Table (i) above.
COMPENSATION FOR TERMINATION OF EMPLOYMENT
Liability extends to any payment, whether voluntary or obligatory made to a person to compensate him for the termination of his contract of employment or services, whether the contract is written or verbal and whether or not there is provision in the contract for such payment.
Following the amendment to proviso (i) and (iii) to section 5 (2) (c) the determination and method of assessing compensation received on termination of contract shall be as follows:-
Methods of Spreading Compensation
Method 1
Where the contract is for a specified term, amount received as compensation on termination of contract shall be deemed to have accrued evenly and assessed over the unexpired period.
Example:
A contract for five years is terminated on 31/12/2016 after it has run for 3 years.
Compensation of Kshs.1,100,000 is paid. The amount will be spread evenly and assessed in the remaining period of 2 years as follows:-
Year Taxable Amount (Kshs.)
2017 – 550,000
2018 – 550,000
Method 2
Where the contract is for an unspecified term and provides for terminal payment, the amount paid as compensation is to be spread forward and assessed at the rate equal to employee’s remuneration per annum received from the contract immediately before termination.
Example:
A contract for an unspecified term provides for payment of Kshs. 700,000 as compensation in the event of termination. It is terminated on 31/12/2016 and the employee’s rate of earning was Kshs. 300,000 per annum. The compensation is spread forward and Kshs.300,000 is assessed in the year 2017, shs.300,000 in year 2018 and balance shs.100,000 in year 2019.
Method 3
Where the contract is for unspecified term and does not provide for compensation, amount received as compensation shall be deemed to have accrued evenly over three years period immediately following termination of contract. The effect of the amendment is that any amount paid as compensation on termination of contract
shall be taxed in full.
Example:
A contract is for an unspecified term with no provision for payment of compensation. The contract is terminated on 31/12/2016 and Kshs. 1,500,000 compensation is paid, the amount is to be spread forward and assessed evenly in three years as follows:-
Year Taxable Amount (Kshs.)
2017 – 500,000
2018 – 500,000
2019 – 500,000
• The amendment is effective from 1st July 2004
NOTES:
• The methods outlined above apply to all employees including whole time service directors.
• If an Ex-gratia is paid it would be assessable in the year of receipt.
• Use the current rates of tax (i.e. 2017) until subsequent years rates are enacted.
• Personal Relief should not be granted in advance before commencement of any year of income.
Submission
B:- Employers are required to submit a list of names of all the employees who have received lump sum payments within 14 days after making payment indicating:-
i. Names of employees and their PIN numbers.
ii. Gross amount paid to each employee.
iii. Nature of payment and the period to which it relates.
iv. Amount of tax deducted and paid (attach a “Lump Sum” Photostat copy of the relevant P11 – see – C below).
v. Employee’s last date of service.
vi. Employee’s gross earnings per annum and P.A.Y.E. deducted for the period to which the lump sum payment relates (subject to a limit of 5 years in the case of gratuity).
vii. In respect of compensation for loss of office, Employer should state the employee’s rate of earning per month/per annum for the period immediately prior to termination of employment.
N.B:
Other advances of cash, e.g. salary advances to an employee, will not normally be subject to deduction of tax when made. In the month when such advances are recovered, the tax deductions will be calculated on the full pay of the month before deduction of the amount to be recovered.
Payment
C:- Payment of Tax deducted from lump sum payments
Tax deducted from the lump sum payment must be paid to the Commissioner of Domextic Taxes using Payment Registration Number (PRN) generated through iTax as the normal PAYE remittances.