Gross up for net benefit systems

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By Gita Tanatika | 23 November 2015

Tax! When you hear the word "tax", people are often dismissive, angry, or at least irritated. Why should we pay taxes? And where does the money we pay as taxes go?

A tax is a form of compulsory contribution to be paid by individuals and companies to governments. We do not get a return directly in line with what we pay. Rather, it is used in the public interest to be enjoyed by all people. Construction of public services such as a highways, street lighting, and other facilities are made possible by the collection of taxes, as are services such as law enforcement, public safety, and courts of law. Many things are taxable, such as income, land, buildings, luxuries, and cars. Taxes may be labeled many different ways: income tax, property tax, sales tax, tariffs, fees, and tolls.

There is also a tax to be considered in the calculation of employee benefits, part of the core business in Milliman’s Employee Benefits Practice in Indonesia. In its accounts, a company must reserve for all of the costs related to employee benefits. Taxes that are due on the employee benefits form a portion of the costs. Employee benefits reported in a company’s accounts are calculated under Indonesian Financial Accounting Standard (PSAK) 24. The standard requires figures to be reported on a ‘gross’ (of tax) basis.

A company typically promises short-term benefits to employees such as salaries, a religious holiday allowance called THR in the form of a 13th month of pay each year, bonuses, annual leave, etc. There are also long-term benefits such as retirement, death, and disability benefits (as stipulated in the Labor Law No. 13/2003) plus gratuities, untaken leave benefits, etc. For the employee, these long-term benefits will be regarded as income, and therefore subject to tax.

It should be noted that the tax on benefits may be subject to its own rules. Tax on regular income (such as salaries, THR, bonuses, annual leave, long service leave, and gratuity) has a different rate to severance taxes (such as pensions, severance death, and disability severance pay). Regular income tax rates are based on Law No. 36 Year 2008 (Fourth Amendment of Law No. 7 of 1983 on Income Tax), while the severance tax rate is based on Government Regulation No. 68 Year 2009 (Income Tax Rate Article 21 of the Income Form of Severance, Retirement Benefits, and Social Security Benefits for Old Age). Both tax rates on regular income and severance benefits vary according to the amount paid, with more tax being paid by higher earners.

A company can operate a gross payroll system based on gross salary (where the taxes are borne and paid directly by employees) or a net payroll system (where the taxes are borne and paid by the company). If the company runs a gross payroll system, the employee will receive severance pay on a gross basis and pay his or her own tax at a later date. In this case, the calculations we carry out for PSAK 24 will automatically be gross.

What if the company operates a net payroll system? If so, then we need to add an amount to reflect the obligation of the company to pay tax in the calculation of liabilities in accordance with PSAK 24. How? There are several methods that can be used:

1. Applying an average tax rate across all employees after determining the benefits based on net salaries.

For severance benefits:

  • Project the severance benefits to retirement age using the net salary (assuming salary increases and discount rate are the same and that the employee will stay in the company until pension age is reached, with no allowance for resignation, death, or disability).
  • Then match the severance benefit with the applicable severance tax rate.
  • Calculate for each employee and then take an average of the severance tax rates to be used for the assumed tax loading to the total projected severance benefit.

For long service leave (sabbatical) / gratuity benefits:

  • Assume that each employee has 13 times the salary as estimated annual income.
  • Then calculate the applicable income tax rates.
  • Calculate for each employee and then take an average income tax rate to be used as the assumed tax loading.

2. Determine tax rates at the individual employee level. This can be done in two ways:

A) Gross-up the net benefit after calculating it from the net salary.

- Gross up on severance benefits:

  • Directly apply the formula to the calculation of the severance tax benefit.

- Gross up on a benefit sabbatical/gratuity:

  • Assume that each employee has 13 times the salary as estimated annual income.
  • Apply the income tax formula (assuming allowance for nontaxable income in line with the rate for single individuals) to the calculation of benefits.

B) Gross-up the net salary so that the benefits can be calculated on a gross basis.

- Gross-up net salary:

  • Assume that each employee has 13 times the salary as estimated annual income (after confirming with the company that 13 times the salary is appropriate for benefits, otherwise the gross salary could be overstated).
  • Apply the income tax formula (assuming allowance for nontaxable income in line with the rate for single individuals).

Having obtained the gross salary, we can directly calculate the gross benefits (both severance, and long service leave/gratuity).

This option is very complex to calculate in practice, as it requires knowledge of all forms of remuneration, including non-fixed allowances and details of hours worked if overtime is paid.

Of the three ways above, the third way to determine in advance the gross value of net salaries is not the recommended option because it is too complex. There are also differences between the payroll tax rate (regular income) and the severance tax rate. The first and the second ways assume that a tax loading can be applied that is more appropriate to the nature of each benefit (be it severance, vacation pay, long service leave, or gratuity).