Interest on PF Contributions: Understanding tax implications

Employees now need to be aware of the circumstances under which the PF contributions as well as the interest thereon would be considered taxable.

Effective from FY 2020-21, the aggregate of exemption in respect of employer contribution to PF, Superannuation and National Pension System was limited to Rs 7.5 lakh, and the interest accrued on such taxable contribution was also made taxable.

Provident Fund (PF) contributions and the interest thereon have always been considered as one of the most tax-efficient retiral benefits, since employer contributions were tax-exempt. Besides, employee contributions were eligible for tax deductions up to Rs 1,50,000 p.a. and the interest accrued on these were also tax exempt without any restriction, subject to conditions of continuous employment of 5 years.

However, employees now need to be aware of the circumstances under which the contributions as well as the interest in this account would be considered taxable.

Effective from FY 2020-21, the aggregate of exemption in respect of employer contribution to PF, Superannuation and National Pension System was limited to Rs 7.5 lakh, and the interest accrued on such taxable contribution was also made taxable. The objective behind this was to limit the exemption available under these schemes, and to ensure that individuals contributing significantly to these schemes were not unduly benefitted, and had to pay taxes beyond a certain limit. If we look at it from a PF perspective, this would impact only employees with an annual basic salary over Rs 62.50 lakh. In practice, however, as employees are contributing to PF, NPS and superannuation, hence the impact exists even at salary levels lower than this.

Effective FY 2021-22, the government also introduced provisions impacting interest earned on employee contributions as well. With the changes introduced vide the Finance Act 2021, interest on employees’ contribution to PF is taxable where the annual contributions made from FY 2021-22 is in excess of Rs 2.5 lakh. Where there is no employer contribution (as applicable to government employees), the enhanced limit of Rs 5,00,000 per annum would apply. From a non-government salaried employee perspective, this would impact those contributing to PF on annual basic salary exceeding Rs 20.83 lakh.

With both the above provisions in place, high income earning employees with significant contributions to PF will need to assess the tax impact of the above provisions.

During August 2021, the Central Board of Direct Taxes (CBDT) notified Rule 9D prescribing the method of calculation of taxable interest in respect of employee contributions exceeding the above specified limits.

The notification requires maintenance of separate accounts within the Provident Fund for non-taxable contributions and taxable contributions from FY 21-22 onwards. The interest on the closing balance of the account as on 31 March 2021 would not attract tax, and the contributions made during the FY and subsequent FYs up to the specified limits (as reduced by any withdrawals) would also not attract taxes. The taxable corpus would be limited to the employee contributions made in excess of the specified limits and the interest accrued on the same during the year of contributions and subsequent financial years as reduced by withdrawals, if any.

While the CBDT notification calls out the requirement for maintenance of separate accounts, we need to wait and watch to see how the PF authorities implement the same. It is also important to see whether the PF authorities would be instructed to withhold tax on a year-on-year basis on such taxable interest.

Other open questions are whether the interest is taxable only in the year of final withdrawal or whether it needs to be offered to tax on yearly basis as and when it accrues. If it is to be taxed on a yearly basis, then one will have to track the interest offered to tax so that the same is not doubly taxed at the point of withdrawal.

Challenges also arise on account of the fact that the interest credit to the PF account happens only after the close of the tax year (in fact after the due date of filing the tax return).

Is it therefore possible to consider the interest rate as per the rate declared for the prior year and the shortfall / excess if any, on credit of interest could be adjusted in the subsequent year, or would it be mandatory to revise the tax return to reflect the correct interest?

Employees may also choose to either declare the taxable interest portion to the employer, who would then consider the same for the purposes of tax withholding or pay the taxes on the same by way of advance tax / self-assessment tax at the time of filing the return?

In case of employer-managed PF Trusts, the responsibility of maintaining separate accounts for taxable and non-taxable contributions and the requirement for tax withholding, where applicable, would fall upon the Trust.

Individuals with contribution to PF in excess of specified limits may need to revisit their investment plan in the wake of taxation of interest on excess contribution.

(By Saraswathi Kasturirangan, Partner, Deloitte India, and Poornima G, Senior Manager with Deloitte Haskins and Sells LLP)

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