In the Budget 2021, the Finance Minister has proposed to tax the interest accruing on the employee contribution to the provident fund account in excess of Rs 250,000.
The taxation provisions in respect of provident fund remained unchanged for several decades. However, the last couple of years has seen significant changes in the taxation on provident fund contributions and on the interest accrued thereon.
Contribution to Provident Fund
As per law, both the employer and the employee need to contribute 12% of their wages towards provident fund. Till March 2020, employer contributions up to 12% enjoyed a tax exemption. Any contributions in excess of 12% were liable to tax. However, as per Budget 2020, the aggregate employer contribution to Provident Fund, National Pension System and Superannuation Fund in excess of Rs 750,000 per annum and the interest thereon would be considered as a perquisite in the hands of the employee in the year of contribution. The employer has an obligation to consider such excess amount as perquisite in the hands of the employee and withhold taxes thereon. As is obvious, this amendment impacts high-income earning employees who meet the above criteria.
The government has notified the perquisite valuation rules for this purpose recently which provide that for taxation of the employer contributions in excess of Rs 750,000 to retiral funds and also the interest accruing thereon. There is a specific formula provided by the government to enable this calculation for the employer.
Taxation of Interest
In the Budget 2021, the Finance Minister has proposed to tax the interest accruing on the employee contribution to the provident fund account (including voluntary contributions) in excess of Rs 250,000.
This interest would be taxable under the head “Income from other Sources” at the applicable slab rates based on the method of accounting (accrual or receipt) followed by the taxpayer on a regular basis. It is expected that this interest would be subject to tax withholding though the mechanism is to be announced. The proposed changes would be applicable from the financial year 2021-22 i.e. from 1st April 2021. In the past, interest earned on the said contribution was not taxable if the contributory period is more than 5 years.
Who would be impacted
The proposed amendment by the government is aimed at rationalising the tax exemption for the higher salaried group who were earning tax-free income. Thus, the government believes that such a move would reduce income disparity. Illustratively, an employee contributing to PF at the rate of 12% on basic salary exceeding Rs 21 lakh annually would need to offer interest accrued on employee contribution in excess of Rs 250,000 to tax. As such it is expected that such a person draws a total salary of about Rs 42 – Rs 50 lakh.
The employees earning below this threshold would not be impacted unless they make voluntary contributions to provident fund. The employee contributions continue to be eligible for a deduction under section 80C up to Rs 1.5 lakh subject to not opting for simplified tax regime. Provident Fund earns an attractive rate of interest on the outstanding PF balance which is exempt subject to contributory period is 5 years or more.
Thus, while PF can still be considered as an attractive tax saving investment option considering the rate of interest, the 100% exemption enjoyed at the time of withdrawal as well as from a low risk factor, one has now to consider the tax incidence of this investment in the longer run.
(By Aarti Raote, Partner, Deloitte India, and Vinod Raj, Deputy Manager, Deloitte Haskins and Sells LLP)