Explained | What are the new I-T rules on PF savings?

The story so far: The Finance Ministry on Tuesday notified new Income Tax rules to implement a fresh tax on Provident Fund (PF) savings. In her Budget 2021-22 speech, Finance Minister Nirmala Sitharaman had proposed taxing the income on PF contributions of over ₹2.5 lakh a year. This limit was later enhanced to ₹5 lakh for PF accounts where employers make no contributions. However, there was a lack of clarity on how this tax was to be levied that the new rules seek to address.

What is the government’s rationale behind the move?

Till this year’s Budget, all income on provident fund savings was exempt from tax. The provision aimed at ensuring people retire with an adequate nest egg was being misused, according to the Finance Ministry. Ms. Sitharaman, asserted in her Budget speech that ‘some people go to the extent of contributing ₹1 crore each month’ (into their PF accounts). For such people to get tax concessions as well as an assured income, is not comparable with an employee who earns ₹2 lakh and gets 8% return on their PF savings, she said. “This exemption without any threshold benefits only those who can contribute a large amount to these funds as their share,” the Budget documents explained.

After facing criticism over the proposal, the Revenue department later highlighted that more than 1.23 lakh high net worth individuals (HNIs) had deposited over ₹62,500 crore into their employees’ provident fund (EPF) accounts in 2018-19. The largest EPF account has a staggering ₹103 crore balance, they pointed out, while the top 20 HNIs have a cumulative balance of ₹825 crore. Of an estimated 4.5 crore EPF accounts, the source said about 0.27% members had an average corpus of ₹5.92 crore and so were earning over ₹50 lakh a year as ‘tax-free assured interest’.

This is the second time the NDA government has sought to tax EPF savings — in 2016, a Budget announcement to tax 60% of EPF account balances at the time of withdrawal was rolled back. In the previous year’s Budget, contribution by employers into employee welfare schemes like the EPF or the National Pension System (NPS) or a superannuation plan, was capped at ₹7.5 lakh a year.

Which PF accounts will be affected?

EPF accounts managed by the Employees’ Provident Fund Organisation (EPFO) and the General Provident Fund (GPF), where government employees save for retirement, will be impacted. There are also a few thousand large companies that manage the retirement savings of their workforce in-house through ‘exempt’ EPF trusts, in order to ensure their employees don’t have to run from pillar to post to access these savings when in need or at the time of retirement. Public Provident Fund (PPF) accounts are not affected by the new tax, nor are retirement savings accumulated under the National Pension System (NPS).

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EPF accounts are mandatory for employees earning up to Rs 15,000 a month in firms with over 20 workers, with 12% of the basic pay and dearness allowance deducted as employees’ contribution and another 12% remitted by the employer. However, government as well as private sector employees are allowed to make voluntary contributions over and above the statutory deductions into the GPF or EPF, respectively. The ₹2.5 lakh annual contribution limit shall apply for EPF members, while in GPF or other PFs where there is no contribution from the employer, the threshold has been set at ₹5 lakh.

Why were new rules needed to implement this tax?

A similar tax provision was introduced in the Budget for income from annual premium payments of over ₹2.5 lakh into unit-linked insurance products, but that clearly stated that maturity benefits will be subjected to capital gains tax.

In the case of PFs, although the intent behind the tax levy was elaborated on, there was no clarity on how it was to be operationalised. For instance, practitioners were not clear if the tax has to be imposed at the time of retirement or withdrawal from the PF account, or each year at the time of annual income accrual. If it had to be done annually, should the PF trustees deduct the tax at source on such income, or should a tax assessee include it in her or his income tax return and pay taxes, and so on. There were also concerns that this tax could be levied on future income on past PF contributions over the new tax-free limits.

The Central Board of Direct Taxes’ chairperson at the time, P.C. Mody, had told The Hindu that taxpayers should factor in the interest income earned on contributions beyond ₹2.5 lakh or ₹5 lakh as the case may be, at the time of filing their tax returns. As interest credits from EPFO are seldom effected in the same year, due to delays in declaration of the annual EPF rate and actual credits to members’ accounts, this formulation posed another implementation problem.

What do the new Income Tax rules say about levying the PF tax?

For calculation of taxable interest relating to contribution in a provident fund or recognised provident fund, exceeding the specified limit, a new Rule 9D has been added. The rule requires all PF accounts to be split into separate accounts – one with the taxable contribution and interest earned on that component, and another with the non-taxable contribution that shall include the closing balance of the PF account as on March 31, 2021 and all fresh non-taxable contributions and interest thereon.

While the government has said this will help arrive at the taxable PF income for a year, it is still not clear if the tax has to deducted from the concerned EPF account or the taxable part added to one’s total income at the time of filing returns. As things stand, the proposed solution to create two accounts seems to suggest that the EPFO and PF trusts may have to deduct tax on the income earned on the ‘taxable contribution’ of the EPF account and remit it to the exchequer each year.

Maintaining two separate accounts is an onerous requirement for EPFO and other PFs’ trustees to comply with. To put the administrative overhaul required for such accounting in perspective, consider that EPFO has 24.77 crore members with EPF accounts, of which 14.36 crore members had been allotted Unique Account Numbers (UANs) by the end of 2019-20. About 5 crore of these members were active contributors into their EPF accounts during 2019-20. Even if a technological solution is devised to rejig existing systems and provide for two EPF accounts for each member, there are other concerns. Deducting tax at source would require the EPFO or trustees of individual PFs to issue tax deduction certificates or the IT Form 26 AS for all such members. Whether the EPFO, the country’s largest retirement fund manager with around ₹15 lakh crore of assets under management, was consulted over the rules or is prepared for the transition to the proposed system, is not known at this point.

Do you need to do anything to your PF account to comply with the new rules?

As of now, as a PF account holder, there is not much for you to do except keep a close watch on developments. If your contribution as an employee is over ₹20,833.33 a month into EPF or ₹41,666.66 in the case of PF accounts with no employer contribution, you may want to reassess whether such contributions should continue, if done on a voluntary basis. With bank deposit rates low and inflation high, you could consult your accountants or investment advisers whether EPF income remains relatively attractive even after the tax deductions as per your income tax bracket.

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The responsibility for creating two accounts out of each PF account ostensibly lies with the administrators of the EPF, GPF and company-managed PF trusts. So keep an eye out on communiques from the EPFO about any formalities that may arise to bifurcate EPF accounts. If your employer manages your PF in-house through an exempt trust, look out for similar missives or updates from its trustees or your HR/Accounts Departments about the next steps they plan to take.