Employers Provident Fund

Finance Minister has proposed a tax of more than Rs 250,000 on interest on employee contributions to the Provident Fund account; In Budget 2021. Taxation provisions in relation to provident funds remained unchanged for several decades. However; in the last few years there have been significant changes in the tax on provident fund contributions and the interest earned on it.

Contribution to provident fund

By law, both the employer and the employee must contribute 12% of their salary to the provident fund. As of March 2020, employers enjoyed tax rebates of up to 12%. Any contribution in excess of 12% was liable to tax. However, as per Budget 2020, the contribution of employer employee in the Provident Fund; National Pension System and Superannuation Fund in excess of Rs 750,000 per year and interest in the year of contribution will be considered as perquisite in the hands of the employee. It is the responsibility of the employer to consider such additional amount in the hands of the employee and to withdraw the taxes. As is clear, this amendment affects high-income employees who meet the above criteria.

The government has recently notified perquisite assessment rules for this purpose; which provide that the retirement amount of more than Rs 750,000 is included for the taxation of the employer and also includes the accrued interest. There is a specific formula provided by the government to enable this calculation by the employer.

Taxation of interest

Finance Minister has proposed to tax the Provident Fund account (including voluntary contributions); on employee contributions to the amount of more than Rs 250,000.

This interest will be taxable under the head “Income from other sources” in the applicable slab rates based on the method of accounting (contingent or receivable) regularly followed by the taxpayer. It is expected that this will be subject to interest tax withholding, although the mechanism is to be announced. The proposed changes will come into effect from the financial year 2021-22 ie from 1st April 2021. Earlier, the interest earned on the said contribution was not taxable if the contributory period was more than 5 years.

Who will be affected

The amendment proposed by the government is intended to rationalize the tax exemption; for high salaried groups who were earning tax-free income. Thus, the government believes that such a step will reduce income inequality. For example; an employee contributing more than Rs 21 lakh to a PF at the rate of 12%; on basic salary would be required to offer interest earned on employee contribution to tax in excess of Rs 250,000. As such it is expected that the total salary of such a person is around 42 – 50 lakhs.

As long as they do not make voluntary contributions to the provident fund, this limit will not affect low-income employees. Employee contributions are eligible for deduction of up to Rs 1.5 lakh; under Section 80C subject to not opting for simplified tax regime. The provident fund earns an attractive interest rate on outstanding PF balances that are exempt 5 years or more, subject to the contributory period.

Thus, while PFs can still be considered an attractive tax-saving investment option given the rate of interest; 100% exemption has been enjoyed at the time of withdrawal as well as a lower risk factor, now taxing it. Have to consider investing in the long run.