PF tax-exemption limit hiked to Rs 5 lakh, which employees stand to benefit

Finance minister Nirmala Sitharaman in her budget speech had proposed to cap the tax exemption for interest accrued on Employees Provident Fund (EPF) and Voluntary Provident Fund (VPF) in the third Union Budget she presented. The Income Tax Act, 1961, presently provides for ‘total’ exemption to any payment from a provident fund and to the “accumulated balance due and becoming payable including interest” to an employee. The proposal saw the light of the day as the income tax department had observed that some rich employees were contributing ‘huge’ amounts to these funds and were getting total tax exemption using this avenue of investment.

What was the budget proposal ?

The memorandum highlighted that such exemption without any threshold limit, benefits only those employees i.e rich employees who can contribute a large amount to these funds. The limit was thus set for an annual contribution of Rs 250,000 which was to be made applicable only for the contribution made on or after April 1, 2021. Therefore, in order to rationalize tax exemption or tax free income for the income earned by high income employees, it was decided that tax exemption for the ‘interest income’ earned on the employees’ contribution to various provident funds be restricted to the annual contribution of Rs 2.5 lakh.

Amendment to budget proposal:

Many trade unions and salaried tax payers had represented to the finance ministry to reconsider the proposal of taxing interest on provident fund and the finance minister had openly agreed to have review on the matter at the time of passing the finance bill. Accordingly, the Central government raised the deposit threshold limit, for which interest would continue to be tax-exempt, to Rs 5 lakh per annum in provident fund (PF) account. This would be applicable to those cases where no contribution is made by employers to the retirement fund. FM increased the deposit threshold limit to Rs 5 lakh per annum in provident fund for which interest would continue to be tax-exempt, if there is no employer contribution. It was made clear that the threshold limit will not be enhanced in the cases where employer is contributing towards EPF.

Thus If employees’ contribution to PF on or after 1 April 2021 exceeds Rs 5 lakh in any year, interest earned on contribution over Rs 5 lakh shall be taxable. This would be applicable to those cases where no contribution is made by employers towards PF. In other cases, where employer had contributed equally the limit was set for an annual contribution of Rs 250,000 where interest would continue to remain exempt hence before.

Who will be affected with this amendment ?

1. Increase in thresh hold limit will be applicable only under certain specified conditions and will not benefit private-sector employees. This is because as per the Employees’ Provident Fund and Miscellaneous Act, 1952, it is mandatory for the employer to make matching contributions (currently 12% of basic and DA) to the EPF account along with the employees’ own contribution, i.e., 12%. Thus, individuals working in the private sector can contribute a maximum of Rs 2.50 lakh in a financial year in EPF and VPF to avail tax-exempt interest as announced in the Budget 2021 effective from April 1, 2021. Thus the employees having an annual salary of Rs 41.66 lakhs where basic pay is half of the total salary, would be liable to pay income tax on interest accrued on their provident fund balance keeping in view a proposed change likely to take place on or after 1st April 2021 in connection with wages code where basic salary will be equal to fifty percent of that of total pay.

2. In the case of government employees, there is such a fund called General Provident Fund where the government does not contribute. Rather, the government’s contribution goes to the pension fund of the employees. As there is no contribution by the employer (i.e., the government), employees of the government sector can contribute a maximum of Rs 5 lakh into PF accounts in a financial year to earn tax-exempt interest. Thus the government employees having an annual salary in excess of Rs 83.32 lakhs would be liable to pay income tax on interest accrued on their provident fund balance keeping in view a proposed change likely to take place on or after 1st April 2021 in connection with wages code where basic salary will be equal to fifty percent of that of total pay. The enhanced limit of Rs 5 lakh shall have an impact on government employees contributing towards the General Provident Fund. However, the limit for private-sector employees shall continue to be Rs 2.5 lakh as the employer needs to contribute towards Employee Provident Fund,

3. In the case of private-sector employees, the EPF scheme rules are governed by the Employees’ Provident Fund Act, 1952. As mentioned above, as per the Act, an employer is mandatorily required to make a matching contribution to the employees’ provident fund account along with employees’ own contribution. Without the employer’s contribution, an employee cannot contribute to his/her own EPF account. Thus, for private-sector employees,’ the maximum contribution they can make in a financial year to continue to earn tax-exempt interest will be Rs 2.5 lakh (EPF + VPF) in a financial year.

4. In short, In the Budget 2021, the Finance Minister had sought to tax interest earned on employee contributions in excess of Rs 2.5 lakh. While announcing the amendments to the finance bill on March 23, 2021, the finance minister has increased this threshold of Rs 2.5 lakh to Rs 5 lakh in cases where no contribution is made by the employer to the fund. The private sector employees would not be impacted by this change as the provisions of Provident Fund Act which apply to the private sector, the employer as well as the employee both contribute to the fund. This change would benefit government employees where now the threshold of Rs 5 lakh would apply.

5. The restriction is largely to impact VPF contributions as less than one per cent EPF contributors were expected to be hit due to the proposed measure.

6. The latest proposal on tax exemption was likely to make huge contributions to provident funds unattractive, especially to those contributing large amounts through VPF.

7. The move was aimed at taxing high-value depositors or salary earners in the Employees Provident Fund and hence those salaried persons drawing consolidated annual salary in excess of Rs. 41.66 lakhs would thus were to be advsersely affected.

8. If the contribution is more than the thresh hold limit then the take home salary of these assessees will be decreased to the extent of additional tax liability on interest portion which herein before was not chargeable to tax. It has been noticed that the amount of interest now will have to be credited to the account annually and despite the ‘sum’ not received in hands of the assessee but credited to accounts by way of book entry, income tax will have to be paid on that sum, which is indicative of the fact that ‘take home salary’ will get decreased.

9. The amendment underlines the fact that the provision of taxability of interest on fulfilling certain criterion continues. However, it will not be applicable if the employer is also contributing towards EPF. The position of taxability will be decided on the basis of year to year contribution based on the contribution made by employee or employer and employee jointly. The litmus test would be if the contribution to an account exceeds Rs 5 lakh, the interest accrued in that account will be liable to income tax.

10. There were discussions going on about the fact as to whether this accrual of interest will be chargeable under which head of income Would it be chargeable to tax under the head income from salary or income from other sources like any other interest. The matter has not been clarified by the CBDT so far. If the interest is treated as perquisites, then it would be income chargeable under the head Income from salary or if it is considered that there is no employer employee relationship, then it would covered under the head income from other sources.

11. If the investment pattern is to be rescheduled in the light of the fact that returns on investment are going to be decreased as ‘exempt income’ now will be becoming ‘taxable income’, then one will have to check for easily available alternatives for replacement of investment. ‘Bank deposits’ and highly rated ‘company deposits’ are similar low risk instruments, but these offer only 7% pre tax return. With employees’s PF contribution becoming taxable, PPF now will be undisputed leader for a guaranteed tax free return but the limitation is the cap of Rs. 1.50 lakh. In future, this investment also could be linked with this thresh hold limit as exemption of interest is under the same section like PF which is available under section 10(11) and (12) of the income tax act 1961. However considering existing 8.5% return on PF, PF will give 5.882% return post tax (assuming a tax rate of 30.8%) which still will be more attractive than tax free bonds that yield less than 5% return.

The Finance Bill, which gives effect to tax proposals for 2021-22, was approved by voice vote by Loksabha. The bill was passed after acceptance of 127 amendments to the proposed legislation.

Author: CA Dr Dilip V Satbhai  | B.Com (Hons), LL.M.(First rank), Ph.D.(Law) | F.C.A., D.I.S.A.(icai), D.I.R.M(icai)