Withdrawal of tax exemption for interest accrued on Employees Provident Fund (EPF) in specified cases

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. The earnings from the Provident Fund have remained tax-free for many years. As per the old provisions, a minimum of 12% of salary had to be contributed by employer and employee towards Provident Fund. Excess contribution above 12% of the salary by the employer was taxable as perquisite..

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. The earnings from the Provident Fund have remained tax-free for many years. As per the old provisions, a minimum of 12% of salary had to be contributed by employer and employee towards Provident Fund. Excess contribution above 12% of the salary by the employer was taxable.

Wooden blocks with words 'EPF, employees provident fund'. Beautiful white background

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 consolidated 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 of employee 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.

12. Govt now notifies rules for interest on PF contribution as to  how it will be calculated . The Central Board of Direct Taxes (CBDT) recently notified Income Tax rules in which interest income accrued in the provident fund (PF) of a person above a specified limit will be taxed. The rule will be applicable to those making contributions of more than ₹2.5 lakh or Rs 5 lakh a year. According to the CBDT, the existing PF accounts will be split into two separate accounts in order to operationalise the new rule. It said that separate accounts within the PF account now shall have to be maintained.  Employees’ EPF contributions exceeding Rs 2.5 lakh/5 lakhs will now have two PF accounts. The Central Board of Direct Taxes (CBDT) has, on August 31, 2021, notified the rules regarding the taxation of the interest on the excess EPF contributions. According to the notification, for the purpose of calculation of taxable interest, separate accounts within the provident fund account shall be maintained during and from the financial year 2021-22. The two accounts will be called as:

i. Taxable Provident fund contribution account

ii. Non taxable Provident fund contribution account

Any contributions made by an individual till March 31, 2021, will be considered non-taxable contributions. Further, from FY 2021-22, interest will be separately calculated on both these EPF accounts. The CBDT notification stated that these rules will come into effect from April 1, 2022. Thus, tax on the interest earned on excess contributions in FY 2021-22 will be payable by employee and the concerned employee will need to declare it in your next year income tax return filing. The Rs 2.5 lakh threshold is meant for non-government employees. In the case of government employees, applicable threshold is Rs 5 lakh, i..e, interest will be taxable in the hands of the employee if contributions to EPF and VPF exceed Rs 5 lakh in an FY.

13) The Budget announcement in February 2021 did not provide clarity regarding how the taxable interest will be calculated and separated from the non-taxable portion. The latest CBDT notification throws light on how the taxable interest on excess contribution will be calculated. “In order to provide clarity on the computation of the taxable interest component, CBDT vide its Notification dated 31st August 2021, has provided a mechanism to facilitate the computation of taxable interest for the financial year 2021-22. The said mechanism requires maintenance of separate accounts within the provident fund account for the financial year 2021-2022 and subsequent financial years wherein taxable contribution and the non-taxable contribution made by the person shall be maintained. The mechanism clearly demarcates as to what would constitute a Non-Taxable Contribution. This would essentially incorporate balance of the provident fund as on 31st day of March 2021, non-taxable contributions made during financial year 2021-22 and subsequent years  (i.e. contributions which are less than the threshold limit of Rs 2.5 lakhs /5 lakhs) along with the interest component accrues on the above.” “While the taxable contribution would in principle only include the contribution made by the employee during financial year 2021-22 in excess of Rs 2.5 lakhs/5 lakhs (i.e. amount exceeding the taxable threshold limit) along with interest on the above. The calculation will be undertaken after factoring in the withdrawals if any.”

14) Here is what the notification states:

Calculation of taxable interest relating to contribution in a provident fund or recognised provided fund, exceeding specified limit.-

(1) For the purposes of the first and second provisos to clauses (11) and (12) of section 10 , income by way of interest accrued during the previous year which is not exempt from inclusion in the total income of a person under the said clauses (hereinafter in this rule referred to as the taxable interest), shall be computed as the interest accrued during the previous year in the taxable contribution account

(2) For the purpose of calculation of taxable interest under sub-rule (1), separate accounts within the provident fund account shall be maintained during the previous year 2021-2022 and all subsequent previous years for taxable contribution and non-taxable contribution made by a person.

(a) Non-taxable contribution account shall be the aggregate of the following, namely:-

(i) closing balance in the account as on 31st day of March 2021;

(ii) any contribution made by the person in the account during the previous year 2021-2022 and subsequent previous years, which is not included in the taxable contribution account; and

(iii) interest accrued on sub- clause (i) and sub- clause (ii), as reduced by the withdrawal, if any, from such account;

(b) Taxable contribution account shall be the aggregate of the following, namely:-

(i) contribution made by the person in a previous year in the account during the previous year 2021-2022 and subsequent previous years, which is in excess of the threshold limit; and

(ii) interest accrued on sub- clause (i), as reduced by the withdrawal, if any, from such account; and

“As per the Budget 2021, interest on provident fund contributions above Rs. 2.5 lakh shall be taxable. CBDT released a notification on 31st August 2021 for the method of calculation of taxable interest. For the purpose of calculation of taxable interest, two separate accounts will be maintained within the provident fund account for taxable and non-taxable contributions. Any contribution up to 31st March 2021 and contribution up to the specified limit from FY 21-22 will be considered a non-taxable contribution. Interest accrued on contributions made from F.Y. 2021-22 exceeding the specified limit will be taxable.”

15. The Central Board of Direct Taxes (CBDT) issued a notification on 31 August 2021, stating how the taxable interest will be calculated relating to the contribution to the Provident Fund or Recognised Provident Fund. As per the notification, this amendment in the income tax rules shall become applicable from 1 April 2022.

Manner of calculation

(a) The notification stated that for calculating taxable interest of the provident fund contribution, separate accounts shall be maintained for all the financial years starting from the current financial year 2021-22.

(b) Two different accounts, one with taxable contribution and another with non-taxable contribution, shall be maintained for all the subscribers.

Calculation of non-taxable contribution

Use below mentioned formula to arrive at the non-taxable Provident Fund contribution :

(A) – Aggregate of the following:

1. Closing balance in the account as of 31 March 2021.

2. Any contribution made by the person in the account for each financial year starting from F.Y. 2021-22 is non-taxable, i.e. below Rs.2.5 lakh or Rs.5 lakh threshold, as the case may be.

3. Interest accrued on the closing balance as of 31 March 2021, as well as interest accrued on the non-taxable contribution for each financial year starting from F.Y. 2021-22.

(B) – Reduced by withdrawal from such an account. 

Calculation of non-taxable contribution = (A) Less (B)

Calculation of taxable contribution 

Use below mentioned formula to arrive at the taxable Provident Fund contribution :

(A) – Aggregate of the following:

1. Any contribution made by the person in the account for each financial year starting from F.Y. 2021-22 is taxable, i.e. above Rs.2.5 lakh or Rs.5 lakh threshold, as the case may be.

2. Interest accrued on the taxable contribution for each financial year starting from F.Y. 2021-22.

(B) – Reduced by withdrawal from such an account.

Calculation of taxable contribution = (A) Less (B)

The threshold limit for non-taxable Provident Fund contribution for employees where the employer does not contribute is Rs.5 lakh (as amended). In all other cases, the threshold limit is Rs.2.5 lakh.

Let us understand this using an example.

Illustration – 1

Mr A has a P.F. balance of Rs. 5,50,000 (including interest) as on 31 March 2021. He works with a private company and has contributed Rs.2,50,000 (total contribution) into the P.F. account in F.Y. 2021-22. Assuming an interest of 8.5% will be received on the contribution made.

What will be his taxable as well as a non-taxable contribution for F.Y. 2021-22?

Answer: 

Let us separate the contribution into taxable as well as non-taxable

S. No. Particulars Non-taxable contribution Taxable contribution
1 Closing balance as on 31st March 2021  (Including interest accrued) 5,50,000 0
2 Contribution made in FY 2021-22 2,50,000 0
3 Interest accrued for FY 2021-22 21,250 0
4 Interest on Opening Balance 46,750 0
  Total 8,68,000 0

Illustration – 2

Mr A has a P.F. balance of Rs. 5,50,000 (including interest) as on 31 March 2021. He works with a private company and has contributed Rs.3,50,000 (total contribution) into the P.F. account in F.Y. 2021-22. Assuming an interest of 8.5% will be received on the contribution made.

What will be his taxable as well as a non-taxable contribution for F.Y. 2021-22?

Answer: 

Let us separate the contribution into taxable as well as non-taxable.

S. No. Particulars Non-taxable contribution Taxable contribution
1 Closing balance as on 31st March 2021 (Including interest accrued) 5,50,000 0
2 Contribution made in FY 2021-22 2,50,000 1,00,000
3 Interest accrued for FY 2021-22 21,250 8,500
4 Interest on Opening Balance 46,750 0
  Total 8,68,000 1,08,500

*Assuming deposit is made at the start of the financial year

Illustration – 3

Mr A has a P.F. balance of Rs. 5,50,000 (including interest) as on 31 March 2021. He works with a private company and has contributed Rs.3,50,000 (total contribution) into the P.F. account in F.Y. 2021-22. During the year he contributed a sum of Rs. 1,00,000 towards voluntary provident fund. Assuming an interest of 8.5% will be received on the contribution made.

What will be his taxable as well as a non-taxable contribution for F.Y. 2021-22?

Answer: 

Let us separate the contribution into taxable as well as non-taxable.

S. No. Particulars Non-taxable contribution Taxable contribution
1 Closing balance as on 31st March 2021  (Including interest accrued) 5,50,000 0
2 Contribution made in FY 2021-22 2,50,000 100,000
3 Voluntary PF Contribution 0 1,00,000
4 Interest accrued for FY 2021-22 21,250 17,000
5 Interest on Opening Balance 46,750 0
Total 8,68,000 2,17,000

Illustration – 4

Mr A has a P.F. balance of Rs. 5,50,000 (including interest) as on 31 March 2021. He works with a private company and has contributed Rs.3,50,000 (total contribution) into the P.F. account in F.Y. 2021-22. During the year he contributed a sum of Rs. 1,00,000 towards voluntary provident fund. He withdrew a sum of Rs. 1,00,000 from the account. Assuming an interest of 8.5% will be received on the contribution made.

What will be his taxable as well as a non-taxable contribution for F.Y. 2021-22?

Answer: 

Let us separate the contribution into taxable as well as non-taxable.

S. No. Particulars Non-taxable contribution Taxable contribution
1 Closing balance as on 31st March 2021  (Including interest accrued) 5,50,000 0
2 Contribution made in FY 2021-22 2,50,000 100,000
3 Voluntary PF Contribution 0 1,00,000
4 Voluntary withdrawal from opening accumulated balance 0 -1,00,000

Withdrawal from opening balance will be reduced from taxable balance as per rule.

4 Interest accrued for FY 2021-22 21,250 8,500
5 Interest on Opening Balance 46,750 0
  Total 8,68,000 1,08,500

Illustration – 5

Mr A the government employee, has a P.F. balance of Rs. 5,50,000 (including interest) as on 31 March 2021. He works with a private company and has contributed Rs.6,50,000 (total contribution) into the P.F. account in F.Y. 2021-22. During the year he contributed a sum of Rs. 1,00,000 towards voluntary provident fund. He withdrew a sum of Rs. 1,00,000 from the account. Assuming an interest of 8.5% will be received on the contribution made.

What will be his taxable as well as a non-taxable contribution for F.Y. 2021-22?

Answer: 

Let us separate the contribution into taxable as well as non-taxable.

S. No. Particulars Non-taxable contribution Taxable contribution
1 Closing balance as on 31st March 2021  (Including interest accrued) 5,50,000 0
2 Contribution made in FY 2021-22 6,50,000 150,000
3 Voluntary PF Contribution 0 1,00,000
4 Voluntary withdrawal from opening accumulated balance 0 -1,00,000

Withdrawal from opening balance will be reduced from taxable balance as per rule.

4 Interest accrued for FY 2021-22 42,500 12,750
5 Interest on Opening Balance 46,750 0
  Total 12,69,250 1,12,750

*****

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)

Author Bio

Qualification: CA in Practice
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Location: Pune, Maharashtra, India
Member Since: 22 Jan 2021 | Total Posts: 4
Dr. Dilip V. Satbhai is the senior partner of Messrs D. V. Satbhai & Co. Chartered Accountants having registered office located at Karve Road, Pune. The senior partner of the firm was the Chairman,Vice-chairman, Secretary and Treasurer of the Pune Branch of the Western India Regional Council of View Full Profile

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