Retirement planning ensures independence, and enables people to lead a life with an uncompromised standard of living after superannuation. India is yet to implement a robust social security system with retirement benefits, thus, the employees plan their retirement kitty during the tenure of employment. The major avenues for such planning are provident fund, gratuity and pension schemes. Such schemes provide considerable tax exemptions, and there have been instances wherein the top cadre employment is seen using them as an active tool for planning taxes. To dissuade these practices, the Union budget 2020 saw amendments to tax the employer's  contributions towards such schemes and interest thereon in excess of specified thresholds. 

Mr. Anurag Jain and Mr. Shubham Goel (Co-founders and Partner - ByTheBook Consulting LLP) discuss these amendments and the rules in the wake of practical challenges caused to employer and employee. They cover various aspects including double taxation of contribution in certain cases, ambiguity of the rules notified for interest computation and hint at possible difficulties in withholding taxes. The authors conclude with a suggestion “…it is imperative that the tax authorities bring clarifications on the working of formula under different practical scenarios/circumstances and also address the issue of potential double taxation of the same income.”

Taxability of contribution towards retiral schemes – Challenges for companies

The Union Budget 2020 had seen Finance Minister bringing amendments to tax employer contributions made towards retiral schemes (i.e. Provident Fund (PF), National Pension Scheme (NPS) and Superannuation) in excess of specified threshold limit and interest accrued thereon.

The amendment was primarily done with a view to curb the practice of companies designing the compensation structure of their top tier employees therein focusing on such retiral components to bring tax optimization.

Accordingly, the Finance Act, 2020 amended the Section 17(2)(vii) of the Income Tax Act, 1961 (‘Act’) with effect from Financial Year (‘FY’) 2020-21 and provided that any contribution made by an employer:

a) in a recognized provident fund;

b) in the scheme referred to in sub-section (1) of section 80CCD (i.e. NPS); and

c) in an approved superannuation fund

to the extent it exceeds INR 7.5 Lakhs in a financial year shall be taxable as perquisite in the hands of employee.

Further, section 17(2)(viia) was also inserted to tax annual accretion by way of interest, dividend or any other amount of similar nature accrued on such funds to the extent it relates to the employer’s contribution referred in Section 17(2)(vii) and computed in a prescribed manner.

The CBDT vide notification[1] dated March 05, 2021  prescribed Rule 3B to the Income-tax Rules, 1962 (Rules) therein providing calculation mechanism for the purpose of section 17(2)(viia).

Formula given as per Rule 3B is as below:  

TP= (PC/2)*R + (PC1+ TP1)*R

Where,

TP = Taxable perquisite under sub-clause (viia) of clause (2) of section 17 of the Act for the current previous year;

TP1 = Aggregate of taxable perquisite under sub-clause (viia) of clause (2) of section 17 of the Act for the previous year or years commencing on or after 1st day April, 2020 other than the current previous year (See Note);

PC = Amount or aggregate of amounts of principal contribution made by the employer in excess of Rs. 7.5 lakh to the specified fund or scheme during the previous year;

PC1 = Amount or aggregate of amounts of principal contribution made by the employer in excess of Rs. 7.5 lakh to the specified fund or scheme for the previous year or years commencing on or after 1st day April, 2020 other than the current previous year (See Note);

R = I/ Favg;

I = Amount or aggregate of amounts of income accrued during the current previous year in the specified fund or scheme account;

Favg = (Amount or aggregate of amounts of balance to the credit of the specified fund or scheme on the first day of the current previous Year + Amount or aggregate of amounts of balance to the credit of the specified fund or scheme on the last day of the current previous year)/2.

Explanation. — For the purposes of this rule, "specified fund or scheme" shall mean a fund or scheme referred to in sub-clause (vii) of clause (2) of section 17 of the Act.

Note: Where the amount or aggregate of amounts of TP1 and PC1 exceeds the amount or aggregate of amounts of balance to the credit of the specified fund or scheme on the first day of the current previous year, then the amount in excess of the amount or aggregate of amounts of the said balance shall be ignored for the purpose of computing the amount or aggregate of amounts of TP1 and PC1.”

Some of the key points emerging from the aforementioned calculation methodology:

• Potential disadvantage to tax payers where the employer contributions exceeding INR 7.5 lacs is made in the latter part of the FY, on account of tax perquisite being greater than the actual amount of interest earned/accrued.

• Taxability of interest on interest earned in subsequent years due to excess contributions.

As per the rules, the interest rate is based on the opening and closing balance of the specified funds. However, it may so happen that the specified funds may be using a different methodology for calculation of interest (e.g.; monthly closing balances). As a consequence, there could be a possibility of difference in actual interest earned and the interest calculated as per the rules.

• In cases of withdrawal, FIFO method is not followed for the calculation of  PC1 and TP1.

Further, the new rule is posing practical challenges for the employer and employee. Some of key ones are as follows:

1. Double taxation scenario – For the employer contribution to PF and NPS, there are individual threshold limits specified under Section 17(1)(vi) and Section 80 CCD(2) of the Act. Considering the overall limit specified under Section 17(2) (vii) of the Act, there could be a scenario of employer contribution to PF and NPS being doubly taxed as ‘Salary’ where both the individual and overall threshold limit is exceeded.

2. Apportionment of employer contribution in excess of INR 7.5 lacs – The current rule appears to be ambiguous on the apportionment mechanism where employer contribution is made towards multiple funds. For example, if the employer contribution to PF is INR 6 lacs and superannuation is INR 4 lacs, the rule does not provide clarity as to whether the excess amount of INR 2.5 lacs is out of PF or superannuation.

3. Computation of accretion in case of NPS and Superannuation: The NPS and Superannuation operate on the basis of ‘Net Asset Value’. Therefore, per se there is no accretion by way of “interest, dividend or any other amount of similar nature”. The present rule 3B does not provide clarity on how the annual accretion need to be computed for NPS and Superannuation.

4. Data sourcing from employee – While it may be easier for the employer to have access to PF (in particular companies having private PF trust) and superannuation data, the statement for NPS will need to be sourced from the relevant employee, who will typically be able to provide this information by year end only (i.e. March 31). Considering that companies tend to finalize the tax withholding calculation on salary income by Mid- March, this may pose a practical problem in the absence of requisite data.

Considering the aforementioned challenges, it is imperative that the tax authorities bring clarifications on the working of formula under different practical scenarios/circumstances and also address the issue on potential double taxation of the same income.

[1] Notification No. 11/2021/F. No. 370142/52/2020-TPL