This is not the first time that the government has proposed to tax Provident Fund money. The 2016 Budget had proposed that the interest accrued on 60% of the EPF be taxed. The proposal was rolled back after a massive outcry against the new levy. However, this year’s proposal may not face as big a backlash because it affects only the creamy layer of salaried employees. Finance Ministry officials estimate that less than 1% of Provident Fund subscribers will be affected. The Rs 2.5 lakh annual threshold means that a person contributing up to Rs 20,833 a month to the Provident Fund (basic salary Rs 1.73 lakh a month) will escape tax.
While it is true that very few subscribers have a basic salary of more than Rs 1.73 lakh a month which puts their 12% contribution to the Provident Fund above the Rs 2.5 lakh tax-free threshold, it is equally true that a significant number of salaried employees use the Voluntary Provident Fund to invest more than the mandatory 12% of basic pay. “The proposed tax will hit high-income salaried people who use the Voluntary Provident Fund to earn tax-free interest,” says Amit Maheshwari, Partner, Partner, AKM Global.
How much you can invest in Provident Fund without attracting tax
Mandatory PF contribution is 12% of basic pay. Anybody with basic pay of up to Rs 1.73 lakh won’t breach tax-free limit
All figures in Rs; calculation assumes 8.5% returns from PF
PF contribution may get hiked The new Wage Code adds another complexity to the issue. The new Wage Code, which comes into effect on 1 April, has laid down that the basic salary has to be at least 50% of the total income of the individual. This means salary structures will have to be rejigged with a higher basic salary, which will automatically increase the individual’s contribution to the Provident Fund.
Under the new code, basic salary must be at least 50% of total income.
If basic pay is hiked, PF contribution will go up in the same proportion
Vikas Dogra contributes only Rs 2.4 lakh to the Provident Fund right now so he won’t be affected. But after the Delhi-based finance professional joins a new company in April, some portion of his Provident Fund contribution will become taxable. “The compensation structure under the new wage code means my basic pay will be close to Rs 2.5 lakh and yearly contribution to Provident Fund will be almost Rs 3 lakh,” says Dogra. With Rs 2.5 lakh of his contribution earning 8.5% and Rs 50,000 earning 5.85% post-tax returns (in the 30% bracket), his overall returns from the PF will come down to 8.06%.
Lower returns from PF
Like Dogra, subscribers with high salaries and those who contribute more than the mandatory 12% will earn lower returns on their Provident Fund. The bigger the contribution to the Provident Fund, the lower will be the return.
How tax cuts returns
Weighted returns after interest on contribution beyond Rs 2.5 lakh is taxed.
Calculation assumes 8.5% returns for PF and 7.1% for PPF
Financial experts are not exactly surprised by the move to tax the Provident Fund interest. “It is a tax anomaly. The change was long overdue,” says Amit Kumar Gupta, Portfolio Manager for PMS at Adroit Financial. Others feel that the tax will push investors to other, more lucrative options. “High income earners should not binge on fixed income. They should reduce the VPF contribution to Rs 2.5 lakh and invest the rest in NPS. They can claim additional tax deduction of Rs 50,000 under Sec 80CCD(1b) and potentially earn higher returns,” says Sudhir Kaushik, Co-founder of tax filing portal Taxspanner.com.
The new tax is another attempt by the government to rationalise the tax exemption enjoyed by high-income employees. Last year’s Budget had capped the tax exemption on employers’ contribution to Provident Fund, NPS and superannuation fund to Rs 7.5 lakh. While that impacted only employees with very high salaries, this year’s proposal has a wider impact.
Will PPF get taxed too?
For Provident Fund aficionados, the problems don’t end here though. Some people fear that the Rs 2.5 lakh limit would include contributions to the Public Provident Fund (PPF). The Budget papers mention interest under Section 10(11), which is the section that covers PPF interest.
If PPF contribution is included in the Rs 2.5 lakh limit, the escape hatch becomes significantly smaller for Voluntary Provident Fund contributions. For investors who put Rs 1.5 lakh a year in the PPF, anything above a monthly contribution of Rs 8,333 in the Provident Fund will then earn taxable income. This will further reduce the weighted average returns from the Provident Fund investments.
There is no clarity yet on whether the limit includes PPF contributions or not. If PPF is not included in the limit, it will become the best fixed income option available to investors. Investors who invest heavily in the VPF and are worried by the proposed tax should invest up to Rs 2.5 lakh in the Provident Fund and then go for the PPF where their investments will fetch higher returns and remain tax-free. Only if they have more to invest after exhausting the Rs 1.5 lakh annual investment limit in PPF should they go for VPF.
However, if PPF is included in the Rs 2.5 lakh limit, the Voluntary Provident will be the preferred option because of the higher post-tax return of 5.85% versus 4.88% in the PPF (see table). This calculation assumes that the EPF rate will remain at 8.5%.
Only PPF offers higher returns than VPF
But the Post Office scheme has an annual investment limit of Rs 1.5 lakh.
While the pre-tax rate of VPF is higher than what PPF offers, the Post Office scheme has some other unmatchable benefits. Unlike the VPF, PPF accounts can be extended beyond retirement in blocks of five years. You can also make partial withdrawals from the corpus. In case of VPF, the account becomes inoperative and stops earning interest if not withdrawn within three years of retirement.
High-value Ulips lose edge
The Budget plans to close down another tax-free haven for HNIs. Under Section 10(10d), gains from an insurance policy are tax free if the cover is 10 times the annual premium. The Budget has proposed to remove the tax exemption to Ulips with a premium of more than Rs 2.5 lakh a year. Such Ulips will now be treated like equity mutual funds, with gains of over Rs 1 lakh taxed at 10%. It is important to note that this Rs 2.5 lakh ceiling is the aggregate premium for all policies held by a policyholder, which means one cannot get past the tax by investing in multiple policies of less than Rs 2.5 lakh.
This will not apply to existing Ulips, but only to new policies bought after the Budget was announced. While most Budget proposals usually come into effect from the next financial year (1 April), this comes into effect immediately, thus closing the window for buying Ulips before the end of the financial year.
Insurance companies are miffed by the proposal but most are keeping mum. “The increase in FDI limit for the insurance sector from 49% to 74%is a positive move. But the taxation change for Ulips would have an impact on such investments. The tax reduces the competitive advantage that Ulips enjoyed as compared to other investments,” says Tarun Chugh, Managing Director & CEO, Bajaj Allianz Life Insurance.
