As per law, both the employer and the employee need to contribute 12% of their wages towards provident fund. Till March 2020, employer contributions up to 12% enjoyed a tax exemption

Finance Minister Nirmala Sitharaman has announced in the Union Budget 2021-22 that PF contributions over Rs 2.5 lakh in a financial year will be taxable from the next financial year.

Contribution to Provident Fund

As per law, both the employer and the employee need to contribute 12% of their wages towards provident fund. Till March 2020, employer contributions up to 12% enjoyed a tax exemption. Any contributions in excess of 12% were liable to tax. However, as per Budget 2020, the aggregate employer contribution to Provident Fund, National Pension System and Superannuation Fund in excess of Rs 750,000 per annum and the interest thereon would be considered as a perquisite in the hands of the employee in the year of contribution. The employer has an obligation to consider such excess amount as perquisite in the hands of the employee and withhold taxes thereon. As is obvious, this amendment impacts high-income earning employees who meet the above criteria.

The government has notified the perquisite valuation rules for this purpose recently which provide that for taxation of the employer contributions in excess of Rs 750,000 to retiral funds and also the interest accruing thereon. There is a specific formula provided by the government to enable this calculation for the employer.

The implication of the amendment

Aarti Raote, Partner, Deloitte India, explained: "One amendment that has impacted most highly paid employees is the taxation of interest accruals on annual employee contributions to the provident fund in excess of Rs 250,000 from April 1, 2021. The PF is considered as an old age security kitty by many and it is one the most favored investment avenue considering the assured rate of return, definitive secured benefit, lump sum withdrawal on retirement, and zero taxation on withdrawal provided the employee has been a contributing member of the fund for five years or more. This is the reason why many employees seek to contribute a higher amount voluntarily towards PF in addition to the mandatory contribution."

"This amendment would impact employees having a PF salary (i.e. Basic + DA+ Retaining allowance) in excess of Rs 20 lakhs and if we presume that this is at least 50% of the employee’s total remuneration, then his total salary would be in the range of Rs 40 lakhs or more.  Hence such employees would need to face the tax cut on interest earnings going forward. Thus while the PF scheme is still attractive for the lower-income group, it does take off the sheen for the higher income group," she stated.

Worth mentioning here is that in the previous Budget, the FM had capped the tax exemption on employers contribution to PF, NPS and superannuation fund exceeding an aggregate of Rs 7.5 lacs per annum. This had an impact only on employees earning seven-digit salary. But the recent proposal will have a wider impact. Mainly those who use the Voluntary Provident Fund to earn tax-free interest will no more be able to enjoy the benefit.