Employees’ Provident Fund: The Clarification of the Clarification of the Clarification…

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There must be some way out of here” said the joker to the thief
“There’s too much confusion”, I can’t get no relief
– Bob Dylan, All Along the Watchtower

Arun Jaitley presented his third budget on February 29, 2016. Since then, the only point from the budget that is being discussed is the income tax to be applicable on the Employees’ Provident Fund and other recognised provident funds.

In fact, the government’s communication on this left a lot to be desired. The finance minister Jaitley said during the course of the speech: “I believe that the tax treatment should be uniform for defined benefit and defined contribution pension plans. I believe that the tax treatment should be uniform for defined benefit and defined contribution pension plans. I propose to make withdrawal up to 40% of the corpus at the time of retirement tax exempt in the case of National Pension Scheme. In case of superannuation funds and recognized provident funds, including EPF, the same norm of 40% of corpus to be tax free will apply in respect of corpus created out of contributions made after 1.4.2016.”

Given that Jaitley gave a 100-minute-long speech, he could have taken a minute more and gone into the details of this change.

Barely had he finished saying this, all hell broke loose on the social media. As soon as he had finished his speech, the television channels caught on to this point. Jaitley should have ideally provided an annexure to his speech explaining the exact details of the plan. But an annexure wasn’t provided and neither did he go into the details. This created a lot of needless confusion.

What Jaitley basically said was that 40% of the accumulated corpus of the EPF and other recognised provident funds, on contributions made after April 1, 2016, would be tax free. As of now 100% of the accumulated corpus on the EPF is taxfree.

The first interpretation after Jaitley’s speech was completed was that now up to 60% of the EPF corpus will be taxable. On the social media people are quick to draw conclusions without waiting toget into details. A reading of the Finance Bill made it clear that wasn’t the case. If 60% of the corpus was used to buy annuities to generate a regular income, this amount would remain tax free as well.

The minister of state for finance Jayant Sinha clarified this on a television channel, late evening on February 29,2016. And then he made a mistake, which added to the confusion. He said income earned by buying an annuity would be tax free. Income earned from annuities is taxable.

Then he was asked if the corpus of the Public Provident Fund(PPF) would be taxed as well. He did not answer in the affirmative to this question, neither did he say no. The anchor asking the question essentially concluded that the accumulated corpus of the PPF would now be taxable.

After this, the revenue secretary Hasmuk Adhia, clarified that PPF would continue to be the way it was i.e. its corpus wouldn’t be taxable. He also made another remark which again introduced more confusion into the entire debate going on. He said a tax would be levied only on accrued interest on 60% of EPF contribution, after April 1, 2016.

This was contradictory to what Jaitley had said in his speech. He had said that 40% of the corpus will be tax free, which essentially means that 60% of the corpus will be taxed.

It is rather sad to see that the top policymakers of a ministry trying to bring in a very important change on a point that impacts so many people, were not clear about basic things. Either they hadn’t been briefed properly or they just didn’t realise how huge is the change they were trying to bring in.

After all this hungama the ministry of finance put out a clarification. The clarification started with these lines: “There seems to be some amount of lack of understanding [the emphasis is mine] about the changes made in the General Budget 2016-17 in the tax treatment for recognised Provident Fund & NPS.”

Rather ironically, the policy makers at the ministry of finance had contributed majorly to this lack of understanding. After this clarification (actually clarification of a clarification of a clarification if we were to start with Jaitley’s speech, go to Sinha’s comments and then Adhia’s clarification) this is how things stand as of now.

As the ministry of finance’s clarification points out: “The Government has announced that Forty Percent (40%) of the total corpus withdrawn at the time of retirement will be tax exempt both under recognised Provident Fund and National Pension Scheme.”

Does this mean what it means? Not really. There are certain nuances to it. For employees within the statutory wage limit of Rs 15,000 per month, things would stay as they currently are i.e. their corpus would continue to be 100% tax free.

Further, if you are a private sector employee and you want 100% of your EPF money to be tax free you need to buy annuities. As the finance ministry’s clarification points out: “It is expected that the employees of private companies will place the remaining 60% of the Corpus in Annuity, out of which they can get regular pension. When this 60% of the remaining Corpus is invested in Annuity, no tax is chargeable. So what it means is that the entire corpus will be tax free, if invested in annuity.”

What this means is that the private sector employees can make 100% of their EPF corpus accumulated on contributions made after April 1, 2016, tax free, by investing 60% of it in annuities. What about public sector employees? This is where things get interesting. The clarification is totally silent on this.

Hence, for public sector employees their provident fund continues to be 100% tax free at maturity. It means that public sector employees (or babulog) do not need to invest money in annuities at all. They can withdraw 100% of the money tax free. A private sector guy wanting to withdraw 100% money has to pay tax on 60% of the corpus he has accumulated on contributions made since April 1, 2016. Further, this is a clear attempt by the babus who drafted this change to ensure that their provident fund continues to remain 100% tax free.

Why is there this differentiation? Why is the private sector employee being treated in this unfair way? The press release further points out: “The idea behind this mechanism is to encourage people to invest in pension products rather than withdraw and use the entire Corpus after retirement.”

Doesn’t the government want public sector guys to do this? Shouldn’t babulog also be buying annuities to generate a regular income from their provident fund corpus after retirement? The government hasn’t offered an explanation for this but a possible explanation for this is that many retired government employees already get a pension from the government. Hence, their provident fund is 100% tax free.

This is bizarre. Many government employees get a fixed pension and on top of that get 100% tax free provident fund. A private sector employee on the other hand is forced to buy annuities. Why? The ministry of finance’s clarification points out: “There are about 60 lakh contributing members who have accepted EPF voluntarily and they are highly – paid employees [italics are mine] of private sector companies. For this category of people, amount at present can be withdrawn without any tax liability. We are changing this. What we are saying is that such employee can withdraw without tax liability provided he contributes 60% in annuity product so that pension security can be created for him according to his earning level. However, if he chooses not to put any amount in Annuity product the tax would not be charged on 40%.”

The term highly-paid is not defined. I have a problem with this approach. It assumes all government employees earn a lower salary than private sector employees. And that is incorrect. If the idea is to tax, why not have a cut off on the basis of the total amount of the corpus that has been accumulated rather than try to differentiate between public sector and private sector employees? That would be a much more equitable way of going about it.

Also, the question is, is this government worried about an equitable way of doing things at all?  I don’t really think so. The government plans to open a compliance window for those who have black money and are willing to declare it. Black money is income which has been earned but on which tax hasn’t been paid.

This would involve a tax of 30%, a surcharge of 7.5% and a penalty of 15%. By paying 15% extra, those who have black money can ensure that “there will be no scrutiny or enquiry regarding income declared in these declarations under the Income Tax Act or the Wealth Tax Act,” They will also have immunity from prosecution. What this means is that if you are willing to pay 15% extra, the law of the land will not apply to you.

Money can’t possibly buy love, but it definitely can buy everything else. The Modi government just showed us that.

The column originally appeared on the Vivek Kaul Diary on March 3, 2016

Modi Government Wants To Tax Your Provident Fund And That’s Bad News

narendra_modi

Arun Jaitley’s third budget had little to offer for the salaried middle class in particular and the middle class in general. But there was a huge negative point which perhaps no one saw coming.

The Employees Provident Fund(EPF) and other recognised provident funds are a huge mode of saving for the salaried middle class. Up until now the EPF worked on exempt-exempt-exempt or the EEE principle. The money invested in this investment is tax free, the interest earned is tax free and so is the corpus earned on maturity.

What does this mean? As Sandeep Shanbhag, Director, Wonderland Consultants, a tax and investment advisory explains: “In EEE tax saving effected is permanent in nature. This means that once the tax is saved for that particular year, it is saved, per se. When the invested amount matures, it is tax-free.”

Nevertheless, Jaitley has proposed to bring EPF and other recognised provident funds under the exempt-exempt-tax or the EET principle. As Jaitley said during his budget speech: “I propose to make withdrawal up to 40% of the corpus at the time of retirement tax exempt in the case of National Pension Scheme.

In case of superannuation funds and recognized provident funds, including EPF, the same norm of 40% of corpus to be tax free will apply in respect of corpus created out of contributions made after 1.4.2016.”

Before getting into the details of what Jaitley means by this, let’s first try and understand what EET means. As Shanbhag puts it: “When the EET system is put into place, permanent tax saving won’t be possible. This is because, by making an investment, you will reduce the same from your income thereby lowering the tax liability. However, when the amount matures, it would be taxable in that year.”

This essentially means that under the EET system, the money invested in EPF and other recognised provident will be tax-free, the interest earned will be tax-free, but the accumulated corpus will be taxed. Hence, as Shanbhag puts it: “Therefore, this is a deferment of tax and not saving of tax. In other words, you will defer (postpone) the payment of tax depending upon the lock-in of your tax saving investment. However, some time or the other, the investment will mature. At that time, tax will be levied.”

Let’s try and understand this through an example. Let’s say you invest Rs 50,000 every year into EPF, starting from April 1, 2016.

The amount invested can be deducted while calculating the taxable income. Every year the interest earned on this would be tax free. Let’s at the end of 20 years, you earn an average return of around 8.7% per year. This means you would have accumulated around Rs 24.73 lakh. Under the EEE principle this amount is totally tax-free.

Under the EET principle this amount will be taxable. How much tax will you have to pay? Jaitley said during his speech that 40% of the corpus will be tax free.

This means 40% of Rs 24.73 lakh or Rs 9.89 lakh will be tax free. Tax will have to be paid on the remaining Rs 14.84 lakh, if this amount is withdrawn. This amount will be taxed according to the prevailing income tax laws at that point of time.

The question everyone is asking is, why is Jaitley or actually the government doing this? A few years back, the government launched the new pension scheme (NPS). This scheme follows the EET principle.

Up until now, 40% of the maturity corpus of NPS had to be compulsorily used to buy immediate annuities. These are essentially insurance policies which help earn a regular income. The remaining 60% of the corpus could be withdrawn. Nevertheless, an income tax needs to be paid on it.

Jaitley in his budget essentially removed this prevailing discrepancy between NPS at one end and EPF and recognised provident funds, on the other. Now on, 40% of the maturity corpus of the investments made on or after April 1, 2016, can be withdrawn and no tax needs to be paid on it. The remaining 60% will be taxed if you withdraw the amount. The same principle applies for other recognised provident funds as well.

Further, if you use 60% of the money to buy immediate annuities, to generate a regular income, you don’t have to pay any tax on it. Even with this, this is a very anti-salaried/middle class move. This is primarily because of the fact that people use their provident funds to get their children educated as well as married.

They even use it to buy a home after retirement. If they want to do something along these lines, they will have to withdraw money and pay income tax on it.

Also, at the end of the day, it is also about letting the individual decide what he wants to do with her or her money. The immediate annuities currently available in the market do not generate returns which are comparable to other investment avenues like simply investing the money in a fixed deposit or buying tax free bonds, for that matter. Hence, to that extent this is a sub-optimal solution for those who know what to do with their money.

Further, why has Jaitley and indeed the government left out maturing amounts paid on insurance policies and tax saving mutual funds, is a question worth asking. These investment avenues continue to follow the EEE principle. Why is there this discrimination?

If Jaitley and the government do not withdraw this change, all it will do is empower the insurance agents of Life Insurance Corporation and private insurance companies to start another sound of mis-selling to the citizens of this country. And that is not a good thing.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Huffington Post India on February 29, 2016

 

 

Why the Rs 7,00,000 crore EPFO needs to look beyond just public sector stocks

EPFOLogoVivek Kaul

A news report in The Times of India today (i.e. October 17,2014) points out that the Employee Provident Funds Organization (EPFO) wants to invest a portion of its corpus in stocks. As the report points out “At an informal meeting with labour minister Narendra Singh Tomar on Monday, representatives from Congress-backed INTUC and Bharatiya Mazdoor Sangh, which is affiliated to the ruling BJP, offered their support to a diversification of the EPFO’s investment mix into public sector stocks. At the same time both recommended that such investment should only be undertaken on expert advice.”
The Rs 7,00,000 crore EPFO currently invests only in government securities. Hence, from the point of view of diversification of investment, this proposal, if it goes through, makes immense sense. Nevertheless, there are several problems with the proposal in its current form.
First and foremost the EPFO wants to currently invest money only in
‘navratna’ public sector stocks. There are a couple of problems with this. If the idea is to give investors in EPFO a certain exposure to equity, then why limit it to only the best public sector companies?
The second problem is that the free float of the public sector companies is a lot lower in comparison to the overall market. Free float is essentially the number of shares that are deemed to be freely available in the market. In case of public sector companies the shares held by the government are not considered to be available for sale.
The free float of the companies that constitute the BSE Sensex works out to 53.3% currently. In comparison the free float of the public sector companies that constitute the BSE PSU Index, it works out to 29.2%.
Even if only 5% of the employees provident fund (EPF) corpus were to be invested in the stock market, this would mean Rs 35,000 crore of new money suddenly finding its way into public sector stocks. With a low free float, so much new money is likely going to drive up the value of public sector stocks. Hence, EPFO will end up buying stocks at a higher price. And this in turn will impact the return that the EPFO investor earns.
This is why it is important that the EPF invests in the best companies and not the best public sector companies. A simple way to do this would be to run an index fund which simply invests in stocks that constitute the BSE Sensex or the NSE Nifty. An index fund simply invests in stocks that constitute a market index.
Further, the EPFO wants experts to manage their equity investment. Experts repeatedly get the direction of the stock market wrong and this is something that EPFO can ill-afford at the beginning of what is basically an experiment. A better bet is to simply run an index fund and keep experts out of the equation totally. It is important that investors in the EPF, at least earn the market rate of return, first.
As far as experts are concerned, it is worth remembering what Nassim Nicholas Taleb writes in
The Black Swan, The Impact of the Highly Improbable, “Simply, things that move, and therefore require knowledge, do not usually have experts, while things that don’t move seem to have some experts. In other words, professionals that deal with the future and base their studies on the non repeatable past have an expert problem. I am not saying that no one who deals with the future provides any valuable information, but rather that those who provide no tangible added value are dealing with the future.”
Stock market experts have to deal with future and base their decisions on a non repeatable past. The EPFO needs to remember this while deciding how to manage its investments into stocks.

This article originally appeared on www.FirstBiz.com on Oct 17, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)