Introduction
Certain amendments to Employees’ Pension Scheme, 1995 in 2014 brought in multi-layered restrictions on the contributions that can be made to the Pension Fund, the benefits that would arise from any Pension Fund, additional conditions to be fulfilled to claim benefits out of past contributions, etc. The amendments had serious repercussions on pensionary benefits otherwise available to employees, resulting in beneficiaries of the scheme across India challenging the amendments before various High Courts. The Supreme Court then intervened and laid down certain conditions subject to which the amendment would apply. To implement the directions of the Supreme Court, the Employees’ Provident Fund Organisation (‘EPFO’) issued a series of Circulars.
These developments have resulted in a certain unforeseen income-tax implications, on the monies that would be contributed to the Pension Fund, as well as monies that would be receivable from the Pension Fund and Provident Fund. To understand the income-tax implications, it is crucial to trace the laws and regulations relating to retiral benefits payable to employees.
Contributions to Employees’ Pension Scheme over Statutory Wage Ceiling
In order to statutorily provide for retiral benefits to employees, the Parliament has notified the following schemes under the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952 (‘EPF Act’):
1. Employees’ Provident Funds Scheme, 1952 (‘PF Scheme’);
2. Employees’ Pension Scheme, 1995 (‘Pension Scheme’);
3. Employees’ Deposit-Linked Insurance Scheme, 1976
4. The EPF Act, inter alia, requires the employer to contribute a minimum of 12% of employee’s monthly salary towards Pension Scheme and PF Scheme– 8.33% towards Pension Scheme and the balance towards PF Scheme.
The minimum contribution to Pension Scheme was set at 8.33% of the actual salary payable to the employee, or INR 15,000/- per month, whichever is lower. However, prior to 1 September 2014, proviso to Paragraph 11(3) of the Pension Scheme provided an option to the employee that employer’s contribution towards the Pension Scheme may be made at 8.33% of actual higher salary (‘higher pension’), i.e., 8.33% contributions beyond the statutory wage ceiling of Rs.15,000/-.
Vide Notification No. GSR 609(E) dated 22 August 2014 (with effect from 1 September 2014), proviso to Paragraph 11(3) of the Pension Scheme was deleted and Paragraph 11(4) was added to the Pension Scheme. Paragraph 11(4) required the existing employees contributing ‘higher pension’ (as on 1 September 2014) to exercise a ‘fresh option’ to continue contributing to Pension Scheme on higher salaries. Failure to exercise the ‘fresh option’ leads to ‘higher pension’ contributed up till the cut-off date of 1 September 2014, along with applicable interest, to be diverted to the employee’s PF account.
The issue of validity of ‘higher pension’ became a bone of contention before various High Courts. It reached the Supreme Court in the case of Employees’ Provident Fund Organisation v. Sunil Kumar B[1], wherein the Apex Court, inter alia, upheld the validity of Notification No. GSR 609(E) of 2014, but to benefit the larger interest of the employees, the period to opt for ‘fresh option’ under Paragraph 11(4) was extended.
For implementation of the Apex Court decision, the EPFO issued Circulars[2] (‘EPFO Circulars’), inter alia, providing that the benefit to eligible employees[3] who wish to contribute higher pension will be facilitated by giving explicit consent to:
1. re-adjustment of funds from PF Scheme to Pension Scheme; and
2. if required, re-deposit.
For the reasons of brevity, this article does not delve into the tax implications of contribution made by an employer to the PF Trust, nor with the taxation of the Trust itself. The scope of this article is limited to the income-tax liability in the hands of the employees on:
1. transfer of balances from PF Scheme to Pension Scheme,
2. contribution to the Pension Scheme from PF Scheme, and
3. receipt of pension from the Pension Scheme at the time of retirement.
Taxation of amount transferred from PF Scheme (for remittance towards Pension Scheme) in pursuance of EPFO Circulars
The higher pension option provided vide EPFO Circulars involving transfer / re-allocation of employer’s contribution from PF Scheme to Pension Scheme results in reduction of the PF account balance of the employee in favour of the employee’s Pension fund account balance.
Forming part of governmental initiative of promotion of pension, superannuation, annuity and other such Exempt-Exempt-Exempt schemes, numerous tax exemptions have been provided for sums contributed to PF Trust, as well as to sums received from the PF Trust upon maturity. Section 10(12) of the IT Act grants a blanket exemption to employees on any sums receivable from a recognised PF when stipulations under Rule 8, Part A, Fourth Schedule of the IT Act (such as continuous service for a minimum period of five years etc.) are fulfilled.
Sums from PF account become payable only upon the happening of one of the contingencies provided under the PF Scheme. These contingencies include employee reaching the age of superannuation, satisfying the conditions of partial withdrawal, and other conditions laid down by EPFO. Section 10(12) of the IT Act grants a general exemption when stipulations under Rule 8, Part A, Fourth Schedule of the IT Act are fulfilled. In other words, the provision does not specifically regulate taxation of sums received from PF account upon happening of specific contingencies. That is, there is no reason why withdrawals pursuant to EPFO Circulars are to be evaluated in the same manner as that of final withdrawals upon reaching maturity. Therefore, provided withdrawal is compliant with Rule 8, Part A, Fourth Schedule of the IT Act, the benefit of exemption under Section 10(12) of the IT Act will be available to all sums withdrawn from a recognised PF Trust towards higher pension dues.
Treatment of amounts deposited in the Pension Scheme (from PF Scheme) in furtherance of EPFO Circulars
Withdrawal from PF account for contribution towards Pension Scheme is permitted as a one-time option by EPFO Circulars. This option is voluntary exercisable, i.e., neither the Supreme Court judgment nor EPFO Circulars require mandatory adoption of such option. It is wholly left to the volition of the employee to determine the forum of investment of his / her funds.
Without consequence to the foregoing, upon withdrawal from PF account, income-tax implications arise in the hands of the employee. In other words, such sums will be included in the total income of the employee for the assessment year under consideration. It is inconsequential whether the tax impact on the same is being protected by exemption provisions. Thus, pursuant to withdrawal, the character of the sums received gets altered to employee’s income.
Therefore, higher pension dues (comprising of employer’s contribution and interest thereto) deposited in Pension fund account should be regarded as employee’s contribution to the Pension Scheme.
Evolution of taxation of pension payouts as profits in lieu of salary
It is crucial to trace the legislative and judicial history behind taxation of sums received from Pension Scheme.
Section 17 of the IT Act pertains to taxation of various incomes under the head ‘salaries’. Section 17(3)(ii) pertains to taxation of any payment from an employer or a former employer or from a provident or other fund, specifically excluding contributions made by the employee and interest accrued on such contributions. The present iteration of Section 17(3) pertaining to taxation of profits in lieu of salary received by employees is a result of legislative evolution of the corresponding provision of Section 7 of earlier regime of the Indian Income Tax Act, 1922 (‘1922 Act’).
Section 7(1), as introduced in 1922 Act, did not bring to tax sums received by persons other than employers. Notably, the provision was restricted to taxation of sums paid by or on behalf of any employer (Government, local authority, company, public body or association, private employer), i.e., it was silent on the inclusion of sums received from PF Fund, Pension Scheme and other funds within the meaning of salaries. As per the common law principle of ejusdem generis, when particular words pertaining to a class, category or genus are followed by general words, the general words are construed as limited to things of the same kind as those specified. In terms of Section 7, the term ‘pension’ is positioned between ‘any salary or wages, any annuity’ and ‘gratuity’, thus, the term ‘pension’ must take colour from its adjacent words, to bring to tax only such receipts received solely from employer. Thus, it would be incorrect to state that that Section 7(1) of 1922 Act will encompass all forms of monies payable to employees carrying any direct and indirect connection to employment.
Note may be had to the Income-Tax Manuals published by Board of Inland Revenue (corresponding to the present Central Board of Direct Taxes), which contained instructions and notes basis which Income-tax authorities were required to conduct income-tax assessments under the 1922 Act. Various editions of the Income-Tax Manual stated that tax under Section 7(1) of the 1922 Act is leviable only on payments made by or on behalf of employer. It further stated that a payment made to an employee from a private Provident Fund cannot be regarded as a payment of salary within the meaning of Section 7(1) because the trust is not the employee’s employer. In other words, income-tax authorities were explicitly instructed to assess only payments received from employers under Section 7(1) of the 1922. These instructions stood intact until the amendment of Section 7(1) vide Indian Income-Tax (Amendment) Act, 1939.
In the absence of specific provision categorically capturing all sums received from employment related funds (Pension Scheme, PF, Superannuation fund etc.), several landmark judgments have helped in development of the law of the land.
With respect to taxation of pension payouts, Privy Council in CIT v. BJ Fletcher [1937] 5 ITR 428 (‘PC’) held that where the sums allotted were entirely at the discretion of the company, not being part of the employee’s original contract of service, will not be taxable as salaries on this alone. Even subsequent to allotment, employee would have no right until fulfilment of conditions like minimum years of service and claim arising only upon retirement. Thus, the Privy Council held that allotments made to the fund in the employee’s name were not in the nature of salary for current services but were merely the measure of a sum which the company volunteered to pay on the termination of service.
Rangoon High Court in CIT v. Rangoon Electric Tramway & Supply Co. Ltd. [1933] 1 ITR 315 (Rang.) drew a distinction between the monies paid by the employer to the employee from the monies that have left the control of the employer in favour of a Trust. As per the Court, the purview of Section 7 of 1922 Acct on salaries is restricted to the former scenario. However, in the latter scenario where the money has left the control and power of the employer, and the decision on outflow of the same is retained by another entity such as a PF trust, then it cannot be gainsaid that tax impact would still be as per the provision of Salaries. While this judgment was regarding sums payable by a PF, by virtue of the similarity of this arrangement with the sums received by employees from Pension Scheme, this judgment can be extrapolated to state that sums received from a Pension fund cannot be brought to tax under Section 17(1) of the IT Act.
To address the seeming lacunae of non-taxation of payments received from provident and other funds, the Indian Income-Tax (Amendment) Act, 1939 introduced payments received from provident and other funds as new subject of taxation under Explanation 2 of Section 7 of the 1922 Act as profits in lieu of salary. Sub-section (6C) of Section 2 of 1922 Act was also simultaneously introduced to define ‘income’ as comprising of, inter alia, sums received as profits in lieu of salary within the meaning of Section 7. Statement of objects and reasons to the Income-tax Amendment Bill, 1938 explained that new subject of taxation was introduced as a corrective measure for prospective nullification of the judgments holding that such sums of pension could never be income.
Therefore, these developments would appear to create two distinct subjects of taxation, i.e., Section 7(1) of 1922 Act to tax pension receipts directly from employer while Explanation 2 to Section 7 of 1922 Act to tax pension receipts received from provident and other funds.
Subsequently, legislative endeavours were undertaken by Law Commission Report (1958) to enumerate and simplify Section 7 of 1922 Act spread across three parts. In pursuance thereof, Income Tax Bill, 1961 provided the following suggestions with respect to the provision of ‘Salaries’:
1. Simplification by omission of extended meaning of Salaries from substantive clause of Section 7 of 1922 Act to separate definitions in the form of interpretation clause of Clause 17 of Income Tax Bill, 1961.
2. Substantive provision in the form of Clause 15 of Income Tax Bill, 1961 to be inserted to bring to tax monies received from employer, where the term ‘employer’ is defined inclusively.
3. Explanation about ‘Profits in lieu of salary’ in Explanation 2 from substantive clause of Section 7 of 1922 Act was to be placed in interpretation clause of Clause 17 of Income Tax Bill, 1961.
4. The Report refused inclusion of payment of annuities under Clause 17(2) irrespective of payee being employee or not, as being against the basic scheme of section. In other words, contract of employment was considered paramount for taxation of sums as Salary under Clause 17(2) of Income Tax Bill, 1961.
It is apparent that no substantive changes were proposed with respect to main charging provision under sub-section (1) of Section 7 and Explanation 2 of Section 7 pertaining to profits in lieu of salary. Thereafter, Section 17 of the IT Act was introduced in line with the suggestions of Law Commission Report (1958). With identical phrasing of the old and new provisions, it is impossible to draw any different interpretation to the Section 17(1) of the IT Act. Therefore, the term ‘pension’ in Section 17(1)(ii) must take colour from its adjacent words and bring to tax only pension payouts received solely from employer.
This inference is further bolstered by the presence of a specific clause in the form of Explanation 2 to Section 7 of 1922 Act, which specifically pertains to taxation of payments received from ‘provident or other fund’. This similarly appears in the IT Act as Section 17(3)(ii).
In view of the bare reading of the provisions of 1922 Act and IT Act, legislative developments revolving around taxation of profits in lieu of salary as well as the juridical law developed over the years, Section 17(1)(ii) of the IT Act [corresponding to Section 7(1) of 1922 Act] and Section 17(3)(ii) of the IT Act [corresponding to Explanation 2 to Section 7 of 1922 Act] must operate in independent domains of law. Any alternative interpretation would leave no scope for harmonious construction of these sub-sections. Therefore, to avoid overlapping operation, Section 17(1)(ii) of the IT Act [corresponding to Section 7(1) of 1922 Act] must relate to pension receipts paid to employees directly by employer while Section 17(3)(ii) of the IT Act [corresponding to Explanation 2 to Section 7 of 1922 Act] must relate to pension receipts paid to employees from Pension Scheme.
Conclusion
The sums received from Pension Scheme linked to transfer / re-allocation qua EPFO Circulars will be liable to tax in the hands of the employees under Section 17(3)(ii) of the IT Act. With the exclusion of employee’s contribution from Section 17(3)(ii), higher pension dues (originally comprising of employer’s contribution and interest accrued thereto) deposited in the Pension Scheme should be considered to be employee’s contribution to the Pension Fund. Consequentially, the portion of the sums received from the Pension Scheme that is linked to employee’s contribution and interest accrued thereto transferred / re-allocated qua EPFO Circulars will be excluded from the levy of tax under Section 17(3)(ii) of the IT Act.
Once employee’s contribution and interest accrued thereto are regarded as non-taxable due to a specific exclusion in Section 17(3)(ii), such sums cannot be brought to tax under other provisions of the IT Act.
[The author is a Senior Associate in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys, Mumbai]
[1] Special Leave Petition (C) Nos. 8658-8659 of 2019, decision dated 04th November 2022.
[2] Circular No. Pension/2022/56259/16541 dated 20th February 2023, Circular No. Pension/SupremeCourtjudgment/PoHW/2022/812 dated 11th May 2023, among others.
[3] (1) Contribution to PF Scheme in excess of the statutory wage ceiling;
(2) Non-exercise of option under the erstwhile proviso to Paragraph 11(3) of Pension Scheme; and
(3) Membership of the Pension Scheme prior to 01st September 2014 which continued till or beyond the date.
