Free Press Journal

Tax treatment of pension

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There are still a lot of uncertainties about the whole scheme of things, as the announcement in the budget is more by way of an ‘intent’, rather than the ‘modus operandi’, writes TENSING RODRIGUES .

Budget 2016 claims to bring at par the tax treatment of National Pension Scheme with the “government pension and superannuation funds”, by the amendment of Section 10. The parity is with regard to the withdrawals from the accumulated balance in these schemes. Under the existing provisions of the Income Tax Actcommutation of Government pension and superannuation fund as well as final withdrawal from the Recognised Provident Funds was exempt from taxation; that is, Exempt (at the time of investment) –Exempt (the interest earned on the balance) – Exempt (at the time of the withdrawal) model was applied to these schemes. As against this the NPS was under E-E-Tax model; that is, the withdrawal was taxed.

With this amendment (I suppose) an uniform norm of E-E-Tax only the withdrawal above 40% of the balanceis going to be applied to all the schemes.  There are still a lot of uncertainties about the whole scheme of things, as the announcement in the budget is more by way of an ‘intent’, rather than the ‘modus operandi’, though the relevant amendments to the IT sections have been proposed in the Finance Bill; the Ministry of Finance, the Minister of State for Finance and the Revenue Secretary have made rather conflicting statements in the immediate aftermath of the budget. That is not un-natural; once the budget document is subjected to the hawk eye scrutiny of the experts, a lot of the loose ends come to sight, and get finally knotted in course of time. So we hope these too will be.


But however satisfactory the resolution of these issues, the real issue shall still remain unresolved. All that we have discussed above is lead 2with respect to the sum withdrawn from the pension corpus. I would consider it insignificant in the context of what the Finance Minister has dreamed as the ‘uniform pensioned society’. Amount withdrawn from the pension corpus does not contribute to ‘pensioned society’; rather it detracts from it. Therefore, I would like to get back to the real taxation issue : the tax treatment of the pension that is earned from the un-withdrawn pension corpus.

Pension is treated at par with salary for the purpose of Income Tax; it is taxed under the head of ‘Income from Salaries’. This was more or less fair in case of ‘defined benefit pension’. Under that model, which was the standard model of pension till about ten years ago, an employer assured a specified monthly pension on retirement predetermined by a formula based on the employee’s earnings history, tenure of service and age; it had no essential relation to the contributions made by the employee or the employer to the pension corpus and its value at the time of drawing the pension. So, for all practical purposes, and in principle too, it was just an extension of the salary. In such a situation, it was not too unfair to treat pension at par with salary for the purpose of Income Tax.

But, once we moved to a model of ‘defined contribution pension’, the entire rationale for treating pension at par with salary vanishes. Pension now is not ‘paid’ by the employer; the employer is only a sort of a custodian of the pension corpus, or better still, a facilitator for the creation of the pension corpus. Pension then becomes more of an investment income, at par with income from bank deposits, mutual funds or equity stocks.

In case of the investment income the distinction between the capital and income – what is invested by the investor and what is earned by her on that investment – becomes critical. The investor’s contribution – the capital, when received back by the investor, cannot be deemed as her income under any circumstances. Only what she earns on that investment is her income and only that can be taxed as income. Pension received by an employee on her retirement is made up of both the capital returned and the earnings on that capital. So only a part of the pension can be subjected to Income Tax.

Under the existing provisions of the Income Tax Act both the capital returned and the earnings are treated as salary. The argument is that the capital returned comes from untaxed income, as these schemes enjoy tax exemption for contribution into them. Agreed. But what about that part of the contribution that does not come from the untaxed income ? Simple arithmetic of the contribution required to create the pension corpus will tell you that you HAVE TO contribute beyond the tax exemption limit under the relevant sections to create a reasonable pension corpus – a corpus that will let you draw a pension that will enable you maintain your living standard.

Let us take a simple example. Let us suppose that you feel that you will need a pension of Rs. 75,000 per month from age 60 to age 80, that is for 20 years, adjusted for inflation at 6% over the next 50 years. Then you will need a pension corpus of about Rs. 90 lakhs, given an interest rate of 8% pa. If you start contributing now (at age 30) you will have to contribute about Rs. 75,000 per year for the next 30 years. Now work out for yourself how to fit all your other deductions within the exemption limit.

Moreover, what is the rationale of giving tax exemption to the contributions to pension schemes ? The sole purpose is to encourage the society to ‘take care’ of their sunset years without becoming a burden to the public exchequer. In a welfare state it is the responsibility of the State to ensure a decent living to the citizens. By extending these incentives, the State invites and incentivises the citizens to share with it in achieving this goal. By double taxing the citizens willing to share in this burden, the State defeats its own purpose. It is high time the Finance Ministry looks deeply into this anomaly and does away with it.