Will NPS investors be hit with a tax surprise when they retire? The unfortunate answer is that no one knows with certainty, and no one in the government has bothered to clarify. Unless the tax treatment of NPS at withdrawal is known with certainty, it simply will not take off. Three weeks ago, the Union Budget 2015 gave a big push to the NPS by creating a Rs 50,000 tax break that can be utilised only by investing in the NPS. In his speech, the Finance Minister also promised that the government would bring legislation that would enable NPS to be an alternative to the EPFO. In the days since, I have written a few times about the NPS and received a lot of feedback.
In general, I find that there are two things that define people's response and opinion about the NPS. One is taxation, and the other is intense hostility towards the scheme from many established financial advisors. The taxation bit is entirely the government's fault. Unlike the EPF and the PPF, NPS withdrawals are taxable income. When an NPS member retires, 40 per cent of the accumulated money in the account has to be used to buy an annuity which will provide a pension. The money is not taxed at the time of the annuity purchase, but the resulting pension is taxed just like any other pension.
The problem that people have with the NPS is is that the remaining 60 per cent is taxable, in contrast to EPF and PPF. Savers consider this to be unfair and most financial advisors cite this as an overarching reason for disqualifying NPS as a vehicle for discretionary retirement savings. However, there is an additional problem with this, over and above the taxability. Common sense would dictate that the accumulation in NPS should be treated as capital gains. Moreover, the acquisition value of the NPS units should be indexed according to the cost inflation index that the government releases every year for the purpose. From the point of view of the nature of the investments and the asset types, NPS is identical to a debt-oriented hybrid mutual fund, and savers should expect a similar tax treatment.
This is a crucial point. As I'd written in this column last week, with cost-adjustment, the equity-centric options of NPS would cumulatively earn so much more than EPF that on a comparative basis, the annuity would be free and even after that, and even after paying capital gains tax, savers would still have more left over than the EPF. But without the cost-adjustment, NPS would truly be at a disadvantage. So is cost-adjustment available for NPS?
As with so many other things in India's taxation system, no one really knows for certain. I asked a number of CAs and tax lawyers and got an almost equal number of divergent opinions. Some thought that indexation would be available and some thought not. There was even a view that the entire withdrawal would be treated as income for that year! That sounds absurd but then, absurdity is hardly a deterrence for India's revenue collectors.
One very logical opinion was that of the PFRDA's first chairman Dhirendra Swarup, who midwifed the whole NPS project during its most critical phase. He thinks that while it made sense for indexation to be available, it would actually get tested only when someone would actually filed an income tax return with such an assumption, and then the assessing officer would reject it and then there would be a round of appeals and cases and arguments and so on.
Since the first generation of NPS members are still a long way from retirement, we are probably still some years from a clarification. This is an absurd situation and if the government is serious about encouraging NPS, it must clarify the grey areas in NPS taxation without delay. Otherwise, with such a huge uncertainty hanging over their heads, it makes little sense for savers to choose the NPS. As things stand, financial advisors are hostile to the scheme because they can't make money out of it. Having an unclear tax treatment just them a stick to beat the NPS with.