In this article, Uday Agnihotri pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, elaborates on legal and regulatory framework for taxation of pensions in India.

Introduction

Pension is a benefit conferred upon an employee by the employers after the retirement and hence, can be referred to as a retirement benefit. Pension, as defined by the Oxford Dictionary of Economics, is a regular income paid by the state to people above pensionable age, by former employers to people who have retired from employment, or by a personal pension fund to a contributor. Pension schemes normally give members pensions for their own lives; they vary in their provisions for surviving spouses and other dependents.[1]

This definition, however, is narrow in ambit as it is conspicuously silent on the pension paid by private employers. Pension, as understood in common parlance, is a benefit that an employee gets post his/her retirement. After January 2004, with the introduction of the National Pension System (and subsequent extension in May, 2009 to include all citizens, including self-employed professionals and others in the unorganized sector), a retired employee can receive pension from the employer or the National Pension Scheme. In addition to that, the individuals are free to invest in any pension plans as per their volition which will give them pension after their retirement.

For the purposes of understanding the framework for the taxation of pension under the Indian law, it is important at this juncture to differentiate between the types of pension. Pension can be classified as Commuted Pension and Uncommuted Pension.

Types of Pension

1. Uncommuted Pension: Uncommuted pension refers to the normal periodic pension which an employee receives post-retirement. There is no lump-sum payment (and therefore, no requirement to forgo a certain portion of the pension receivable). It is a periodic payment post-retirement, just like salary pre-retirement. For example, a person, post-retirement, receives a monthly pension of Rs. 5,000.
2. Commuted Pension: Generally, pension is received periodically i.e. just like an employee earned salary periodically (monthly, for instance) before retirement; post-retirement, the employee will receive pension periodically (monthly, for instance). However, many employers permit the employee to forgo a certain portion of the pension receivable to him and in turn, receive a lump-sum amount. This lump-sum amount received as pension is called Commuted Pension. This may be fully or partly commuted. Commuted pension can be explained through an example: a person, who is entitled to receive a pension of Rs. 10,000 monthly for the rest of his life can commute 25% of his pension in advance of the next 10 years and get the lump-sum of Rs. 3,00,000 (25% of 10,000 x 10 x 12). Along with this commuted pension, the person will receive Rs. 2,500 per month for the next 10 year and Rs. 10,000 thereafter as full pension.

Taxation of Pensions

1. Uncommuted Pension: As per Section 14 of the Income Tax Act, 1961, all income received are classified under 5 heads of income for the purposes of computation of total income and for charging income tax. These 5 heads are:

• Salary
• House Property
• Profits and Gains of Business or Profession
• Capital Gains
• Other Sources

Uncommuted Pension, for the purposes of taxation, is considered under the head ‘Salary’ and therefore, is fully taxable as salary i.e. it is treated as salary and hence, is taxable by the hands of both whether government employees or non-government employees, as per the provisions of the Income Tax Act, 1961 related to salary as well as the slab rates decided by the yearly Financial Statement (Budget).

2. Commuted Pension: Taxation of commuted pension is not as simple and easily understandable as the uncommuted pension. In case of the taxation of commuted pension, the first and the most important thing to see is whether the employee is a government employee or a non-government employee.

In case of a government employee, commuted pension is fully exempt. That is to say, if we refer back to the example of commuted pension, in case the person is a government employee, the lump-sum of Rs. 3,00,000 that he receives as commuted pension is completely exempted from income taxation and Rs. 2,500 and the subsequent Rs. 10,000 (after 10 years) would be considered under the head ‘salary’ and taxed as per the prevalent tax slabs (as this amount is uncommuted pension).

In case of a non-government employee, there can further be two situations that are required to be considered for the purposes of taxation of commuted pension. After establishing whether the employee was a non-government employee, it is imperative to ascertain whether the pension is received alone or is coupled with gratuity. Therefore, the question whether gratuity is received with the pension or not has to be answered. Gratuity can be defined as a benefit given to the employee upon leaving the job in gratitude for the services offered by him to the employer while the person was working with the employer. The Payment of Gratuity Act of 1972 governs gratuity and its administration. As per Section 4 of the Act, Gratuity shall be payable to an employee on the termination of his employment after he has rendered continuous service for not less than five years,- (a) on his superannuation, or (b) on his retirement or resignation, (c) on his death or disablement due to accident or disease.[2]

There are two paths that determine the tax burden depending upon whether gratuity is received along the pension or not. If gratuity is received along with pension, then one-third of the amount of pension that would have been received if the entire pension (100%) was commuted is exempt from the commuted pension. The remaining, however, will be considered under the head ‘salary’ and taxed accordingly. On the other hand, in case only pension is received (gratuity is not received with it), half of the amount of pension that would have been received if the entire pension (100%) was commuted is exempt and the remaining amount would be considered as ‘salary’ and taxed accordingly.

Therefore, in ascertaining the tax liability on pension, three questions have to be answered:

1. Whether the pension received is commuted pension or uncommuted pension?
2. Whether the person receiving the pension was a governmental employee or a non-governmental employee?
3. Whether gratuity was received along with the pension or not?

Certain Special Conditions

In certain special conditions, pension is taxed slightly differently (or exempted altogether). These conditions are as follows:

1. Family Pension: Normally, pension is received by the retired employee. However, pension may be received by the spouse or other dependents of the retired employee in the form of family pension. In case of family pension, pension received is taxable under the head of ‘income from other sources’ and not ‘salary’ as there is no employer-employee relationship[3]. With this regard, commuted pension paid to the family of the retired employee is exempt from any taxation[4]. And with respect to uncommuted pension, one-third of the amount of the pension or Rs 15,000 (whichever is less) is exempt and the rest is taxed under ‘income from other sources’.
2. Pension received by family members of Armed Forces: Family pension that is received by the dependents of any member of the Armed Forces is exempted from taxation.
3. Pension received from the United Nations: Pension that is received from the United Nations (or any organization under it) by any employee or his/her family is also exempted from taxation.
4. Pension received by the Judges of the Higher Judiciary: Half of the commuted pension which is received by the retired Judges of the Supreme Court or the High Courts are exempted from taxation[5]

Conclusion

Taxation of pension under the law is not as simple a concept as it is seen ex facie. The simple reason for this is because pension has various different elements and aspects in it that makes a simple straitjacket solution not possible. To ascertain the tax liability of pension, the answers to the three questions raised above (refer to the section ‘taxation of pension’) become imperative. The three questions are reproduced as follows:

1. Whether the pension received is commuted pension or uncommuted pension?

If the pension received is uncommuted pension, then the amount of pension (treated as ‘salary’) is taxable as per the provisions of the Income Tax Act, 1961 related to salary as well as the slab rates decided by the yearly Financial Statement (Budget). However, if the pension is uncommuted pension, the answer to the next question becomes relevant in ascertaining the tax burden.

2. Whether the person receiving the pension was a governmental employee or a non-governmental employee?

If the answer to Question No. 1 is ‘uncommuted pension’, what is to be found next is whether the person receiving the pension was a governmental employee or not. In case he is a retired government employee, the commuted pension will be fully exempted. On the other hand, if the person was a non-governmental employee, the answer to Question No. 3 becomes relevant.

3. Whether gratuity was received along with the pension or not?

If the person was found to be a non-governmental employee in Question No.2, it is required to find out whether gratuity was paid along with the pension or not. If gratuity is received along with pension, then one-third of the amount of pension that would have been received if the entire pension was commuted is exempt from the commuted pension and the remaining is considered under the head ‘salary’ and taxed accordingly. On the other hand, if gratuity is not received with the pension, half of the amount of pension that would have been received if the entire pension was commuted is exempt and the remaining amount would be considered as ‘salary’ and taxed accordingly.

Apart from the aforementioned three-tier test, there are certain special conditions too, in which the tax burden is calculated differently (refer to the section ‘certain special conditions’).

[1] Definition of ‘pension’, Oxford Dictionary of Economics.

[2] Section 4, the Payment of Gratuity Act, 1972.

[3] Section 57(ii)(a), the Income Tax Act, 1961.

[4] Circular No. 573 dated 21.08.1990.

[5] Circular No. 623 dated 06.01.1993.