How your NPS Tier II account withdrawals are taxed

National Pension System (NPS) has two type of accounts: Tier I and Tier II. Tier I account is the main account and is mandatory whereas opening of Tier II account is optional. Tier II account is like a saving bank account where you can deposit and withdraws money as and when you want. One can transfer money anytime from Tier II account to Tier I account and not vice versa. All subscribers are eligible for tax benefits for contributions made to Tier I account but tax benefits for Tier II account contributions are available only to central government employees with three years lock-in period. Since there are no specific provisions for taxation of withdrawals from Tier II account under the law, I thought I will try to explain how such withdrawals should be taxed logically?

Are the withdrawals from Tier II account taxable?

As per Section 10 (12A) of Income Tax Act, 60% of the amount withdrawn on closure or at the time of opting out from the account referred to in Section 80 CCD are tax-free in the hands of the subscriber. Likewise, at the time of partial withdrawals 25% of subscriber’s contribution, from the account referred to in Section 80 CCD comes tax-free as per Section 10 (12B). Section 80 CCD implied refers only to Tier I account because deduction under this section is available only for contribution to Tier I account and not for contributions made to Tier II account for which deduction is available under Section 80C(2)(xxv).

There is no specific and direct provision for taxation of withdrawal from Tier II account under the Income Tax Act. If tax law does not have any specific provisions for taxation of an item, it does not by default becomes tax-free or taxable. In such a situation one has to apply the logic and take help of other provisions of the same law. The full value of the money withdrawn from Tier II account cannot be taxed as the law makers would not have contemplated taxing something at the time of withdrawal if no tax benefit has ever been claimed when the money was deposited. But this does not mean that the entire amount withdrawn would come tax free. The withdrawals from Tier II account are like regular withdrawals from your saving bank account, which are not taxed except to the extent of interest earned.

For arriving at the logical rules for taxation of Tier II account withdrawals I take support from provisions of Section 80CCC. Section 80CCC (1) provides for deduction of premium paid to buy an annuity. Section 80 CCC (2) provides for taxing of surrender value of such policy which restricts the taxability to the extent to which the tax benefits under Section 80 CCC(1) have been claimed by the individual and not beyond that except the accretion to the investment. The same logic has to be applied here.

How the withdrawals should logically be taxed

Due to the reasons explained above I am of the strong opinion that whole of the money withdrawn from Tier II account cannot be taxed by any stretch of imagination. What can and should logically be taxed is the appreciation, if any in the value of investments as comprised in the withdrawals.

Since the investment made in Tier II account does not carry any fixed rate of return like fixed deposits or bonds or debenture, the appreciation in the value of investments cannot be taxed under the head “Income from other sources”. As a subscriber is allotted units for his investments in different categories of funds like of equity, corporate bonds and government securities at their Net Asset Value (NAV) at the time of investment, it is logical to treat contribution to tier II account as investments and treat any profits thereon as capital gains.

Since investment in NPS can neither be called listed equity shares nor can be treated as units of equity mutual funds, it shall become long term only if the units are sold after 36 months. Since Securities Transactions Tax (STT) is not paid at the time of redemption, the same cannot be taxed as equity oriented schemes under Section 112A even in respect of the equity component. It shall be taxed at flat of 20% after indexation if held for more than 36 months. If the units are redeemed within 36 months, the profits on redemption is to be treated as short term capital gains and to be included in your regular income which will get taxed at the slab rate applicable to your total income.

The difference between NAV of purchase and redemption has to be multiplied by the number of the units used for redemption to arrive at the profit on realised on redemption of specific transaction.

Please note that whatever I have mentioned is not the exact legal position in absence of specific and direct provision in the Income Tax Act but is purely my opinion arrived at with the help of common sense and logic. In view of the confusion surrounding tax on withdrawal for Tier II account, it is the duty of the government to make the legal position clear as early as possible. This will help many people to take the decision to avail the benefit of low cost investment avenue of Tier II account.

Balwant Jain is a tax and investment expert and can be reached at [email protected]

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