Social Security in India is largely provided by the Provident Fund (PF) system. The system is Defined Contribution in nature with both employers and employees required to contribute 12% of “covered salary” up to a limit of INR6,500 per month - although most PF plans require contributions to be paid on up-capped covered salary. On leaving employment the account balance plus accrued interest is paid to the employee as a lump sum.

Typically the contributions are invested in “multi-employer” funds operated by the government and interest is built up at a rate as notified by the government - the rate is currently 8.5% pa. Some large employers in India have set up their own independent Provident Funds with the interest rates then determined by the performance of these specific funds.

The times are a changing

Until October 2008, “International Workers” - employees with a non-Indian passport - were exempt from participating in the PF system. This all changed on 1 October though when the government announced that International Workers had to participate in the PF with immediate effect - the first contribution being due before 15 December!

The contribution rules for the International Workers are the same as for the other classes of employees - 12% of covered pay for employer and employee - with the additional burden that the salary has to be un-capped. The only exception to this ruling is for employees from a country which India has a Social Security Totalization Agreement (SSTA) with - of which there were none when the legislation was published.

The new legislation took employers by surprise in its nature but more significantly in the extremely short timeframes for compliance. Since then companies have been scrambling for more information and it is anticipated that a majority of affected companies were non-compliant when the first payment deadline fell due on 15 December.

What does this mean for employers and the PF market?

The immediate focus for employers is to comply with the new legislation as quickly as possible. In the slightly longer term the changes will mean an increase in costs to the employer. The cost increase will be at least 12% of covered pay but may be even higher as many International Workers are offered an “excess tax” packages meaning that the employee contributions will also need to be picked up by the employer.

From an employee perspective, the individuals may be liable for the employee contribution portion and in any case they will be enrolled in the PF system. On leaving employment if the employee is from a country without an SSTA with India they will not be eligible to receive any benefits from the system.

The PF system itself - and the government in particular - stands to be the biggest winner from this change. The contributions related to International Workers are effectively additional tax revenues - given that employees cannot withdraw any benefits form the system. The flipside to this is the increased expense of hiring foreign employees into India - which may ultimately bring a far higher economic cost than the additional “tax revenues”.

In the case of the Independent PF’s operated by some large employers, the fund managers will also benefit from larger funds under management and the associated fees earned.

Why did the government make the change?

The motive for the change is somewhat unexpected; to encourage employers to set up an SSTA with India and then benefit from the exemption from the new legislation - Germany and Belgium have already taken steps to ensure both countries have SSTA arrangements taking effect from 1 January 2009.

The rationale for this is that India has far more of its own countrymen working overseas than it has foreigners working in India. By encouraging countries to then set up SSTA agreements means that many of those Indians working overseas will then be exempt from paying social security in their country of residence and will be able to remain in the Indian PF system. The government is particularly concerned about those employees working overseas who will return to live their old age in India and may not have any other substantial sources of income.

It is not clear why the government implemented the change so quickly and it has certainly caused short term headaches for employers, employees and civil servants alike.