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Home / Opinion / Taxation when a life insurance policy behaves like an asset

Till 2004, proceeds of all life insurance policies (other than keyman insurance policies) were exempt from tax. The exemption, contained in section 10(10D), has since been curtailed to exclude certain types of policies where the premium in any year exceeds the specified percentage of the sum assured under the policy. What are these provisions and how are the sums received to be taxed?

For policies issued from 1 April 2003 till 31 March 2012, the premium in any year should not exceed 20% of the sum assured, for the exemption to apply. In case of policies issued on or after 1 April 2012, the premium in any year should not exceed 10% of the sum assured, to get the benefit of the exemption. Even in case of such policies, where the premium in a year exceeds the specified percentage of the sum assured, the amount received on death of the policyholder will continue to be exempt.

The sum assured is to be computed by taking the minimum amount assured under the policy, and excluding premiums agreed to be returned and bonus payable under the policy. It needs to be kept in mind that if the premium for even one year during the term of the policy exceeds the specified percentage, the exemption would not be available for the proceeds of the policy, though the premium in the other years may be within the specified percentage.

The taxability applies not only to amounts received on final maturity of the policy, but to all amounts received under the policy. Is the full amount received to be taxed, or is any deduction available for premium paid? The answer to that would partly depend upon the head of income under which the proceeds of the policy would be taxed. Again, merely because the exemption provision provides exemption for all proceeds of life insurance policies, other than the proceeds of the excluded types, it does not mean that the entire proceeds of the excluded policies are taxable. It is well-settled that in computing income under the income tax Act, a taxpayer is entitled to deductions specified under the respective heads of income.

The definition of income specifically includes only proceeds of keyman insurance policies. The heads of income “salaries", “income from business or profession" and “income from other sources" specifically have provisions to tax proceeds of keyman insurance policies. No provision relating to any head of income specifically refers to other insurance policies. The only reference to taxability of such amounts is in the exception to the exemption provision for proceeds of life insurance policies, which again does not refer to the manner in which such proceeds will be taxed.

The issue really is whether an insurance policy is a capital asset or not. An insurance policy that provides for a return of money is certainly similar to an investment, which is a capital asset. A policyholder has certain rights to receive some amounts under the policy on the happening of certain events or on certain specified dates. A life insurance policy can also be assigned. Therefore, a life insurance policy can certainly be regarded as a capital asset.

The second issue which arises is whether there is a transfer of a capital asset when proceeds of a policy are received. The definition of the term “transfer" includes extinguishment, and when a part of the policy matures and proceeds are paid to the policyholder, there is a partial extinguishment of the policy. There is, therefore, a transfer of a part of the capital asset.

That being the position, the income arising on receipt of amounts under a life insurance policy would be computed as capital gains. In computing capital gains, cost of acquisition as well as cost of improvement is deductible. These can be indexed by using the notified cost index if the capital gains are long-term capital gains.

The policy would be a long-term capital asset, if more than three years have elapsed since the commencement of the policy. The initial premium paid would be the cost of acquisition, and subsequent premiums paid would be the cost of improvement of the policy. Indexation of cost would accordingly be worked out year-wise depending upon the year of payment of the respective premiums.

When amounts are received periodically under the policy, one would have to determine what proportion of the policy has matured by referring to the terms of the policy, and accordingly claim proportionate cost (premiums paid) against such proceeds.

Unfortunately, the tax laws do not explicitly provide for the manner of taxation of such policies, though they exclude such policies from the exemption. One wishes that the tax laws would provide greater clarity on the subject, or that the Central Board of Direct Taxes (CBDT) would clarify the position, so that countless policyholders are saved the needless headache of possible litigation on the manner of taxation of the proceeds of such policies.

Gautam Nayak is a chartered accountant.

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