Tax on maturity proceeds from a Life Insurance Policy


Tax on maturity proceeds from a Life Insurance Policy

There is a myth or misconception among the people is that receipt of proceeds from a life insurance policy is always tax-free. However, this is not always true. It is true to a certain extent but not always and the tax exemption comes at certain conditions. The Income-tax law contains certain provisions under which proceeds including bonus received on maturity or surrender of a life insurance policy are taxable. In this article, we will be discussing the applicability of income tax on maturity proceeds from a Life Insurance Policy. More credit goes to misselling by the insurance agents who either by ignorance or deliberately hide the fact of applicability of income-tax on a life insurance policy and always say that proceeds from a life insurance policy are always tax-free.


    Introduction

    Proceeds from a life insurance policy are received on the following occasion-
    • On maturity of a life insurance policy, at the end of the term
    • On surrender of a life insurance policy, before the end of the term and,
    • On the death of the policyholder.
    It may be noted that prior to 2003, receipt of proceeds from any life insurance policy was tax-free without any riders. 

    However, from 2003, the Income Tax law was amended and receipt of proceeds from a life insurance policy on maturity or surrender of the policy including bonus was made taxable in certain circumstances.

    Therefore, it is of utmost importance to know those conditions when such proceeds are taxable and when not. In many cases, tax incidence may be so high that one may end up by paying taxes out of capital or policyholder’s own pocket. It is taxable in the hands of the insured or policyholder and not in the hands of the proposer of the policy. This article is aimed to provide all the information on the taxability of a life insurance policy and if it falls in the taxability clause then how to save tax on receipt of maturity or surrender proceeds from a life insurance policy.

    Remember, under any circumstances, any proceeds received by the nominee on the death of the policyholder is always tax-free and does not come under the taxability purview. Thus benefits received on the death of the policyholder of a life insurance policy is always exempt from tax without any condition.

    Pension policies issued by life insurance companies and includes an element of life insurance are treated differently for taxation purpose and is, therefore, outside the purview of this article.

    Legal provisions about the applicability of Income Tax on maturity proceeds from a Life Insurance Policy:


    Section 10(10D) of the Income Tax Act, 1961 states that - (extract)

    "any sum received under a life insurance policy, including the sum allocated by way of bonus on such policy, other than—

         (a) any sum received under sub-section (3) of section 80DD or sub-section (3) of section 80DDA; or

            (b) any sum received under a Keyman insurance policy; or

           (c) any sum received under an insurance policy issued on or after the 1st day of April, 2003 but on or before the 31st day of March, 2012 in respect of which the premium payable for any of the years during the term of the policy exceeds twenty per cent of the actual capital sum assured; or

           (d) any sum received under an insurance policy issued on or after the 1st day of April, 2012 in respect of which the premium payable for any of the years during the term of the policy exceeds ten per cent of the actual capital sum assured:

              Provided that the provisions of sub-clauses (c) and (d) shall not apply to any sum received on the death of a person:
                  .....................

    Provided also that where the policy, issued on or after the 1st day of April, 2013, is for insurance on life of any person, who is—

    (i) a person with disability or a person with severe disability as referred to in section 80U; or

    (ii) suffering from disease or ailment as specified in the rules made under section 80DDB,

    the provisions of this sub-clause shall have effect as if for the words "ten per cent", the words "fifteen per cent" had been substituted."

    On the basis of foregoing provisions, we can summarize the applicability of Income Tax on maturity proceeds from a Life Insurance Policy is based on the period of issue of the life insurance policy as charted below -

    Period of issue of a life insurance policy
    Conditions
    Tax applicability
    Life Insurance Policy issued before 01.04.2003 
    None
    Always tax-free 
    Life Insurance Policy issued between 01.04.2003 and 31.03.2012 (both days inclusive)
    Amount of annual(ized) premium is more than 20% of Sum Assured
    Maturity proceeds are taxable
    Life Insurance Policy issued on or after  01.04.2012
    Amount of annual(ized) premium is more than 10% of Sum Assured
    Maturity proceeds are taxable
    Life Insurance Policy issued on or after  01.04.2013
    Amount of annual(ized) premium is more than 15% of Sum Assured - applicable for an insured person who is suffering from a severe disability or disease specified in section 80U of Income Tax Act, 1961 or Section 80DDB read with  Rule 11DD of Income Tax Rules, 1962
    Maturity proceeds are taxable

    In case of monthly or quarterly or half-yearly premium, one has to consider the annualized premium for determining the taxability in such cases. For example, if the monthly premium is Rs. 850 then the annualized premium to be considered for applicability of income tax on maturity proceeds of a life insurance policy is Rs. 10,200 though if the annual mode of payment is opted for paying the premium for the same policy the premium would have been Rs. 9,900.

    Let us elaborate on the example. Suppose the sum assured of the life insurance policy is Rs. 1,00,000. The monthly premium is Rs. 850 and the policy is issued after 01.04.2012 and to a healthy person. If the annual premium mode is opted, the premium quoted by the life insurance company is Rs. 9,900, since discount or rebate is allowed in annual mode. Though the monthly premium is within 1% of the sum assured, however, one needs to consider the annualized the premium which comes to Rs. 10,200 (Rs. 850 x 12 months). If the policyholder opts for the annual mode of premium payment, then the annual premium does not exceed 10% of the sum assured. In such a case, the proceeds from such a policy on maturity or surrender of the policy will remain tax exempt.

    Also Read:






    What is Sum Assured

    What is Sum Assured - The income tax law has used the term 'sum assured' as 'Actual Capital Sum Assured' and is defined in Section 10(10D) read with Explanation to Section 80C(3A). As per the Explanation, "actual capital sum assured" in relation to a life insurance policy shall mean the minimum amount assured under the policy on happening of the insured event at any time during the term of the policy, not taking into account—

          (i) the value of any premium agreed to be returned; or

       (ii) any benefit by way of bonus or otherwise over and above the sum actually assured, which is to be or may be received under the policy by any person.

    Tax on maturity proceeds from a Life Insurance Policy


    Therefore, the term 'sum assured' means the amount payable by the insurance company to the insured on the happening of the event for which the policy is taken without taking into consideration the allocated bonus and return of premium if any. In layman terms, it is the value of the policy on which the insurer fixes the premium amount.

    It is to be noted that if the premium payable in any year during policy term or period exceeds the prescribed percentage of 10% or 15% or 20%, then the proceeds from the life insurance policy on maturity or surrender loses the exemption. However, if a policy is issued before 01.04.2003 and still in force then the maturity or surrender proceeds will remain tax-free. For example, if a life insurance policy is issued on 10th March 2003 for a period of 30 years, the same will remain exempt, as per current provisions of the law, even if the premium exceeds 10% or 15% or 20%, as the case may be, in the year 2033 when the policy will mature. The situation will not alter if the policy is surrendered before the maturity period.

    It may be noted that the question of applicability of Income Tax on maturity proceeds from a Life Insurance Policy only when the proceeds are received by the insured on maturity or surrender of the life insurance policy issued on or after 01.04.2003. If the insured dies and the nominee of the insured receive the proceeds from that life insurance policy after the death of the insured or policyholder, the receipt of whole proceeds is tax-free and will remain exempt in the hands of the nominee. It is then irrelevant whether the premium paid was more than 10% or 15% or 20%, as the case may be, of the actual sum assured. It will remain tax-free under the circumstances.

    In this context, it is important to note that 'Keyman insurance policy' is not tax-exempt under section 10(10D). However, Keyman insurance policy' is not the subject matter of this article and hence excluded from the discussion.

    An easy way to determine whether proceeds to be received on maturity or surrender of an insurance policy is tax-free or not is the applicability of TDS. 

    TDS on life insurance policies

    TDS on life insurance policies - The Finance Act, 2014 introduced section 194DA. Under the section, income-tax at the rate of 1% will be deducted from any payment by an insurance company to a resident person for a life insurance policy held by the person with the insurance company, except in a case where the payment amount will remain exempt u/s 10(10D) or does not exceed Rs. 1,00,000 in a financial year The payment shall include allocated bonus on such policy.

    Tax on maturity proceeds from a Life Insurance Policy


    The major ingredients for applicability of TDS on a life insurance policy are listed below-
    1. The payment is made by an insurance company.
    2. The payment is made for a life insurance policy held by a policyholder.
    3. The payment is made on the maturity of the policy or on surrender of the policy.
    4. The payment shall include allocated bonus on such policy.
    5. The payment which is made by the insurance company to the policyholder does not constitute income and is tax-free u/s 10(10D). In other words, if the premium amount does not exceed 10% or 15% or 20% of the actual sum assured, as the case may be based on the period in which the policy is issued. It also covers a policy which is issued prior to 01.04.2003.
    6. TDS on a payment made under a life insurance policy shall not apply in case of death of the policyholder since such payments are always tax-free u/s 10(10D).
    7. Even if the payment from a life insurance policy is otherwise taxable, but no income-tax will be deducted if the payment(s) made to the policyholder in a financial year does not exceed Rs. 1,00,000 in aggregate.
    The objective of introducing the TDS on a life insurance policy was to devise a mechanism to report the income to the income tax authority. The Memorandum Explaining The Provisions in The Finance (No. 2) Bill, 2014 explained the rationale of introducing the TDS on non-exempt payments made under a life insurance policy, as mentioned below-

    "Under the existing provisions of section 10(10D) of the Act, any sum received under a life insurance policy, including the sum allocated by way of bonus on such policy is exempt subject to fulfillment of conditions specified under the said section. Therefore, the sum received under a life insurance policy which does not fulfill the conditions specified under section 10(10D) are taxable under the provisions of the Act. 

    In order to have a mechanism for reporting of transactions and collection of tax in respect of sum paid under life insurance policies which are not exempted under section 10(10D) of the Act, it is proposed to insert a new section in the Act to provide for deduction of tax at the rate of 2 percent. on sum paid under a life insurance policy, including the sum allocated by way of bonus, which are not exempt under section 10(10D) of the Act. In order to reduce the compliance burden on the small tax payers, it has also been proposed that no deduction under this provision shall be made if the aggregate sum paid in a financial year to an assessee is less than Rs.1,00,000/-. 

    This amendment will take effect from 1st October 2014."

    Many people were not including the payment received under a life insurance policy even though it is taxable and does not enjoy the tax-exempt status, either deliberately or unknowingly that such receipts are taxable. Thus, the rate of TDS was kept at 1%. When the provision was introduced, the 2% rate of TDS was proposed but reduced to 1% by the Finance Act, 2016. 

    The prescribed rate of 1% shall apply where the policyholder possesses PAN. In case the policyholder fails to furnish the PAN then, by virtue of Section 206AA, the higher rate of TDS of 20% shall apply. That is, if the policyholder does not have PAN, income-tax will be deducted @ 20% on the payment made by the insurance company under a life insurance policy.

    Further, small policyholders, where that payment under a life insurance policy does not exceed Rs. 1 lakh in aggregate are excluded from the applicability of TDS even though such payments are taxable.

    Till now we have discussed the applicability of Income Tax on maturity proceeds from a Life Insurance Policy. after determining the tax incidence on such receipts, it is now pertinent to discuss how much of the proceeds are taxable as income and under which head of income.

    Income element in maturity proceeds from a Life Insurance Policy

    There is no anonymity or uniformity or consensus as to what shall be the amount of income in the proceeds received under a life insurance policy. 

    According to some experts, the entire or whole amount of proceeds is taxable. No deduction for premium paid shall be allowed. The logic behind the contention is that the premiums for a life insurance policy are paid for hedging the risk of loss of life and are not contributed or deposited for any return. If the insured dies in the policy period, the entire sum assured is paid by the insurance company. So premiums are equal to investment amount or principal amount.

    Some experts believe that only the surplus of proceeds under a life insurance policy, after deducting all the premiums paid from the maturity proceeds, constitutes income and thus only the surplus of maturity proceeds over the premium paid is taxable. Their logic is simple that it is like an investment where premiums paid is the principal amount.

    There is one more section of experts who believe that a life insurance policy is a capital asset and the premiums paid for such a policy constitutes 'cost of acquisition' and thus surplus is computed as per provisions related to 'Capital Gains'.

    Heads of Income for maturity proceeds from a Life Insurance Policy

    It is worthy to note that income tax law nowhere mentions under which head of income the proceeds received under a life insurance policy be taxed. It is a thumb rule of income-tax law that when a particular income does not fall in any head of income, it is taxed under the residual head 'Income from Other Sources'. However, where a life insurance policy is treated as a capital asset, then income shall be chargeable under the head 'Capital Gains'.

    To find out the element or quantum of income in the insurance proceeds of a life insurance policy and the head of income under which it will be taxed, it is imperative to refer to CBDT Circular No. 07/2003 dated 05.09.20003 which was issued after the enactment of Finance Act, 2003, which introduced the taxability on receipts of a life insurance policy for the first time, was passed.

    Para 10.3 of the said circular states that the insurance policies with high premium and minimum risk covers are similar to deposits or bonds. With a view to ensure that such insurance policies are treated at par with other investment schemes, necessary amendments have been made to section 10(10D).

    The circular has referred the objectives behind the amendment of making the proceeds from that life insurance policy either on maturity or surrender or otherwise but not on the death of the insured, whose premium is more than 20 percent of the sum assured. The board has recognized those policies as 'investment' similar to deposits or bonds. As we know, in case of deposits like Fixed Deposits, only the interest amount is taxable under the head 'Income from other sources'. Though in some particular cases, it may be taxed as 'Business Income'. The principal amount is not taxed as it is not income. the maturity amount in excess of the deposit of principal amount is considered as income in the form of interest. Similar is the case of a Recurring Deposit with a bank where the principal amount is deposited periodically and on maturity, at the end of the term, the Recurring Deposit is paid with interest and only the interest amount is subject to tax.

    Similar objectives of making such policies taxable are also set out in the Memorandum explaining the Finance Bill, 2003. Thus the intention of the lawmakers to bring those policies whose premium is more than 20 percent ( or 10 percent or 15 percent) of sum assured is because such insurance policies are akin to investment. They are considered as investment products rather than insurance products where the premium is high but risk coverage is minimum.

    The fact that on the death of the policyholder entire Sum Assured with bonus is paid to the nominee of the insured does not absolve such policies from being treated as investment products under insurance parlance. It remains insurance even for maturity or redemption, though they are treated as 'investment' products under the income-tax laws. The law has distinguished and recognized that a life insurance policy payable on maturity and a life insurance policy payable on the death of the insured are two separate, distinct and independent events.

    In investments, only the interest amount or the excess of maturity amount over the principal amount is taxed as income as 'interest' under the head 'Income from other sources'. If we go by this contention, then the entire amount of maturity proceeds of such investment-oriented life insurance policies shall not be chargeable to tax. One has to deduct the premiums paid from the maturity proceeds under a life insurance policy and the surplus shall bear the burden of the tax.

    In some cases, especially in case of surrender of a life insurance policy before the tenure or term, which is similar to pre-mature a fixed deposit with a bank, it may so happen that the proceeds from a policy are less than the amount of premium paid. In such a case, nothing will be taxable as amount received on surrender of the life insurance policy is less than the principal amount or amount of investment. The entire proceeds constitute a recovery of partial principal amount and no income element is embedded there. However, if the surrender proceeds include allocated bonus, then the proceeds need to be segregated and the surrender proceeds to the extent attributed towards allocated bonus shall be exigible to tax.

    Please note that under the head of income 'Income from Other Sources' there cannot be any loss and the amount of any loss shall be ignored.

    Can a life insurance policy be regarded as a capital asset for taxability under the head 'Capital Gains'?

    Tax on maturity proceeds from a Life Insurance Policy

    We have seen that where a life insurance policy is issued prior to 2003, the entire proceeds from such life insurance policies are exempt from tax. The exemption contained in section 10(10D) has since been curtailed to excluded certain types of policies where the premium in any year exceeds the specified percentage of sum assured under the policy.

    Merely because the exemption provision provides an exemption for whole proceeds of life insurance policy other than the proceeds of the excluded types, it does not mean that the entire proceeds of the excluded policies are taxable.

    The definition of income specifically includes only proceeds of keyman insurance policies. The heads of income like 'Income from Salary', 'Income from Business or Profession' and 'Income from Other Sources' have explicit provisions to tax or compute the income from the proceeds of a keyman insurance policy. No provision relating to any head of income specifically refers to any other life insurance policies. The only reference to taxability of such amount is found in as an exception to the exemption provision contained in section 10(10D) which again does not refer to the manner in which such proceeds will be taxed.

    Unfortunately, the tax laws do not explicitly provide for the manner of taxation of maturity proceeds of such life insurance policies, though they exclude such policies from the exemption.

    The issue is whether an insurance policy is a capital asset so as to compute the income from exemption excluded policies under the head 'Capital Gains'.

    It is already held that where the premium exceeds a specified percentage of sum assured of a life insurance policy is an investment product. But a life insurance policy also carries a right, a right to receive a contracted amount from the insurer on the happening of certain event or events or on specified or contracted date or dates. A life insurance policy or the right can also be assigned. This feature of embedded 'rights' makes a life insurance policy capital asset. When a life insurance policy gets matured or is surrendered his 'right' gets extinguished. In other words, the policyholder has extinguished his rights under those circumstances. Extinguishment of right is considered as a transfer under the income tax laws and for the purpose of capital gains. Therefore, proceeds received on maturity or surrender of a life insurance policy amounts to transfer. The underlying concept of insurance is that an insurance policy is a contract which gives an assignable right to the insured.

    The life insurance policy would be a long term capital asset if held for more than 36 months from the date of commencement of the policy. The premiums paid during the policy period are the 'Cost of acquisition'. Though, many are of the views that initial or first premium is the 'Cost of acquisition' and subsequent premiums are 'Cost of improvement'. In the case of long term capital assets, the resultant capital gain is 'Long term capital gain' and the benefit of indexation is available for both the cost of acquisition and cost of improvement.

    When the amount is received periodically under the policy and as per terms of the contract, proportionate cost of acquisition or cost of improvement has to be computed for partial receipt of amount or proceeds from a life insurance policy.

    Conclusion

    The law is very clear that if the premium payable on a life insurance policy exceeds the specified percentage of the actual capital sum assured, the payment of proceeds received from the life insurer under a life insurance policy is subject to tax and taxable since the exemption provision does apply to those life insurance policies.

    Further, it is also wrong to recommend that the entire payment of proceeds received from the life insurer under a life insurance policy is fully taxable. This proposition goes against the intention of the law.


    Update:

    Amendment after Union Budget 2019

    Read the important amendment in Union Budget 2019 on the topic:

    Tax on Income from Life Insurance Policy Clarified in Union Budget 2019

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    3 Comments

    1. I too of the view that entire payment from a LIP cannot be taxed fully. Only the surplus above premium paid can be treated as income.
      Well covered the topic

      ReplyDelete
    2. I would like to thank you for the efforts you have made in writing this article. I am hoping the same best work from you in the future as well. Thanks... Life Insurance

      ReplyDelete