When the budget for 2006 was presented and passed, people in life insurance industry heaved a sigh of relief that there was no announcement about taxing the claim proceeds of life insurance policies (as well as PPF, etc allowed for deduction u/s 80C) according to the principle of EET (Exempt, Exempt, and Tax) evolved in the last budget, even though the EET committee appointed also is understood to have submitted a report in favor of taxing life insurance proceeds! But the relief is short-lived! The FM came out with a statement that it has been only held back temporarily and it will be introduced in due course. It is said that at any time the decision can be implemented with an announcement by the government by way of a notification. This article traces the history behind the position of not taxing the life insurance claims and justifies the continuation of the status quo. Savings through life insurance for a rainy day or the protection of the family in case of death of the breadwinner has been a traditional method used by many prudent persons all over the world. Considering the protection aspect, there is no substitute for life insurance as it creates an instant estate and gives the family what the breadwinner wanted to save for the family rather than what he has saved, in case death overtakes his saving program. This prudence on the part of the individual has always been recognized by way of tax concessions everywhere. In our country also such tax sops have been provided in the Income-tax, for various valid reasons. Life insurance people used to borrow the words of Benjamin Franklin to highlight the tax benefits and life insurance: In this world nothing is certain but death and taxes Benjamin Franklin immortalized these words in a letter written to Jean-Baptise Leroy on 13th Nov 1789. Only a life insurance salesman can give a fitting rejoinder! He only can confidently say that his product, – life insurance alone can help both at the same time and nothing else. (Now he will have to add, of course, subject to tax)  Yes, life insurance mitigates the problems of death in the family and life insurance premiums as well as the claim amount bestow a host of advantages to the taxpayer and thus mitigates the harsh incidence of taxes as a reward for prudence. In almost all countries, some kind of a concession or relief is given for life insurance in income tax and other direct taxes like Death Duty, etc. The relief is given either at the front end, that is, at the time of paying the premium or at the rear end, that is, at the time when the claim money is received. Some sort of a rear-end concession is given in almost all countries, whereas the front-end concession is granted mainly in the emerging Asian countries. In our country, both front end and rear end concessions are given to life insurance. The front end, in the form of deductions from the taxable income under the section 80C, (the first E) The accumulations are not taxed (the second E) and the returns are tax-free u/s 10 (10D) with some minor restrictions, as the rear end concession (as the third E) and this is now proposed to be taxed making it EET and not EEE! Thanks to the EET principle evolved in the budget 2005, this may become history. The lives assured or if he is not alive, even the claimants, now will have to pay tax on life insurance claims if the government to have uniform norms to implement the EET decides to tax returns on life insurance!

The gist of the current tax-free life returns on insurance 

The rear-end concessions under Income tax as on date are very simple. When the claim is paid on the death of the policyholder no tax is payable by the beneficiary. Till recently, even the maturity claim paid to the policyholder on the completion of the policy period was tax-free, subject to the exception of a certain special type of policy. Now, the claim on maturity is tax-free only on long-term policies and very short-term, premium rich and single premium policies are taxable at maturity stage. Thus, EET is partially applicable to life insurance already. However, as such policies are very few, we can take it that by and large maturity claim of life insurance policies are also tax-free. Under the Wealth-tax life, insurance monies are taxed. There is no wealth tax on a policy that has not become a claim by maturity. But the moment it is due for payment, the policy value is added to the wealth of an assessee and taxed @1% along with other taxable wealth.

The history of the tax-free life insurance claims

When there is a move to tax the life insurance returns under the new EET we should learn the history behind the tax-free treatment of life insurance claims and understand the issues in the proper perspective: The amount of death claim received is always tax-free for income tax and as Estate Duty has been abolished long back, there is no estate duty liability also. Money received as maturity from a life insurance policy was always taken as a return of the capital and therefore, held as not taxable. In fact, in the first comprehensive Income Tax Act 1922, there was a specific section 4(3)(v) which said that life insurance proceeds received on completion of the contracts were not taxable as it was a return of capital. In 1937 a decision given in a case by the Privy Council clarified that the sum received in payment of a life insurance policy is ordinarily of the nature of capital and is exempt from income tax. Given this Privy Council verdict this section in the Income Tax 1922 mentioned earlier was perhaps considered as superfluous and was not carried over to the current Income Tax Act 1961 when it was enacted! Only because of some misunderstanding of the position in the income tax circles, the present section 10(10D) was introduced in 1991! In the budget presented on 24-7-1991, Dr. Manmohan Singh, the then Finance Minister, added a new section viz., Section 10(10D) to the Income-tax Act under the incomes exempted from tax clarifying that the bonus received on maturity of a life insurance policy was free from income tax. In the explanatory note given in the budget document, it was stated,  payments received under a life insurance policy are treated as incomes not taxable. However, in a recent judicial pronouncement, a distinction has been made between the sums assured under an insurance policy and further sums allotted by way of bonus under a life policy with profits. The sum of the bonus has been held to be chargeable to income tax in the year in which the bonus was declared by LIC. Since such bonus has always been considered as payment under an insurance policy, section 10 of the Income Tax has been amended to exempt from Income Tax, the bonus declared or paid under a life insurance policy by LIC. The amendment was retrospectively made effective from 1-4-1962! It is said that in certain Income Tax Circles, before 1962, if the assessee received a maturity claim in the previous year the bonuses were taxed based on the judicial pronouncement! This anomaly could be set right only with a suitable retrospective amendment effective for about 30 years backward!! It is clear from the above, that the sum assured was always treated as tax-free and only for the bonus there was some doubt and that was rectified by the amendment. This is the interesting piece of history of the birth of section 10 (10D)! The claim either by death or maturity in a Key Man insurance policy taken by the firm on the life its key man was treated as income to the company in the year of receipt as it was taken for the benefit of the firm to recoup the financial loss arising out of the death of the key man and also because the premiums were allowed as a business expense under section 37(1). This was based on a clarification received by LIC from the CBDT in 1963. When the specific retrospective amendment came treating the maturity and death claims including bonuses as tax-free under section 10(10D) confusion arose in the business circles and the amendment was taken as applicable to the proceeds of key man insurance policies also by some CAs and tax consultants! Further amendments like clarifications were passed to say that Keyman insurance policy claim amount would be taxable in the hands of the company notwithstanding the new section 10(10D) The companies were assigning the key man policy to the key man himself as a gift and this practice was not approved by CBDT and a clarifying amendment was passed with effect from 1-10-1996 stating that the surrender value of such policies assigned to the key man will be treated as taxable income in the hands of the company in the year of such transfer by assignment by amending the charging section 28(vi) and also again, as taxable income in the hands of the key man when the policy is assigned to him to the same extent of surrender value and the relevant section 17(3) was also amended to include this kind of income. A CBDT circular No. 762/4 dated 18-2-1998 elaborating the amended provisions was also issued making it effective from 1-10-1996. LIC issues a policy called Jeevan Adhar to provide pension income to the disabled dependent maintained by an assessee by depositing the amount of Rs 40,000 allowed under section 80DD (now increased to Rs 50,000/75,000) However, when the disabled dependent died before the assessee, the whole efforts to make the provision becomes futile. The policy in that event will return all the premiums to the assessee. This return of the amount was not treated as a tax-free insurance payment under section 10(10D). This was also clarified by another amendment to section 10(10D) Another very interesting and historic amendment was made to the same section in the Finance Act 2003. In the recent past LIC, SBI Life and some other companies started issuing short-term high premium insurance policies with risk cover and return of the money with a handsome accumulated interest on survival. As these policies covered risk also during the short term, the return of the money at the point of maturity with accumulated guaranteed additions was taken as tax-free income under the existing section 10(10D). These high premium minimum risk cover policies were in fact, similar to the bank deposits or bonds. The Finance Act 2003 brought an amendment to section 10(10D) to rationalize the tax concessions to provide that the exemption available under the section will not be allowed to on any sum received under an insurance policy in respect of which the premium paid in any of the years* during the term of the policy exceeds 20% of the actual capital sum assured. However, any sum received under such policies on the death of the person shall continue to be exempt The idea was to bring such high premium and short-term insurance policies on par with bonds and deposits on taxing the returns. It was also clarified that the value of any premium to be returned or any benefit by way of bonus or otherwise, over and above the sum assured, which is to be or received under the policy by any person, shall not be taken into account to calculate the actual capital sum assured under this clause , In other words, the premium should not exceed 20% of the face value of the sum assured. A corresponding provision was also added under section 88 (now 80C) to provide that the deduction in respect of the sums paid or deposited as premium under any insurance policy shall be available only on so much of the premium or other payment made on an insurance policy other than a contract of a deferred annuity, as is not more than 20% of the actual sum assured This provision has been carried over to the new 80C also. Even though the amendment proposed to tax all such maturity claims falling due for payment after 1-4-2003, on the appeals and pleas made by the industry, when the budget was passed it was made applicable only to policies bought after 1-4-2003. * This means, if for any reason the premium is varied in any year during the term of the policy, as it often happens while topping up of the premiums in a Unit-linked policy, the entire proceeds will be taxed on maturity.

Already there is some confusion about the amount to be taxed

The amendment made to section 10(10D) in 2003 has bracketed maturity claim proceeds of life insurance policies where the premium payable exceeds 20% of the face value along with Keyman policy and Jeevan Adhar policy proceeds which are fully taxable! What is to be taxed is perhaps, only accruals to the life insurance policy and not the entire sum assured and the bonus. The wordings of the amendment seem to suggest that the whole claim amount is to be taxed. From the background of the introduction of section 10(10D) in 1991 and the expressed intention in the budget documents of 2003 to bring the taxable position of a short term high premium policy on par with the fixed deposits and bonds, only additions to the life policy over and above the premium invested has to be taxed and not the whole claim proceeds which include a large portion of the return of the capital. The correct amount to be taxed will be the difference between the premiums paid and the maturity amount received irrespective of the fact whether it is a with or without profit policy. If the bonus only is taxed it will exclude without profit policies from the purview. This is the basis adopted in other countries (for example the USA) to tax life insurance proceeds. The above interpretation is not evident from a mere reading of the amended section 10(10D) and therefore a clarification in the form of an amendment or CBDT circular is found essential and the new element of EET has further complicated the issue.

The last question! Is it fair to tax returns on life insurance?

From the history of the tax treatment of life insurance narrated above it is clear that taxing life insurance proceeds is against the basic tenets of taxation adopted in our country. When the IT department taxed the bonus part of policy monies it was found to be wrong and the amendment was made with retrospective effect putting the clock back by about three decades to rectify the wrongdoing by the honorable PM who was our FM in 1991! The retrospective amendment made it applicable from the effective date on which the Income Tax Act 1961 came into force. Now the same government wants to go back on the principles! The further amendments made to tax Keyman insurance or Jeevan Adhar were for the sake of clarification, and the one made in 2003 was to prevent the misuse of the tax-free position. At no time the basic principle has been altered. The EET, if implemented will alter the very fabric. Life insurance claim represents the hard-earned money of the individuals set apart over long years, for the specific purposes of money milestones like marriage, education, or one’s old age. To pay, for example, a 30% tax on that will defeat the purpose of the long term saving. To say that this is global practice is not relevant. In those countries, there are excellent social security schemes in place. In our country life insurance is a voluntary self “made provision for the security for old age or the dependents and government cannot provide the social security worth it for the precise reason that the front and rear end tax concessions were given.

In my opinion, if EET taxes life insurance monies it will be taxing for the third time in the long process! Let me explain:

When someone starts putting his hard-earned money in life insurance he first taxes himself as he forgoes certain current expenses or pleasures which he has to sacrifice to provide for the long-term saving for the family through life insurance. When he receives the money it is already taxed by the government through inflation for the second time! Even at 5% inflation, the value of one rupee at the end of 20 years will be just 38 paise. At 6% inflation, it will be 31 paise! People knowingly invest in insurance taking the risk to their purchasing power due to inflation as something is better than nothing in the circumstances. There is no indexation like long term capital gains When the EET imposes a tax on the claim it will be for the third time. It will knock off from the old men and the widows, perhaps 30% in many cases. Many who are not taxable for incomes below the threshold limit will become taxable at the maximum rate by the addition of life insurance maturity payable in that previous year! Many persons who receive claims of maturity may become tax assessee for the first and last time in their lives by receiving insurance claims beyond the threshold limit of Income Tax! The same will be the fate of many widows also!! As already discussed, to arrive at the amount to be taxed from the claim amount received is another issue to be decided in a fairway. Considering all that we have seen is it necessary to tax life insurance money going against the established tenets of taxation, norms of equity and hurting the hard-earned prudent savings of people? The amendment made in 2003 already provides for taxing short-term policies. If 20% is found to be high it can be reduced to 10%, (as it used to be the limit for claiming section 88 as well as old 80C up to 1-4-1965) if a tax-free benefit is to be extended only to long-term life policies. The status quo under Life insurance can be best continued without much loss of revenue or principle. The life insurance industry that taps long-term savings from the public and channelizing it back for socially useful purposes, deserves such special treatment. It will cripple the nascent life insurance industry in our country that is just picking up nicely after the privatization.

A word about PPF

Whatever said above will largely hold good for PPF also. When it was introduced in 1968 the government promised almost the same status of regular PF.  In PPF there is another provision, in addition to the tax-free income. It is, that the creditors or court cannot attach the PPF accumulations. (Life insurance can be attached) Now the government wants to go back on their promises. Now let us keep our fingers crossed and wait for the verdict on the FM based on the EET committee report.

By Mr.C. Ramanathan, Retired Executive Director, LIC, Published in Life Insurance Today, May 2006

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