Life Insurance is a critical part of an individual's personal insurance portfolio. It's a strategic part of the future security that one must provide for one's family in the face of the inevitable.

The proper type and the appropriate level of life insurance can be a matter of life and death. Securing the long-term financial security and quality of life for the people you love most is crucial, and the first step in securing it is life insurance.

Many individuals also look at life insurance from tax planning perspective.

Position prior to the Finance Act, 2003

It would not be wrong to say that the Life Insurance Corporation has risen to its current stature because of tax concessions given to policyholders.

It is the prospect of substantial reduction in tax that has generally induced individuals and Hindu undivided families to take insurance policies.

While the premium paid went to reduce the annual tax burden by way of tax rebate, the lump sum received when the policy matures was treated as tax-exempt capital receipts.

Any controversy about taxing bonus payments in excess of the maturity value was set at rest when the Finance (No. 2) Act, 1991, inserted Section 10 (10D) in the Income Tax Act, 1961 with retrospective effect from April 1, 1962.

It was laid down that any sum received under a life insurance policy, including the sum allocated by way of bonus on such policy, would be exempt from tax.

Amendment made by the Finance Act, 2003

This established position of exempting maturity proceeds of life insurance policies has been unsettled in this year's Finance Act 2003.

Section 10 (10D) is now substituted by a new section with effect from financial year commencing from April 1, 2003 relating to assessment year 2004-05 so as to deny exemption to any sum received under an insurance policy in respect of certain life insurance policies where premium payable in any of the years during the term of the policy exceeded 20 per cent of the capital sum assured.

Examples of such plans are Bima Nivesh, Jeevan Dhara, Kotak Insurance Bonds and Birla Flex Plan.

The reason for bringing the proceeds of tax insurance policies with high premium and minimum risk cover under the tax bracket is similar to the reason for taxing deposits or bonds. Hence, such policies are to be treated at par with other investment schemes.

It is difficult to understand how a life insurance policy can be compared with the normal deposit or investment in bonds. Moreover, when tax rebate is also denied, levy of tax on maturity of the policy is unjust.

The original amendment in the Finance Bill 2003 was modified to exempt the sum received under an insurance policy issued on or before March 31, 2003 in respect of which the premium payable for any years during the term of the policy exceeds 20 per cent of the actual capital sum assured is taxable.

Further, any sum received under such policy on the death of a person shall continue to be exempt.

The taxability of such insurance policy at the time of maturity or surrendered arises only when the premium payable exceeds 20 per cent of the capital sum assured as per the terms of the policy and not actual premium paid during the year exceeds 20 percent of the capital sum assured.

While calculating the capital sum assured, no account shall be taken of the value of any premium agreed to be returned or any benefit by way of bonus or otherwise over and above the sum actually assured which is to be or may be received to the insurer at the time of maturity.

A question will arise as to the computation of income in respect of the amount received.

Policy is a 'capital asset' within the meaning of section 2(14). On maturity or surrender there will be a 'transfer' and amount received will be treated as a consideration and premium paid will be considered as cost and indexation benefit will be available.

The income so arrived will be taxable as long-term capital gains.

Rebate under section 88

Life insurance policies are also popular as the premium paid is eligible for tax rebate under section 88 at the rate of 20 per cent or 15 per cent of the premium paid during the year, based on the level of total income.

A new sub- clause (2A) has been inserted in section 88 by the Finance Act 2003 to deny rebate on premium exceeding 20 per cent on the sum assured.

This amendment will apply to financial year 2003-04, which relates to assessment year 2004-05.

Earlier section 88(3) restricted the rebate to only so much of premium or other payment made on a policy as was not in excess of 10 per cent of the actual capital sum assured.

This provision was deleted by the Finance Act 1995, with effect from April 1, 1996.

Section 88 itself came into the statute book with effect from April 1, 1991, having been inserted by Finance Act, 1990. section 88 comes in the place of section 80C.

The scope, effect and object of the present section 88 were explained in Circular No. 572 of August 3, 1990. The 10 per cent restriction was removed with effect from April 1, 1996.

The reason for omitting section 88(3) was given in Circular No. 717 of August 14, 1995.

The Central Bureau of Direct Taxes pointed out that the 10 per cent restriction had the effect of discouraging insurance policies of less than 10-year duration.

With a number of insurance policies launched for those in the higher age groups, single premium or premiums limited to a few years are now quite common.

The CBDT felt that it would be unjust to exclude from the benefit of section 88, the higher premium paid generally by older persons for effecting life insurance policy.

It is difficult to understand the rationale for the sudden change in the established position of the law. Now, with the insertion of new sub-section in the Act, the rebate on the premium paid on life insurance policy will be restricted to 20 per cent of the capital sum assured.

Conclusion

An investor who is looking to invest in life insurance policy as a tool of tax planning will have to consider implications of the above mentioned changes in respect of tax on proceeds of insurance policies received at the time of maturity and also where premium exceeds 20 per cent of the sum assured restricting the rebate available under section 88 on the premium paid.

-- by Nitin Shingala & Virendra Jain, chartered accountants.

This article forms a part of Money Simplified - Life insurance. Hear it from the experts, a free-to-download online guide from Personalfn. To download the entire guide, click here.