Taxation of Life Insurance Policies | Section 10(10D)

Table of Contents

1. Concept and Types of Life Insurance

2. Current Tax Provisions

3. Proposed Amendment

4. Analysis of Amendments Proposed in Section 10(10D)

5. Overview of Tax on Various Life Insurance Policies

Check out Taxmann's Budget Guide | 2023-24 which is a comprehensive commentary on proposed provisions of Finance Bill 2023, authored by Taxmann's Editorial Board. It covers provisions relating to Direct Tax Laws, Indirect Tax Laws and Corporate & Allied Laws. It explains all complex provisions through examples/illustrations, which helps the reader comprehend the new provisions in a simplified manner.

1. Concept and Types of Life Insurance

Life insurance is a valuable financial agreement between an individual and an insurance company that offers death benefits to the beneficiaries of the policyholder in the event of his death. Beyond death coverage, life insurance policies also serve as savings instruments, providing financial security and stability to policyholders and their families. The life insurance industry offers several types of policies that vary based on their features and benefits.

1.1 Term Life Insurance

This life insurance offers coverage for a specific and predetermined term. If the policyholder passes away during the term, the death benefit is paid to the beneficiaries. Term life insurance is a simple and cost-effective option, providing only death benefit protection without any savings or investment components.

1.2 Endowment Policy

This type of life insurance acts as both an insurance and savings instrument. It aims to provide maturity benefits to the policyholder, such as a lump sum payment at the end of the policy term, even if a death claim has not been made. This type of life insurance is best suited for individuals looking for coverage and risk-free returns.

1.3 Unit Linked Insurance Plan (ULIP)

This type of life insurance allows the policyholder to invest the cash value component in various investment options, including stocks and bonds. The death benefit and cash value of the policy are subject to the performance of the investments. ULIP is a complex and risky option compared to other types of life insurance and is typically suitable for experienced investors with a long-term investment horizon.

2. Current Tax Provisions

In terms of taxation, the sum received under a life insurance policy is exempt from tax under Section 10(10D). However, this exemption has been misused in the past by high-net-worth individuals who invest in policies with large premium contributions and claim exemption on the sum received. To prevent the abuse of tax exemptions, several changes have been made to the relevant provisions:

(a) The Finance Act, 2003 introduced a limit on the premium payable for any year during the term of the policy. Where the premium exceeds 20% of the sum insured in any year, no exemption will be granted for the sum received under such insurance policy.

(b) The Finance Act, 2012 further reduced the threshold limit to 10% for policies issued on or after 01-04-2012.

(c) The Finance Act, 2021 introduced a monetary cap on the premium payable in respect of unit-linked insurance policies (ULIPs), disallowing exemption if the premium payable for any year during the term policy exceeds
` 2,50,000.

After the Finance Act, 2021, both the monetary and percentage caps apply to ULIPs. Further, in the Finance Act, 2021, ULIPs were included in the definition of a capital asset, clarifying that income from ULIPs shall be taxable under the head capital gains. However, for other life insurance policies, only the percentage cap remains, and there is no clarity as to under which head the income shall be taxable.

3. Proposed Amendment

In the Union Budget 2023, a monetary limit is proposed on other life insurance policies, and the following provisions have been inserted in Section 10(10D) in this respect:

(a) It is provided that no exemption shall be available in respect of life insurance policies (excluding ULIP) issued on or after 01-04-2023 if the premium payable for any year during the term of policy exceeds ` 5 lakhs [Sixth proviso to Section 10(10D)].

(b) If the premium is payable by a person for more than one life insurance policy, the exemption shall be available only for those life insurance policies (other than ULIPs), where the aggregate amount of premium does not exceed ` 5 lakhs in any of the previous years during the term of any of those policies [Seventh proviso to Section 10(10D)].

(c) The above provisos shall not apply where the sum is received on the death of a person [Eighth proviso to Section 10(10D)].

Further, it is provided that any amount received under life insurance policies (other than ULIPs) shall be taxable under the head of other sources if not exempt under Section 10(10D). The following provisions have been inserted in this respect:

(a) Sum received under life insurance policies shall be treated as income [sub-clause (xviid) of Section 2(24)].

(b) The income from life insurance policies (other than ULIPs) shall be taxable under the head of other sources if not exempt under section 10(10D) [clause (xiii) of Section 56(2)].

(c) Sum received under life insurance policies, in excess of the aggregate of premium paid during the term of policy, shall be treated as income under the head of other sources. The rules shall also be prescribed for the computation of such income [clause (xiii) of Section 56(2)].

(d) Premium for which deduction has been claimed under any provision of the Act (such as Section 80C) shall be ignored while computing the income from life insurance policies under the head of other sources. [clause (xiii) of Section 56(2)]

Considering the amendments proposed in Union Budget 2023, the taxability of life insurance policies (other than ULIPs) can be categorized into the following:

(a) Exemption under Section 10(10D);

(b) Taxability and classification of income (Section 2 and Section 56); and

(c) Deduction under Section 80C.

4. Analysis of Amendments Proposed in Section 10(10D)

4.1 When is an exemption allowed under section 10(10D)?

Section 10(10D) provides for exemption with respect to any sum received under life insurance policy, including the sum allocated by way of bonus on such policy. However, if the premium paid is in excess of the limits prescribed, no exemption will be provided except in case of the death of the policyholder.

4.2 When is exemption not allowed under section 10(10D)?

Exemption under Section 10(10D) is not allowed with respect to any sum received under the life insurance policies in the follow- ing cases:

4.2.1 Excess premium on life insurance policies

If the premium payable for any of the years during the term of the policy exceeds 10% of the actual capital sum assured, then no exemption under this section would be allowed with respect to the sum received under the policy. Such a situation is hereinafter referred to as ‘excess premium life insurance policies’.

4.2.2 High premium life insurance policies

Besides restricting the exemption under Section 10(10D) for payment of excess premium, the Finance Bill, 2023 has proposed to insert the Sixth and Seventh Proviso to Section 10(10D) to provide that no exemption shall be available in respect of life insurance policies issued on or after the 01-04-2023 if the amount of premium payable for any of the previous year during the term of the policy exceeds ` 5 lakhs (‘high premium life insurance policies’).

The Sixth Proviso provides that no exemption shall be available for a policy acquired on or after 01-04-2023 if the premium paid in any year during the tenure of the policy exceeds ` 5 lakhs (single policy). So, where the premium payable for a policy exceeds ` 5 lakhs in any year during its tenure, no exemption under Section 10(10D) will be allowed with respect to such policy.

The Seventh Proviso deals with the situation wherein an assessee holds multiple policies at a given time. The said proviso allows the exemption for all those policies whose aggregate premium in any year during the tenure of such multiple policies is less than ` 5 lakhs. It implies that if the person has acquired more than one policy on or after 01-04-2023, and the premium payable for each of such policies during any year does not exceed ` 5 lakhs but the aggregate of premium payable for all such policies exceeds `5 lakhs in a year, the exemption under this section would be allowed only in respect of those policies whose aggregate premium is within such prescribed limit of ` 5 lakhs. In other words, the exemption shall be allowed only with respect to low premium policies, the aggregate of which is under ` 5 lakhs.

For example, Let us determine whether the exemption is available under Section 10(10D) for a single policy purchased by four dif- ferent persons in the following scenarios.

For example, Let us determine whether the exemption is available under Section 10(10D) for multiple policies purchased by one person on or after 01-04-2023 in the following scenarios.

* Though the last four policies are eligible for exemption under Sec- tion 10(10D) but the exemption can be claimed in respect of only those policies whose aggregate premium during the year does not exceed ` 5 lakhs (i.e., low premium policies). The threshold limit of ‘5 lakhs should be exhausted for those policies first which have a higher yield, as it will, in turn, reduce the ultimate taxable income. If the income from such eligible policies is the same, the investor should consider Policy E, G and H as the aggregate premium of such policies equal to ` 5,00,000. If policy F is included, the limit of ` 5,00,000 cannot be exhausted fully.

4.3 Analysis of amendments proposed in Section 2 and Section 56

4.3.1 Taxability and classification of income

The taxability of the sum received under life insurance policies [if not exempt under section 10(10D)] has always been a disputed matter, whether it would be taxable under the head capital gains or other sources. It is also argued that in the absence of its inclusion within the meaning of ‘income’ under Section 2(24), it should be treated as capital receipts not chargeable to tax.

By making amendments to Section 2(24) and Section 56, the Finance Bill, 2023 has put this controversy to rest. Thus, the sum received from life insurance policies (other than ULIPs and Keyman insurance policy) shall be treated as income if not exempt under section 10(10D) and taxable under the head of ‘other sources’.

As per Section 56, the income from life insurance policies shall be computed as follows. The CBDT may also prescribe the rules for the same.

4.3.2 Impact of claiming deduction in respect of premium

Section 56 provides that if any deduction has been claimed in respect of premium under any other provision of the Act, it shall not be included in the aggregate amount of premium to be deducted for computing the income. The deduction for the premium paid in respect of the life insurance policy is allowed under Section 80C. However, deduction under Section 80C is restricted to 10% of the actual capital sum assured. It means if the person pays an exorbitant premium for an insurance cover, the deduction shall not be allowed for the entire premium. The deduction will be limited to 10% of the sum assured, and any amount of premium paid more than this limit is not deductible under Section 80C.

For example, Mr A has taken a life insurance policy with a sum assured of ` 10 lakhs and has paid a premium of ` 3 lakhs per annum. He can claim a deduction under Section 80C for the premium paid towards the life insurance policy. But the deduction is restricted to 10% of the actual capital sum assured, which is ` 1 lakh (10% of ` 10 lakhs). If he claims a deduction of ` 1 lakh for the premium paid towards the life insurance policy under section 80C, he will be allowed a deduction of the remaining ` 2 lakhs while computing income under Section 56.

For example, Let us determine the amount of income taxable under Section 56 in the following scenarios.

5. Overview of Tax on Various Life Insurance Policies

The new provisions shall apply from the assessment year 2024-25.