Do you know what tax evasion is? It is the illegal practice of not paying or underpaying taxes that you owe to the government. Tax evasion can lead to severe consequences, such as fines, penalties, imprisonment or even confiscation of your assets. Tax evasion differs from tax avoidance, which is the legal use of tax laws to reduce tax liability.
One way that people try to avoid taxes is by investing in life insurance policies. Life insurance policies offer tax benefits under section 10(10D) of the Income Tax Act, which exempts the maturity or death proceeds from tax, subject to certain conditions. However, the government has recently amended the income tax rules on taxation of life insurance policy receipts to curb tax evasion and misuse of life insurance policies.
New Income Tax Rules on Life Insurance Policy Receipts
According to the Central Board of Direct Taxes, or CBDT notification dated 5 February 2023, the new income tax rules on taxation of life insurance policy receipts will apply to policies issued on or after 1 April 2023. The notification specifies the conditions and formulas for calculating the taxable income from life insurance policies as follows:
- If the premium paid in any year exceeds 2.5% of the actual capital sum assured, the entire policy proceeds will be taxable as income from other sources.
- Suppose the premium paid in any year does not exceed 2.5% of the actual capital sum assured. In that case, the policy proceeds will be exempt from tax, provided that the policy is not surrendered or terminated before the expiry of five years from the date of issuance.
- The actual capital sum assured is the minimum amount assured under the policy on the death of the life assured at any time during the policy term, without considering any bonus, guaranteed additions or other benefits.
- The taxable income from the policy will be the excess of the total amount received over the total premium paid.
For example, suppose you buy a policy after evaluating it on a life insurance premium calculator on 1 April 2023, with a premium of Rs. 1 lakh per year, a term of 10 years, and an assured coverage of Rs. 20 lakhs. The actual capital sum assured is Rs. 20 lakhs, 20 times the annual premium. Therefore, the premium does not exceed 2.5% of the actual capital sum assured, and the policy is eligible for tax exemption as long as you do not surrender or terminate it before five years.
However, if you surrender the policy after paying four premiums, you will receive Rs. 3.5 lakhs as the surrender value. This amount will be taxable as income from other sources, as the policy was not held for five years. The taxable income will be Rs. 3.5 lakhs minus Rs. 4 lakhs (the total premium paid) is Rs. -0.5 lakhs. Since the taxable income is negative, you will not have to pay any tax on it.
Penalty for Evasion of Tax in Life Insurance
If you evade tax by misreporting or underreporting your income from life insurance policies, you will be liable to pay a penalty under section 271AAC of the Income Tax Act. This section was introduced by the Finance Act 2023 to deter tax evasion and black money generation through life insurance policies. The penalty under this section is as follows:
- The assessment officer will levy the penalty in addition to the tax payable on the underreported or misreported income.
- The penalty will be a minimum of 50% and a maximum of 200% of the tax payable on the underreported or misreported income.
- The assessment officer will consider various factors, such as the nature and extent of underreporting or misreporting, the taxpayer’s previous record, the case’s circumstances and any other relevant factor while deciding the quantum of penalty.
Impact of the New Rules and Penalties on the Life Insurance Industry and the Policyholders
- The amendment will prevent tax evasion and misuse of life insurance policies by high net worth individuals, who buy policies with low sum assured and high premiums to claim tax exemption and launder black money.
- The amendment will encourage policyholders to buy policies with adequate sum assured and reasonable premiums to meet their long-term financial goals and protection needs rather than for tax-saving purposes only.
- The amendment will promote transparency and compliance in the life insurance sector and enhance the trust and confidence of the policyholders and the regulators
- The amendment will reduce the attractiveness and competitiveness of life insurance products, especially compared to other tax-saving instruments, such as mutual funds, public provident funds, national savings certificates, etc.
- The amendment will affect the profitability and growth of the life insurance industry, as it may lead to lower demand and higher surrender of policies, resulting in lower premium income and higher claim outgo.
The amendment has both positive and negative implications for the life insurance industry and the policyholders. Therefore, the policyholders need to understand the new rules and penalties and choose the right life insurance policy based on their financial goals and risk appetite. It is also important for policyholders to pay their taxes honestly and promptly and avoid any penalty or prosecution for tax evasion.