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ULIP taxation: Limited clarity on key aspects after Budget announcement

Tax experts differ over the implications of early ULIP surrenders, debt fund options

February 11, 2021 / 10:15 AM IST

More than a week after the Union Budget 2021 announcements, Unit-linked insurance policies (ULIPs) continue to be under the spotlight. This is because ULIPs with annual premiums of over Rs 2.5 lakh will not hold the tax edge over equity mutual funds, starting February 1, 2021.

Any gains made on ULIP investments were, so far, tax-free as section 10(10D) exempts proceeds received under life insurance policies from tax. However, long-term capital gains of over Rs 1 lakh on other equity-oriented investments (shares/ equity mutual funds) in a financial year attract 10 percent LTCG tax since 2018.

What change has Union Budget 2021 brought in for high-value ULIPs?

Now, ULIPs with annual premiums of over Rs 2.5 lakh will not be eligible for the exemption, except when proceeds are handed over to dependents in case of the policyholder’s death. “Exemption under this clause [10(10D)] shall not apply with respect to any ULIP issued on or after the 1st February, 2021, if the amount of premium payable for any of the previous year during the term of the policy exceeds Rs 2.5 lakh,” states the Memorandum to the Finance Bill. ULIPs with premiums under this threshold will continue to enjoy tax benefits at all stages (investment, accumulation and redemption) under the old, with-deductions tax regime.

Due to ULIPs’ product construct and surrender rules – that is, redemption before the end of the original tenure – the amendment has raised questions that necessitate clarifications. The Finance Ministry and Central Board of Direct Taxes (CBDT) could come up with details of computation of gains and taxes soon.

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How will the holding period be computed?

First, let’s understand the ULIP surrender structure. They come with a lock-in period of five years; so, even if you discontinue the policy in, say, year two, you will not be able to get your hands on the money immediately. Your accumulated fund value will be moved into a discontinued policy fund and earn a fixed return (4 percent currently) until the expiry of the lock-in. “When you surrender before five years, the money does not reach you, but passes on to the discontinued policy fund. It will be made available at the end of five years. Therefore, the holding period will be five years,” says Vighnesh Shahane, MD and CEO, Ageas Federal Life Insurance.

Note that the holding period determines whether the gains made will attract LTCG or STCG tax. Equity-oriented investments are treated as short-term assets if the holding period is less than one year, attracting 15 percent STCG tax. If held for over 12 months, these are treated as long-term investments – a 10 percent tax kicks in for gains over Rs 1 lakh in a financial year. In the case of debt fund units held for over three years, the gains made will be subject to 20 percent LTCG tax with indexation.

So, if I surrender within a year, will I have to pay LTCG or STCG tax?

The Union Budget has proposed new section 45(1B), which specifies that tax will come into the picture in the year you receive the proceeds. “As per the proposed new section 45(1B), the taxability would arise in the year of receipt of the proceeds, and not in the year of surrender of the policy. Since the policy doesn’t really end or get terminated at the time of surrender, and that the payment is made to the policyholder after five years, in my view, the taxpayers can claim it to be a long-term capital asset,” says Vaibhav Sankla, Principal, Billion Basecamp Family Office.

But, the memorandum to the Finance Bill does make a mention of section 111A, which pertains to short-term capital gains tax on equity-oriented capital assets. provisions of section 111A and 112A would apply on sale/redemption of such ULIPs,” the memorandum states referring to ULIPs with premiums of over Rs 2.5 lakh. This, therefore, calls for clarification. “It is not clear whether the gain till the time of discontinuance of the policy and post transfer to discontinued policy fund will be treated separately or the entire gain till will be taxed at the final withdrawal (after five years). The gain will be taxable as the income of the financial year in which it is withdrawn, but to determine whether it will be taxable as STCG or LTCG, we may have to wait for the corresponding rules to be framed by CBDT,” says Chetan Chandak, Director, TaxBirbal.in, a tax consultancy firm.
Preeti Kulkarni
first published: Feb 11, 2021 10:15 am

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