The Budget 2021 changed the way Unit Linked Insurance Plans (ULIPs) will be taxed. This reduces the difference between the taxation of mutual funds and ULIPs.
Let’s find about how ULIP taxation has changed.
What is the new rule about ULIP taxation?
If you buy a ULIP on or after February 1, 2021 and the aggregate annual premium of such ULIP (ULIPs) exceeds Rs 2.5 lacs in a financial year, the maturity proceeds (or any form of pay-out except death benefit) from such ULIPs will be taxable.
The change is NOT applicable to traditional life insurance plans or term life insurance plans.
- What happens to your ULIPs bought before Feb 1, 2021?
- How will the maturity proceeds be taxed? As income? As capital gains? What kind of capital gains?
- How switches between ULIP funds be accounted for?
In this post, let us try to find answers to the above questions.
Your old policies are not affected by the change in rule. The new rule applies only to policies issued on or after February 1, 2021. Let us consider a few examples.
ULIP Taxation after Budget 2021: A few scenarios
Case 1: You are paying Rs 10 lacs towards the annual ULIP premium. All your policies were purchased before Feb 1, 2021.
Any pay-outs from the policies will continue to be exempt from tax (provided Sum Assured >= 10 times annual premium).
You may continue to pay an annual premium of Rs 10 lacs in the future too. The maturity proceeds shall continue to be exempt from tax.
Case 2: You are paying Rs 10 lacs towards the annual premium for ULIPs issued on or before January 31, 2021. You buy a new ULIP with an annual premium of Rs 1.5 lacs. The new policy is bought after Feb 1, 2021.
All the ULIPs (old and the new one purchased after Feb 1, 2021) shall remain tax-exempt.
The new ULIP is tax-exempt because the aggregate annual premium is less than Rs 1.5 lacs.
Case 3: You are paying Rs 10 lacs towards the annual premium for ULIPs issued on or before January 31, 2021. You buy 2 new ULIPs with an annual premium of Rs 1.5 lacs each (Rs 3 lacs in total). The new policies are bought after Feb 1, 2021.
The pay-out from old ULIPs shall be exempt from tax.
The pay-out from the new ULIPs shall be taxable (since the total premium exceeds Rs 2.5 lacs).
Case 4: You buy the first ULIP policy with an annual premium of Rs 1.5 lacs in FY2022. You buy the second policy with an annual premium of Rs 1.7 lacs in FY2023.
In FY2022, the first policy is not taxable. However, as soon as you buy the second policy, the total premium breaches the limit of Rs 2.5 lacs per annum.
Therefore, from FY2023, any pay-out from both these policies is taxable.
You may stop paying the premium in one of the policies later. However, that will not turn the taxable nature of policies back to tax-exempt. Once taxable, always taxable.
The way provisions are worded, if the aggregate premium for all the ULIPs (issued on or after February 1, 2021) exceeds Rs 2.5 lacs in any of the previous years during the policy term, such ULIP (or ULIPs) become taxable.
Note : In all cases, for both new ULIPs and old ULIPs, the death benefit shall be exempt from tax.
Note: There can be a difference between the way Excess Premium policies (Sum Assured< 10 times annual premium) and HIGH Premium ULIPs (Issued on or after Feb 1, 2021 AND Aggregate annual premium > 2.5 lacs) are taxed.
In this post, we are focussing only on the HIGH Premium policies because Budget 2021 has changed the taxation of only such policies. Excess premium policies were always taxable.
By the way, the regulations do not specify such nomenclature. I have simply borrowed the nomenclature (Excess Premium ULIPs and HIGH Premium ULIPs) from this Taxmann article.
High Premium ULIPs are those ULIPs issued on or after Feb 1, 2021, where the aggregate premium exceeds Rs 2.5 lacs in a financial year. Tax exemption under Section 10(10D) does not apply to HIGH Premium ULIPs. Pay-out from HIGH Premium ULIPs (except Death benefit) is taxable.
In the next section, let us look at the why of the above chart.
Changes to Various Sections of the Income Tax Act
This is important to understand why ULIPs should be taxed in a particular way.
Section 10 (10D) specifies the tax treatment of any sum received under a life insurance policy. Thus, it speaks only about the sums received by a policyholder or the nominee under a life insurance plan. “Sum received” could be in the form of maturity benefit (or survival benefit) or death benefit.
Old Rule: The only time when the pay-out from a life insurance policy is not exempt from tax is when the Sum Assured (Minimum Death Benefit) is less than 10 times the Sum Assured. This rule is applicable to all kinds of life insurance policies, not just ULIPs.
New Rule: In addition to the above rule, HIGH Premium ULIPs are taxable too. Or Tax-exemption under Section 10(10D) does not apply to HIGH Premium ULIPs.
Section 2, among other things, provides the definition of a Capital Asset.
Any ULIP to which the tax exemption under clause 10(D) of Section 10 does not apply shall be considered a Capital asset. (Done by inserting sub-clause (c) in clause 14 of Section 2 of the Income Tax Act).
Thus, HIGH Premium ULIPs become capital asset.
Section 45 speaks about Capital Gains.
Sub-section (1B) has been added to Section 45: For any payment received from High Premium ULIPs (where relief under Section 10(10D) does not apply), the resulting gains/income shall be considered Capital Gains.
Section 111A and Section 112A specify preferential treatment to capital gains arising from the sale of equity investments (provided STT has been paid). Section 111A is about short-term capital gains taxation of equity funds. Section 112A is about long-term capital gains taxation of equity funds.
Section 112A has been amended such that High premium ULIPs (aggregate annual premium > 2.5 lacs) shall be considered “Equity oriented Funds”. Note that there is an additional condition to be satisfied (to be considered an Equity Oriented fund). The ULIP fund must invest at least 65% in stocks of domestic companies. Therefore, capital gains resulting from the sale of ULIP equity funds shall be taxed at 10% without indexation. LTCG on sale of equity funds/stocks up to Rs 1 lacs is exempt from tax. Such relief will be available to ULIP equity funds too. To put it differently, the relief of Rs 1 lac per annum is the aggregate limit available to ULIP equity funds/equity mutual funds/stocks.
Section 111A refers to Section 112A for the definition of “Equity oriented fund”. Therefore, while no change has been made to Section 111A, the change in the definition of Equity oriented fund (to include High Premium ULIPs) in Section 112A automatically means that short term gains on the sale of High Premium ULIPs (sale of High premium ULIP equity funds) shall be taxed at 15%.
Section 98 of the Finance Act (and not Income Tax Act) has been amended to specify that STT of 0.001% shall be applicable on the sale of ULIP equity funds. This is also necessary for beneficial treatment under Section 111A and 112A of the Income Tax Act. Note that this applies only to ULIP equity funds.
STT will be applicable only on sale/surrender/redemption of equity-oriented funds of High Premium ULIPs. STT will NOT be applicable on non-equity-oriented funds of High Premium ULIPs.
High Premium ULIPs are those ULIPs issued on or after Feb 1, 2021, where the aggregate premium exceeds Rs 2.5 lacs in a financial year. Tax exemption under Section 10(10D) does not apply to HIGH Premium ULIPs.
How will ULIP debt funds be taxed?
When you invest in a ULIP, your money does not just get invested in equity funds.
Just like mutual funds, ULIP funds can be of multiple types.
ULIP funds can be equity oriented or non-equity oriented (say debt funds).
If you have invested in a ULIP fund (with at least 65% in the domestic stocks), it shall be considered an equity-oriented fund under Section 112A (provided it is a HIGH Premium ULIP).
Otherwise, it is a non-equity oriented ULIP fund.
Non-equity-oriented ULIP funds shall be also subject to capital gains taxes. Note that Section 2 has been amended to consider HIGH Premium ULIPs as capital assets. And gains/income arising from the sale/redemption of such assets shall be considered capital gain.
Now, since preferential tax treatment is available only to equity-oriented funds, ULIP debt funds (of HIGH Premium ULIPs) shall be taxed like any other capital asset. Such funds shall be taxed as debt mutual funds. Short term gains (holding period <=3 years) shall be taxed at the marginal tax rate. Long term capital gains (holding period > 3 years) shall be taxed at 20% after indexation.
Points to Note
Again, this is applicable only to HIGH Premium ULIPs. High Premium ULIPs are those ULIPs issued on or after Feb 1, 2021, where the aggregate premium exceeds Rs 2.5 lacs in a financial year. For other ULIPs, sale/redemption from ULIP debt funds remains tax-exempt.
Your old policies (bought before Feb 1, 2021) are unaffected.
Moreover, you are not bothered if the aggregate premium of ULIPs purchased after Feb 1, 2021 does not exceed Rs 2.5 lacs in a year.
No tax-free rebalancing for HIGH Premium ULIPs
One of the biggest advantages of ULIPs over mutual funds was that you would easily rebalance your portfolio by switching across ULIP schemes without incurring any tax liability.
Because ULIPs were not considered capital assets.
Mutual funds are capital assets. Thus, rebalancing the portfolio by switching between MF schemes leads to capital gains tax liability.
Big advantage to ULIPs.
Now, this seemingly undue advantage has been withdrawn, at least for HIGH Premium ULIPs (Issued on or after Feb 1, 2021; AND Aggregate premium > 2.5 lacs).
Since HIGH Premium ULIPs are capital assets (after amendment in Section 2 of the Income Tax Act), any sale in any ULIP fund (of HIGH premium ULIP) shall result in capital gains (or losses) as applicable.
And a fund switch is: Sale in one fund followed by purchase in another.
When you are switching funds in a HIGH Premium ULIP, you must sell one fund (capital asset) and buy another. And the sale will give rise to capital gains.
Thus, no tax-free rebalancing for HIGH Premium ULIPs.
Additional Points to Note
- Some of the ULIP charges (mortality charges, policy admin charges, etc) are recovered through redemption/cancellation of ULIP fund units. As I understand, such redemptions for recovery of charges shall give rise to capital gains tax liability too.
- If you are an NRI and have invested in a HIGH Premium ULIP, there may be TDS implications too (not sure of this). This can be extremely messy. TDS can eat into your returns. Just think about this. You switch Rs 100 from a ULIP debt fund to an equity fund, but after adjusting for TDS, only Rs 97 gets invested in an equity fund (just an example). Rs 3 deducted as TDS. Reduces attractiveness of a ULIP fund for an NRI sharply.
- An even bigger problem: The insurance company does not know about your other ULIPs. Therefore, the insurance company may deduct TDS (for an NRI) even though the aggregate premium does not exceed Rs 2.5 lacs (and does not qualify to be a HIGH Premium ULIP). Again, not sure.
Disclaimer: There are many loose ends in the Finance Bill, 2021 with respect to the taxation of ULIP policies. Further clarification is awaited in the matter from the Central Bureau of Direct Taxes (CBDT). I have shared my opinion. My understanding may be incorrect. Please consult your Chartered Accountant before taking any action. I will update this post as better clarity emerges.