The tax exemption which ULIPs have been getting so far was taken away in Budget 2021, which made any gain from ULIPs, where annual premium above Rs 2.5 lakh, taxable. However, there were many factors which needed clarity as how the taxation would work in various scenarios which were unique to ULIPs.
Here is a look at the amendment regarding taxation of ULIPs:
“In section 112A of the Income-tax Act, in the Explanation, in clause (a),—
(i) in the opening portion, after the word and figures “section 10”, the words, brackets, figures and letter “or under a scheme of an insurance company comprising unit linked insurance policies to which exemption under clause (10D) of the said section does not apply on account of the applicability of the fourth and fifth proviso thereof” shall be inserted;
(ii) after the proviso, the following proviso shall be inserted, namely:—
“Provided further that in case of a scheme of an insurance company comprising unit linked insurance policies to which exemption under clause (10D) of section 10 does not apply on account of the applicability of the fourth and fifth proviso thereof, the minimum requirement of ninety per cent. or sixty-five per cent., as the case may be, is required to be satisfied throughout the term of such insurance policy.”
Unlike in a mutual fund (MF) scheme, ULIP investors get the option to invest in several funds with varying degrees of exposure to equity and debt, under the same ULIP. While introducing the new ULIP taxation in Budget 2021, the Finance Bill, however, did not give details about taxability of ULIPs in various scenarios such as tax treatment of investment into different funds in same the ULIP, and what happens during switching from one type of fund to another under same ULIP.
The latest amendment announced by the government is an attempt to remove such ambiguities. The proposals announced in Budget 2021, including the one on ULIP taxation, will come into effect from April 1, 2021.
Here is a closer look at the implications of the amendment on taxation of ULIP investments.
How the taxation will work
Any return on the ULIP investment, where the annual premium is up to Rs 2.5 lakh a year, will continue to be exempted from tax. However, if the annual investment goes beyond Rs 2.5 lakh, as per the new amendment, the investor needs to identify the nature of funds to ascertain its taxability.
“ULIPs will face taxation similar to that of equity mutual funds when they have at least 65% of their assets in equity where directly investing in stocks or at least 90% of their assets in equity where indirectly investing in equity,” said Archit Gupta, Founder and CEO, ClearTax.
What this means is that the nature of the ULIP fund where your investment goes above Rs 2.5 lakh will determine its tax treatment. If the fund invests directly in stocks and if overall equity investment is more than 65%, it will be treated as an equity MF for tax purpose. However, if the fund invests indirectly into equities say through exchange-traded funds (ETF) or other equity mutual funds, it will need to have 90% of its investment in such funds to be eligible for equity MF taxation.
“Profits and gains arising from the Units of Equity Oriented Funds shall be taxable under Section 112A. Such gains in excess of Rs 100,000 shall be taxable at the rate of 10% without indexation,” said CA Naveen Wadhwa, DGM, Taxmann.com. The minimum holding period will also be similar to equity MF, which is one year to be eligible for long-term capital gains (LTCG) tax.
However, in case the ULIP fund does not meet the equity MF criteria, the taxation will work like debt mutual funds. “Profits and gains from the units of non-equity funds (debt-based, money market, etc.) shall be taxable under Section 112 at the rate of 20% with indexation,” explained Wadhwa. As the non-equity investment portion will be considered as debt investment, the minimum holding period will have to 3 years in order for it to eligible for LTCG tax.
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ULIPs with over Rs 2.5 lakh annual premium to lose their tax-edge over equity MFs
Fund switches may be restricted with minimum holding period
At present, most ULIPs offer several free switches from one fund to another and even from a debt fund to equity fund and vice versa. However, after the amendment, where taxability has to be ascertained, the unrestricted free switching facility may no longer be available. “These conditions must be mentioned as terms of the ULIP, which means ULIPs may not be able to offer ‘the switch’ they could earlier,” said Gupta.
ULIPs would be required to meet some minimum holding period criteria to ascertain the eligibility of the investment for long term or short-term capital gains. “Such ULIPs would also be required to meet some minimum holding period criteria. And tax rates depend upon their holding period, i.e., they are chargeable to tax at slab rate if held for a period of less than 3 years and at the rate of 20% with indexation if held for a period of 3 years or more,” explained Kapil Rana, Founder & Chairman, HostBooks, a tax compliance solution provider.
There is another view regarding the determination of the holding period to ascertain the long-term or short-term gains. “The taxability under Section 112A or Section 112 shall be determined on basis of units held at the time of maturity. If units are switched from equity-oriented funds to other funds but are switched back to equity-oriented funds before the maturity, the entire gains shall be taxable under Section 112A,” says Wadhwa.
Death benefit to remain tax free
As earlier, irrespective of the annual premium amount the amount received by the beneficiary as death benefit will continue to remain tax free. “The amount received on the death of a person by the nominee will be still remain exempt from tax under section 10(10D) without any cap on the amount of premium” confirmed Rana.
Also Read:
Should you still invest in ULIPs despite Budget 2021’s new tax?
Further clarity needed on ULIP taxation
Despite the amendment, there is more clarity needed regarding the taxation of the high premium ULIPs. Here are two such ambiguities that needs clarity.
1) To be eligible for tax free maturity amount there is a condition that the annual premium during the entire period of investment should not go beyond 10% of the sum assured. What if this condition is not met?
“We need clarity on how the maturity proceeds of ULIPs/Insurance policies shall be taxable if no exemption is provided under Section 10(10D) due to reason of payment of excessive premium (more than 10% of the sum assured)?” Wadhwa said.
2) The overall tenure of ULIP may be long but what if there are number of switches within a short span of time from one fund to another fund within the same ULIP. Will it be exempted from tax? “It should be as the taxability will eventually arise at the time of maturity on the total gains and profits,” added Wadhwa.
