Introduction
Insurance industry has been in existence since the
12th century, but the last century has witnessed
widescale adoption among the general masses. With the growth of the
insurance industry, life insurance policies as well as annuities in
the modern-day have come to be developed as highly complex
products, so much so that both products have come to integrate
various overlapping features. Further, the drastic difference in
income-tax treatment of both the instruments requires closer
examination of their meaning to distinguish one from another.
However, there is no guidance as to the meaning of either
‘life insurance policy‘ or
‘annuity‘ in the Income Tax Act, 1961
(‘IT Act‘). In absence of definition in
the IT Act, the meaning propounded by judicial interpretations and
legal dictionaries assumes importance.
Life Insurance Policy
The maxim ‘Nihil certius morte, nihil incertius hora
mortis‘ means that nothing is more certain than death,
nothing more uncertain than the hour of death. This element of
uncertainty results in life insurance policies to be considered as
something more than an ordinary contract. They are treated as
securities for money1 which is bound to be paid at an
uncertain future date, but on a future event which is bound to
occur (apart from the operation of excepted perils).
Bunyon’s Treatise Upon the Law of Life Assurance defines
life insurance ‘to be that in which one party agrees to pay
a given sum upon the happening of a particular event contingent
upon the duration of human life, in consideration of the immediate
payment of a smaller sum or certain equivalent periodical payments
by another.’ This definition has been adopted by various
High Courts subsequently.
Therefore, an LIP has been explained by Courts to mean a
contract where one party agrees to pay a given sum upon the
happening of a particular event contingent upon the duration of
human life, in consideration of the immediate payment of a smaller
sum or certain equivalent periodical payments by another.
Payments received under a contract of insuring life has been
exempted from taxation under the Act by virtue of clause (10D) of
Section 10 of the IT Act. These payments are inclusive of not only
the principal sums but also any bonus that the policy holder might
receive under such life insurance policy2.
Annuity
Section 280B(4) of the IT Act (omitted vide Finance
Act, 1988), defined ‘annuity’ as ‘any annual
instalment of principal and interest…‘. However, under
the current iteration of IT Act, only annuities pursuant to
employment contract are a subject-matter of tax in Section 17.
Other forms of annuities, such as annuities provided to a wife by a
deed of separation, or alimony payable annually under a judicial
decree, annuities purchased under a private contract with a life
insurance company, are not specifically charged to tax. With regard
to these annuities, Privy Council in Maharajkumar Gopal Saran
Narain Singh v. CIT, [1935] 3 ITR 237 (PC) held that
the annuity is ‘income’ falling under the residuary head of
charge, i.e., ‘Income, from other sources’ even when the
annuitant derives no profit or gain.
Halsbury’s Laws of England3 explains annuity as a
yearly payment of a certain sum of money granted to another in fee
for life or for a term of years either payable under a personal
obligation of the grantor or out of property (not consisting
exclusively of land). The right created by an instrument (whether
deed, will, codicil or statute) to receive a definite annual sum of
money is an interest which may be, strictly speaking, either a rent
charge or an annuity.4 To constitute an annuity, the
annuitant must have handed over money or other asset altogether,
converting it into a certain or even an uncertain number of yearly
payments. Annuity requires adventure of capital.5
Therefore, in the ordinary sense of the expression, annuity can
be regarded to be purchase of income by conversion of capital, such
that the capital ceases to exist. The existence of a real existing
capital sum, but representing some kind of capital obligation, has
been held to be a requirement to be considered as an annuity. This
classic definition of an annuity given more than 150 years ago, has
never been departed from.
The next logical question arises whether annuity is merely
return of the capital invested?
Capital repayment – Whether it is also Annuity?
The Court of Appeal in Sothern-Smith v. Clancy
[1940] 24 TC 1 (CA) held that one distinction between an annuity
simplicitor and capital payment is that the latter is in discharge
of a pre-existing debt. However, no simple test can be laid down
for distinction. It placed reliance on older judgments to state
that regard must be had to the true nature of the transaction from
which the annual payment arises and ascertain whether or not it is
the purchase of an annual income in return for the surrender of
capital. Annual payment in the nature of capital payment is not
taxable. But where capital payment is coupled with interest, then
the sum may be dissected, and tax charged only on the portion
representing interest. However, annual payment pursuant to
whole-life annuity cannot be regarded as return of capital plus
interest because the annual payment is calculated on the
grantee’s expectation of life. Here, the annuitant retains no
interest in the capital once it has been paid, i.e., the capital
ceases to have any existence. Further, at the end of the annuity
period, the annuitant may receive sums considerably exceeding the
normal interest earning capacity on that investment.
Simultaneously, the annuity grantor takes the risk of the life
being prolonged beyond a period which will yield a profit to him on
the transaction. This adventure of capital towards purchase of
income is liable to tax in whole.
Where the capital has gone and has ceased to exist, but has been
converted into recurring income, that is an annuity. It therefore
follows that where, in a given transaction, capital is not at
stake, i.e., capital has not been hazarded, and the annual payments
are merely a mode of realising the capital in instalments, there is
no annuity in the real sense of the term.
The Supreme Court in CIT v. Kunwar Trivikram Narain
Singh (1965) 57 ITR 29 (SC) held that the question of
taxability is determined by the real character of the payment, and
not by the nomenclature assigned to it by the parties. When a
capital asset is exchanged for a perpetual annuity, such receipts
are taxable. On the contrary, if the exchange is for a capital sum
payable in installments, receipt of such installments would not be
taxable. The Madhya Pradesh High Court in Parmanandbhai
Patel v. CWT (1989) 177 ITR 339 (MP) further
explained the fine distinction between capital repayments and
annuities. One test is to ascertain whether the principal is gone
forever and is satisfied by periodical payments. In other words,
the question is whether or not it is the purchase of the annual
income in return for the surrender of the capital. If it is
purchase of income, the annual payment is taxable; if it is capital
payment, it is not. Where the property is sold for what is an
annuity in the strict sense of the word, the principal disappears
and the annuity which takes its place is chargeable to tax.
Court of Appeal ruling in IRC v. 36/49 Holdings
Ltd (1942) 25 TC 173 (CA) was approved by the Supreme Court in
National Cement Mines Industries Ltd v. CIT
(1961) 42 ITR 69 (SC) held that annuity is where capital sum is
parted with in consideration of a grant to him of a number of
periodical payments of revenue character. That is, the capital has
gone and has ceased exist. In its place, only a promise to pay has
arisen. The only continuing relation between the annuity and the
vanished capital is that the amount of the vanished capital is
arbitrarily taken to measure the minimum period for which the
annuity is to run. The sums received by the annuitant should not
have any relation to the capital sum paid. At the end of the
payment period of a whole-life annuity, sums received by the
annuitant may considerably exceed the normal interest earned on the
capital invested. Conversely, grantor will have to pay much less,
if the annuitant does not live the expected number of years. Owing
to such uncertainty, a contract of annuity cannot be said to be in
the nature of an investment producing a capital return equivalent
to the capital invested. The financial result may be comparable to
that of a debt. However, it is not permissible to look beyond the
real nature of the transaction and to enquire into its financial
nature, i.e., calculations to segregate the principal from the
interest. The entire instalment is profit and is taxable.
Juxtaposing Life Insurance Contracts vis-à-vis
Annuities
Interestingly, from the perspective of an insurer, Section 2(11)
of the Insurance Act, 1938 defines ‘Life insurance
business‘ to mean the business of effecting contracts of
insurance upon human life (contingency depended human life, death
or a term dependent on human life) as well as the granting of
annuities upon human life. This is because both life insurance
policies as well as annuities require actuarial calculations on the
basis of life of a person.
Annuity simpliciter is characterised by receipt of periodic
payments of revenue character with an element of regularity. To
this end, the annuitant contributes lump sum amount of capital
nature. On the other hand, in a life insurance contract
simpliciter, periodic premium payments are made by policyholder
over a pre-determined period in exchange of a promise to receive
lump sum upon happening of a contingent event. In other words,
annuity simpliciter involves conversion of capital sum into
guaranteed revenue income while life insurance policy simpliciter
involves conversion of revenue payments into capital lump sum. In
simple terms, annuity may be regarded as the inverse of a life
insurance policy.
Life insurance policy and annuity cannot be distinguished simply
by the nature of payments being lump sum or periodical. The Court
of Appeal in IR v. DH Williams’s Executors
[1943] 11 ITR Suppl 84 (CA), affirmed 26 TC 23 (HL) and
conclusively held that there is no distinction between a lump sum
and a periodical sum received under a life insurance policy. The
question is only as to the nature of the sum. Therefore, the sums
by whatever name called, received either as lump sum or as
periodical payment, should not lose their true character. Gujarat
High Court in CIT v. M.K.S. Ranjitsinhji [1998]
232 ITR 140 (Gujarat) has held similarly in the case of annuities
as well.
Notably, the distinction has not remained so clear with the
modern-day products. For instance, certain traditional
endowment products presently being offered by life insurance
companies have received approval from Insurance Regulatory and
Development Authority of India as a life insurance policy. The
benefits payable under such contracts would prima facie
appear to be purely in the form of life insurance as lump sum
payment upon completion of term of insurance.
However, close scrutiny would reveal that such plans
additionally provide for payment of guaranteed benefits (periodic
payment) to the insured / nominee irrespective of death of the
insured, i.e., extending for a considerable time beyond completion
of the term of insurance. This raises the question about
non-existence of contingent event in such life insurance policies.
To qualify as a life insurance policy, it is crucial for the
benefits under the policy are payable upon fulfilment of event(s)
contingent on the life of the insured. Therefore, guaranteed
benefits receivable subsequent to insurable period lack this
insurance element embedded in it in the form of a life cover.
It would appear that such plans are being offered more as a
saving product, than as an insurance product. It is possible for
the Revenue Authorities to contend that such plans are a
combination of both insurance and annuity policies, leading them to
seek bifurcation of the policy into two independent contracts. This
can result in the annuities being fully taxable, despite the plans
having an insurance element.
Conclusion
The IT Act relies on the insurance laws and regulations for the
meaning of life insurance policies and annuities. From income-tax
perspective, payment of benefits under a life insurance policy
without the requirement of life cover could result in taxation of
the entire policy proceeds. As demonstrated above, owing to the
thin line of difference between features offered by modern
iterations of life insurance policies and annuities, it is crucial
for insurance companies to take proactive steps to separate the
elements of the life insurance policies from that of annuities. It
is advisable to pre-empt the customers about possibility of the
litigation. In any case, if tax exemption is to be retained, the
plans should be modified as life insurance products instead of a
saving product.
Footnotes
1. Romilly M.R. in Stokoe v. Cowan (1861) 4 L.T. 695,
696.
2. In the recent years, the exemption under Section
10(10D) of the Act have been subject to certain conditions. We are
however not concerned with the applicability of these conditions.
We have proceeded on the footing that the additional conditions
specified in the Section would be complied with.
3. Halsbury’s Laws of England, third edition, volume
32, at page 534, paragraph 899.
4. Ahmed G.H Ariff v. CWT (1970) 76 ITR
471 (SC).
5. Perrin v. Dickson 14 TC 608, 615
(CA); Foley v. Fletcher 3 H & N 769: 117 RR
967.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
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