MAY 15, 2024

By S Sriram, Partner & Samyak Navedia is Senior Associate, Direct Tax Team, Lakshmikumaran and Sridharan Attorneys, Mumbai

Introduction

THE scope of taxation under the Income Tax Act, 1961 ("IT Act") extends to all incomes received by a person. More than 90 years back, the Privy Council in Shaw Wallace & Co [1932] 6 ITC 178 (PC) held that monies received under a contract of life insurance would not be treated as ‘income' within the ordinary meaning of the word. The principle would hold good in relation to monies received (a) by the nominee on death of the insured, (b) by the insured itself upon completion of the policy term, (c) by the insured on surrender of the policy, and also on (d) periodic payments received under the policy. The law has been amended in the recent years, to bring to tax certain sums received under life insurance contracts.

On the other hand, the Privy Council in Maharaj kumar Gopal Saran Narain Singh v. CIT, [1935] 3 ITR 237 (PC) observed that periodic payments received, even as consideration for conversion of a capital item, would be regarded as taxable income. In other words, it was observed that periodic payments received would always be taxable as income. Interestingly, annuity contracts can only be issued by life insurance companies.

This article seeks to analyse the overlap of exemption available to period payments received from life insurance contracts, and taxability of annuity received.

Money payable under contract of life insurance

Though the statute today, by virtue of Section 10(10D), grants a specific exemption to "sum received under a life insurance policy", the meaning of the phrase, in itself, has not been defined. The maxim "nihil certiusmorte, nihil incertius hora mortis" means that nothing is more certain than death, nothing more uncertain than the hour of death. This element of uncertainty in life insurance policies separates it from an ordinary contract. They are treated as securities for money 1 which are bound to be paid at an uncertain future date, but 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. 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.

Money payable under contract of annuity

No specific provisions bringing general annuities to tax or providing exemption to annuities have seen the light of the day in the IT Act, apart from the exception of annuity purchased pursuant to employment contract being a subject matter of tax in Section 17. Other forms of annuities, for instance 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 Maharaj kumar Gopal Saran Narain Singh (supra) held that the pay-out from annuity contracts 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 England 2 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 either in the form of a rent charge or an annuity. 3 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. 4

Courts have recognised that payment of annuity would largely amount to repayment of capital sums paid by the annuitant. However, the juridical law has observed that when a contract of annuity involves conversion of capital sum into periodic revenues, where revenue would be subject matter of taxation under the IT Act. 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?

Though bringing to tax repayment of capital seems to be onerous, until the juridical or legislative deviation of age-old principle, taxpayers would have to be suffer the tax consequences of purchasing annuity contracts. The Court of Appeal, however, in Sothern-Smith v. Clancy [1940] 24 TC 1 (CA) held that one distinction between an annuity simpliciter and capital payment is that the latter is in discharge of a pre-existing debt. However, no simple test can be laid down for this 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. The Supreme Court of India in CIT v. Kunwar Trivikram Narain Singh - 2002-TIOL-1729-SC-IT-LB 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.

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 income-tax be 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, sums received at the end of the annuity period by the annuitant may considerably exceed the normal interest earning capacity on that investment. Simultaneously, the annuity grantor takes the risk of prolongation of annuitant's life beyond a period of profit yield 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 a transaction does not involve capital being 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.

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 instalments, receipt of such instalments 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.

The Court of Appeal ruling in IRC v. 36/49 Holdings Ltd (1942) 25 TC 173 (CA) ,approved by the Supreme Court in National Cement Mines Industries Ltd v. CIT - 2002-TIOL-969-SC-IT-LB, held that annuity is where capital sum is parted with, in consideration of a grant of a number of periodical payments of revenue character. That is, the capital has gone and has ceased to 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 dependent on human life, death or a term of human life) as well as 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. Similarly in the case of annuities, Gujarat High Court in CIT v. M.K.S. Ranjitsinhji [1998] 232 ITR 140 (Gujarat) has held that irrespective of payments being lump sum or periodical, annuity will be taxable as such, so long as it does not lose its character.

Notably, the distinction has not remained so lucid with the modern-day products. For instance , Insurance Regulatory and Development Authority of India has granted approval to certain traditional endowment products as life insurance policies, and the benefits payable therein would also prima facie appear to be purely in the form of life insurance policy with lump sum payment upon completion of term of insurance.

However, closer scrutiny would reveal that such plans additionally provide for payment of guaranteed benefits (periodic payment) to the insured / nominee irrespective of a life contingency (term of life or death of the insured), i.e., extending for a considerable time beyond completion of the life of the insured. 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 that 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 life of the insured would result in such life insurance policies lacking this insurance element embedded in it in the form of a life cover.

Such offering of insurance products as a saving product could lead Revenue Authorities to bifurcate the product into two independent contracts, contending that such plans are a combination of elements of both insurance and annuity. An argument may also lie that total pay-out be taxed because the annuity element is colouring the entire product. Consequentially, the annuity element may bring pay-outs to taxation, despite their marketing and approval as an insurance product.

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.

[The views expressed are strictly personal]

1 Romilly M.R. in Stokoe v. Cowan (1861) 4 L.T. 695, 696.

2 Halsbury's Laws of England, third edition, volume 32, at page 534, paragraph 899.

3 Ahmed G.H Ariff v. CWT - 2002-TIOL-1333-SC-IT-LB.

4 Perrin v. Dickson 14 TC 608, 615 (CA); Foley v. Fletcher 3 H & N 769: 117 RR 967.