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 money[1] 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 policy[2].
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 England[3] 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.
[The author is a Senior Associate in Direct Tax Team at Lakshmikumaran and Sridharan Attorneys, Mumbai]
[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.
