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Commentary

Keyman Insurance Loophole Plugged: All Proceeds Will Be Taxed, No Exemption

Budget 2013 has plugged a loophole in the tax system. Consider a small company that wanted to pay its management a bonus based on a large profit it had received.The company can deduct the amount paid, as an expense (so it’s taxes are lower). The individual would have that much money as an income, on which he would pay tax.

If the company didn’t pay the person, the company had that much more profit and thus the company would pay the tax. No matter what you did, the government got a cut of the profit earned.

However, there was a loophole.

A company could buy “Keyman insurance”, where it insures itself against the death of a key person. The premiums it pays – and they could be huge – are tax exempt as they are an expense. So the company pays no tax on the money. The employee hasn’t yet got the money, so he pays no tax either.

However, sometime during the term, perhaps early enough, the company “assigns” the policy to the employee and collects the “surrender value” from the key employee, which is typically as low as 10% or 20% of the fund value. The employee then pays subsequent premiums, and then gets the full proceeds at maturity. Normally, proceeds of a keyman insurance policy are taxable in the hands of whoever gets it; but the employee would argue that since he has been assigned the policy and had paid a premium, it was not a keyman insurance policy any more. And thus, the proceeds were tax free.

Effectively, a company managed to transfer money to its employees, without the government being paid tax.

In a recent case, the Delhi High Court ruled that such an instance was a legal way to avoid tax because this was specifically allowed. Escorts Health Institute was supposedly buying keyman insurance every year, and then assigning them to employees, thus effectively avoiding the tax.

In Budget 2013, the Finance Minister has plugged this loophole. It is now specifically stated that even if a keyman insurance policy is assigned, it will remain a keyman insurance policy. This means that proceeds will be fully taxed. The change works for any assignment done or proceeds received after April 1, 2013.

The lesson to learn is: Don’t screw with the Income Tax department. Escorts might have gotten a high court order in their favour, but this change means that any future policy maturity from now on (or April onwards) will be fully taxed in their hands. Meaning, all that litigation and time and money spent is effectively worthless.

My opinion: Keyman policies were a tax avoidance method forever. We were first approached by agents for it in the late 90s as a “tax-efficient” measure, when I was running my company with four co-founders. Just as we were figuring out whether to do this, the tax department came up with a notification that indicated they wanted to curb the abuse by taxing proceeds. Luckily we decided it wasn’t worth our time to try and save taxes this way. In that sense, I believe this was a method to avoid tax and was quasi-legal, depending on the specific wording of the tax law to make their case.

The income tax department hasn’t acted retrospectively – that is, taxed past proceeds – but only those that come in the future, and this is quite within their rights. What’s your view?

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