Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial

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?

  • Ranganath says:

    The objective of Key man insurance is to protect the employer from the possible loss that he may incur in case of demise of the key employee during a specified period ( which is normally the period for which the policy remains assigned to the employer). Whereas, under an employer-employee scheme the objective of the insurance policy taken on the life of the employee is to use it as a retention tool to keep the employee with the employer for the period mutually agreed upon. Important point, that is not to be missed in this context, is that the proceeds by way of death claim, any time, during the term of the policy are paid to nominees of the life assured (ie., the employee), irrespective of whether the policy is in assignment to the employer or not at the time of death of the life assured. Again at the time of reassignment of the policy to the employee (ie., the life assured), he/she will have to pay tax on the lower of the total of premiums paid by the employer or the SV of the policy as on the date of reassignment. Thus, i feel, policies taken under employer-employee scheme are out of purview of this new rule. Pl clarify.

    • It’s very straight forward. If it was a keyman insurance policy when it started, it remains a keyman insurance policy even if it has been assigned to the employee. Any policy that was never a keyman insurance policy will not be called a keyman insurance policy. If a company pays the premiums on a policy which then pays out the premium to an employee, then the payment of the premium itself is likely to be considered a benefit to the employee and thus taxed as his income. Only clause that’s different is for certain pension plans which are specifically exempt. This is of course just my opinion.

  • Harit says:

    Please clarity, if the policies are issued as “Employer-Employee” and taken on life of “non-key” employees, will that still be tax free on maturity? Also the premium paid by employer (allowed to him as tax deduction) would be taxable to employee as perquisites pre assignment?

    • Employer-Employee – I don’t know the implications unless I see specific wording. But I’m not a lawyer or CA, can you get professional advice for your case please?
      Prima facie if the benefit is to the employee, it sounds like the employee should be taxed as if getting a a perquisite. But I don’t know if there is court history etc.

  • Kirti Shukla Negi says:

    Pls confirm whther the keyman insurance opolicy can be assigned to another company.

  • rajashekar says:

    Dear Sir,
    Please clarify i am holding Keyman Insurance policy from Bajaj the current fund value is 52 lacs and i have invested 50 lacs over 5yrs term under ULIP. If this is assigned to me before April 1st 2014 i have to pay perquiste tax on 52 lacs. My plan is having partial withdrawal benefit and I would like to withdraw 10 lacs and put that money under employer – employee scheme under traditional plans. What are the tax implications on this? What happens If I show both the entry and exit transactions in Book of Records and What happens If I do not show? Please clarify at the earliest.

  • Mukesh says:

    Please let me know your views on the below queries referring to revised norms from 1st April 2013 on
    Keyman policies:
    1) Can Keyman Policy be assigned in case Key employee leaves the organization whereby he can continue to pay the premium and accordingly his family can benefit from the same as currently (pure term) is aloud under Keyman which does not have any maturity benefits?
    2)How can it be kept as collateral security when it cannot be assigned as the ownership rights would not be transferred till the time assignment takes Place?
    3)Can Keyman Policies be taken by Partnership/Sole proprietor/Trusts
    Employer Employee Policies
    1)Does Premium Paid on behalf of the employee is considered as Perks and taxable in the hands of employee? If yes, then how do we account the same although the premium is paid by the employer directly and maturity is deferred based on policy terms? Do we tax the employee every year or on maturity although he has not received the money wherein employer has already taken the tax benefit?
    Mukesh Agarwal

    • Please visit a chartered accountantfor specific queries and to get a qualified answer. My opinion is:
      a) Keyman insurance policy if assigned then the proceeds at maturity are fully taxable in the hands of the assignee.
      b) It can be assigned. Just that the proceeds are taxed.
      c) Keyman policies by trusts etc. = best to contact the insurers.
      I don’t know about the tax treatment of employer-employee policies, please contact an accountant.