India tax: Impact of Direct Taxes Code on life insurance sector

The Draft Indian Direct Taxes Code Bill, 2009 (Code) will have a significant impact on the taxation of life insurance companies. Released in August 2009 with proposed effect from 1 April 2011, the Code attempts to bring clarity to the taxation of life insurance companies but leaves several issues open with regard to the alternative minimum tax (MAT), loss carryforwards, dividend distribution tax (DDT) and withholding taxes. These open issues could have unintended adverse effects.

The draft Code seeks to significantly change (and simplify) the basis of taxation for life insurance companies, which remained unchanged even after the life insurance sector opened to private sector companies in 2000. Prior to the private sector's entry, the Life Insurance Corporation of India was the only company carrying on life insurance business and was not required to maintain separate accounts for policyholders and shareholders. Further, taxable income had to be determined based on the actuarial surplus in the revenue account. After 2000, the Insurance Regulatory and Development Authority required life insurance companies to prepare and maintain separate revenue accounts for shareholders and policyholders.

However, there was no corresponding change made in the income tax law with regard to taxation of the surplus in the shareholders' revenue account, leaving the question open to interpretation.

Under current law, life insurance companies are liable to tax on their profits derived from life insurance business (i.e. on the actuarial surplus in the policyholders' account) at the rate of 12.5% (plus a surcharge, if applicable, and the education cess, collectively "additional charges"). They are also subject to MAT at the rate of 15% of book profits (plus additional charges) if the MAT liability is higher than the normal tax liability computed at 12.5% (plus the additional charges). As noted above, uncertainty remains as to whether the income in the shareholders' account is to be considered income from a life insurance business and aggregated with the actuarial surplus in the policyholders' account and taxed at a concessional rate, or to be computed and taxed applying the general provisions of the law or whether such income is to be ignored altogether in the absence of a specific provision governing its taxation.

The discussion paper issued with the draft Code states that life insurance companies will be treated as pass-through entities and will not be liable to tax on income received by them for or on behalf of investors. It would follow that investors will be liable to tax on income that accrues to them from an investment in life insurance companies, except to the extent expressly provided otherwise. However, in contradiction to the pass-through status, a separate Schedule has been prescribed for computing the taxable profits from life insurance business in the shareholders' revenue account. There is no corresponding Schedule prescribed for the policyholders' revenue account, nor is the surplus from it expressly exempted from tax. The discussion paper, however, clarifies that the actuarial surplus in the policyholders' revenue account will not be liable to tax.

Thus, there are several anomalies in the Code with regard to the taxation of life insurance companies that need to be addressed to achieve the intended clarity and simplification of the proposed changes.

A reading of the discussion paper in conjunction with the provisions in the Code suggests that the intention is to exempt the surplus in the policyholders' revenue account and tax the shareholders' surplus. If that is the case, the Schedule providing the list of exempt persons in the Code should be amended to include the policyholders' revenue account and the list of specified businesses whose income is to be computed in accordance with a schedule should be prescribed to include the shareholders' revenue account of life insurance companies.

Another aspect that does not seem to be addressed is whether life insurance companies will be subject to asset-based MAT under the Code. If so, the Code would need to specifically provide for the exclusion of assets relating to the policyholders' account, as otherwise the intention to exempt policyholders' would not be achieved. In absence of a specific exclusion in the Code, the MAT liability is likely to be significantly higher than the tax that may be computed on the profits in the shareholders' account.

The Code also does not have any specific provision with respect to the carryforward of existing losses, which for insurance companies, could be mainly from the policyholders' account. It will be interesting to see whether losses with respect to the policyholders' account will be allowed to be carried forward while the income with respect to the policyholders' account is proposed to be exempt. Life insurance companies will become liable to pay tax on the profit in the shareholders' account unless the benefit of a carryforward and setoff of past losses continue to be available.

The Code specifically provides that companies will not be required to pay DDT on dividends to life insurance companies. Again, it remains to be seen whether this benefit will be available only with respect to investments from the policyholders' account or also from the shareholders' account. If the benefit is also available with respect to investments from the shareholders' account, then to the extent no DDT was paid by the distributing company, the dividends will be taxable in the hands of the life insurance company.

Indian law currently exempts from withholding tax payments made to life insurance companies by way of premiums or from capital gains earned by life insurance companies. The draft Code covers such payments or income in the residual category of "any other income," requiring withholding tax at 10%, thereby withdrawing the benefit of receiving premiums and income by way of capital gains without withholding tax. Again, this cannot be the drafters' intention and an appropriate amendment must be made to exempt such payments.

Without addressing the above anomalies in the Code, the government's intention of bringing clarity and simplicity to the taxation of life insurance companies' may go unrealized and adversely impact the industry. The government posted the draft Code on its website and provided a comment period (until 31 October 2009). It is expected that these anomalies will be addressed by the government before the Code is tabled before the Parliament for enactment.