Understanding Employer-Employee Insurance Schemes: The Hidden Tax Trap

In recent times, I have been approached by several insurance consultants promoting the Employer-Employee Insurance Scheme as a tax-efficient investment option for businesses and their employees. While this may appear attractive on the surface, a deeper analysis of Section 10(10D) of the Income Tax Act reveals significant tax implications that are often conveniently hidden by agents.

As a Chartered Accountant with years of experience in taxation and financial advisory, I believe it is my responsibility to shed light on this issue and ensure that businesses and individuals make informed decisions. This article aims to clarify the long-term tax implications of Employer-Employee Insurance Policies and prevent others from falling prey to mis-selling tactics.

The Keyman Insurance Policy Trap

Section 10(10D) of the Income Tax Act provides tax exemption on sums received under life insurance policies. However, there are specific exceptions, one of which is a Keyman Insurance Policy. According to Explanation 1 of Section 10(10D, as amended by the Finance Act, 2013, w.e.f. 1-4-2014), any life insurance policy taken by an employer on the life of an employee can be classified as a Keyman Insurance Policy. This includes:

1. Purpose: A life insurance policy taken by a person on the life of another person who is or was the employee of the policyholder or is connected in any way with the business.
2. Assignment: The policy remains a Keyman Insurance Policy even if it is assigned to the employee, either with or without consideration.
3. Taxability: The maturity proceeds received under such a policy are treated as taxable income and are not eligible for the tax exemption under Section 10(10D).
4. Death Benefit: Even in the case of the insured employee’s death, the proceeds received under a Keyman Insurance Policy are taxable.

The Long-Term Tax Trap

One of the biggest concerns with these policies is their long-term nature. Many Employer-Employee Insurance Policies have terms of 30-40 years, while the premiums are paid off in 5-10 years. This creates a long-term tax trap, as the true tax impact of the policy may not become visible until decades later, when it might be too late to rectify the financial consequences.

In the end, the employee may be taxed on the very proceeds for which the employer had claimed a business expense under Section 37(1) of the Income Tax Act. This means that the tax burden ultimately falls on the employee, even though the employer initially benefited from claiming the premium as a business expense.

Misleading Claims by Insurance Agents

Some insurance agents conveniently hide these facts and misrepresent the product by claiming that the insurance proceeds in the hands of the employee will be tax-free. This is misleading and can lead to financial hardships for the employee when the policy matures or in the event of death.

Many agents falsely state that:

• The insurance proceeds will be tax-free for the employee.
• The policy provides a tax-free maturity benefit.

However, the reality is that these policies often fall within the definition of a Keyman Insurance Policy, making them taxable.

Impact on Close-Ended Companies and Partnerships

Many businesses use this tactic to take life insurance policies for directors or partners under the guise of an Employer-Employee Scheme. While this may seem like a clever financial maneuver, it can result in unexpected tax liabilities in the future, affecting both the business and the individuals involved.

For instance, close-ended companies or partnership firms may face significant tax burdens if the policy proceeds are later classified as taxable income.

Important Considerations:

1. Future Tax Liability: The true tax implications may only become clear after 20-30 years, by which time it may be too late to rectify the financial impact.
2. Employer’s Deduction: The employer may initially claim the premium paid as a business expense, but the employee will eventually be taxed on the policy proceeds.
3. Tax on Death Benefit: Even in the event of the employee’s death, the proceeds received under a Keyman Insurance Policy are taxable.

Take an Informed Decision

Before opting for such policies, it’s crucial to understand the tax treatment of the maturity proceeds.

• Don’t be swayed by misleading claims of tax-free benefits.
• Ensure you’re fully aware of the long-term tax consequences.
• Consult with a qualified Chartered Accountant or tax advisor before making any investment decisions.

As a Chartered Accountant, I am committed to creating awareness about such issues to help businesses and individuals make informed financial decisions. Let’s work together to promote financial transparency and avoid falling prey to mis-selling tactics.

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