Any amount received from any life insurance companies being totally tax free is one of the most common presumptions of the taxpayers.  This is not entirely correct. Amount received from life insurance companies (including bonus) is tax free u/s 10(10D) of the Income Tax Act- 1961, except the following receipt:

(a)  any sum received u/s 80DD(3) or u/s 80DDA(3); or

(b)  any sum received under a Keyman insurance policy; or

(c)  any sum received in respect of any policy issued,

(i) between 01.04.2003 to 31.03.2012, if the premium in any years exceeds 20% of the actual capital sum assured
(ii) after 01.04.2012, if the premium in any years exceeds 10% of the actual capital sum assured. However, if the policy is issued for the life of person with specified disability or person suffering from specified diseases then 10% needs to be replaced by 15%.  [No tax impact would be there if such amount is received on the death of a person].

There is no escape from tax on insurance proceeds if the premium paid exceeds 20% or 10% or 15% of the sum assured. Similar conditions are applicable for deduction u/s 80C as deduction is admissible only if premium is within the limit of 20% or 10% or 15% as referred above.

To track the taxability of such transactions, section 194DA provides for deduction of tax @ 1% (20% if no PAN) of sum paid under a life insurance policy which is not eligible for exemption u/s 10(10D) if aggregate sum paid in a financial year is Rs. 1 lakh or more.  In short, if the TDS credit statement (Form 26AS) of the taxpayers reflects TDS U/s 194DA, one can be sure that amount is taxable.  However, one needs to carefully note that Rs. 1 lakh limit is there for TDS u/s 194DA & not for 10(10D).

An important issue now emerges is with regards to computation of taxable income if amount is not exempt u/s 10(10D). Whether entire amount received is taxable or only the difference between (i.e., amounts received less amount invested) is taxable? The issue is all the more relevant as the TDS is to be done on entire amount payment & not on the difference. The long standing dispute has been put to an end by amending section 194DA by recent Union Budget, 2019 w.e.f. 01.09.2019 which has now provided for TDS on differential amount only, though at a higher rate of 5% (as against 1% earlier). Relevant part of the explanatory memorandum behind above amendment in section 194DA reads as under:

Several concerns have been expressed that deducting tax on gross amount creates difficulties to an assessee who otherwise has to pay tax on net income (i.e., after deducting the amount of insurance premium paid by him from the total sum received). From the point of views of tax administration as well, it is preferable to deduct tax on net income so that the income as per TDS return of the deductor can be matched automatically with the return of income filed by the assessee.  Hence, it is proposed to provide for tax deduction at source @ 5% on income component of the sum paid by the person.

Above amendment in section 194DA has made it absolutely clear that the entire amount cannot be treated as ‘income’ and it’s only the differential amount that would be taxable as income. However, even after above amendment, one issue still remains unresolved i.e., whether income would be taxable- whether as “Income from Capital Gain” or “Income from Other source”?  Issue is controversial as above amendment treats the differential amount as income for TDS @5%. From taxpayer perspective, income is obviously arising from the investment activity of the taxpayer and so should form the part of the “Capital Gain Income” & if the period of investment exceeds 3 years, then the benefit of indexation can also be enjoyed by the taxpayers. However, if taxpayer offers income as capital gain then the amount may not match with the TDS statement in Form No. 26AS. A suitable clarification by the CBDT would be in the interest of the taxpayers as well as revenue.