Understanding the Calculation of Capital Gains Taxes on ULIPs

A ULIP policy combines investments and insurance in an attractive package for investors. A notification describing the methodology for calculating the capital gains on unit-linked insurance plans (ULIPs) was circulated by the Central Board of Direct Taxes (CBDT). As stated in the budget for 2021, the return obtained on ULIP investments with yearly premiums over Rs 2.5 lakh (high-value premium insurance) will not be tax-exempt. The fundamental paradigm proposed by CBDT considers all payments made to policyholders, whether they are withdrawals or bonuses, as income. 

In its circular dated January 19, 2022, CBDT recommended that to calculate gains, the total premiums paid up to that point should be subtracted from the income received up to that point to determine the capital gain amount. Therefore, the investment returns on ULIPs are subject to capital gains taxes, just like many other investments. This article will discuss how capital gains taxes are calculated on ULIPs. 

Capital gains types and taxation

First, it is essential to understand the different types of capital gains that can arise from ULIPs. When an asset is sold, the seller realizes some gains or profits. These profits are known as capital gains because they result from selling a capital asset. These capital gains might be long-term or short-term, depending on how long the seller kept the asset.

A capital asset is often one that has been kept for 36 months or more before being transferred.

Long-term capital gains tax is applied on capital gains received through the transfer of a long-term capital asset. Because ULIPs have a 5-year lock-in period, any returns from investing in ULIP funds qualify as long-term capital gains.

The LTCG earned on the maturity of any ULIP plan purchased on or after February 1, 2021, with an aggregate annual premium exceeding 2.5 lakhs, is not tax-free. Amounts over Rs. 1 lakh will be taxed at 10%. However, ULIPs purchased before this date are tax-free if they meet the standards outlined in Section 10 (10D).

In addition to the capital gains tax, ULIPs also attract a service tax of 4% on the premium paid. This service tax applies to the premium paid for the life insurance cover and the premium paid for the investment component of the ULIP. 

It is also important to note that ULIPs are subject to a lock-in period of 5 years. This means that the investor can only withdraw the investment after the completion of 5 years. 

Rule 8AD and its tax implications

The CBDT notification essentially states that after rule 8AC in the Income-tax Rules, 1962, Rule 8AD shall be inserted for the computation of capital gains for subsection (1B) of section 45-(1) where any person receives any amount under a specified unit linked insurance policy, including the amount allocated in the form of bonus on such policy, then, -“

Case I

The capital gain in the prior year will be computed as follows when an investor receives an amount (including bonus and withdrawals) under a specific ULIP for the first time during the previous financial year: 

If

A = The total amount paid out under the policy in the preceding year, including any bonuses.

B = Total premiums paid (until the amount A was received) throughout the investment plan.

Then, to calculate Capital Gains, the formula is A-B. 

Case II

At any point, after receiving the sum indicated in Case I by investors under a specific ULIP during the preceding fiscal year, the procedure for calculating capital gains resulting from this sum is as follows: 

 X = This includes any bonuses given out during this time but excludes any sums that have already been used to compute gains under this tax regulation.

Y = The total premium paid throughout the income obtained in this condition, up until the date of receipt of the money, less any amounts taken into account in the computation under this.

The computation method is X-Y

Conclusion – How Will The Calculation Look In Real Life?

All the nitty gritties asidem let’s take a simple example to sum up our discussion. Assume you bought a ULIP with Rs. 3 lakhs annual premium. You earn Rs. 5 lakhs as long-term capital gains at the end of the 20-year insurance period.

You will have to pay tax on the LTCG tax on your ULIP in this scenario because

•Your annual premium is more than Rs. 2.5 lakhs.

•Your long-term capital gains exceed Rs. 1 lakh.

As a result, you will have to pay 10% LTCG tax on Rs. 4 lakhs (i.e., Rs. 5 Lakhs – Rs. 1 Lakh). Long-term capital gain tax on your ULIP amounts to Rs. 40,000.

Barring the new tax rules, you already know what is a ULIP policy and what its benefits are. However, considering the LTCG rules, investors need to be aware of these differences when calculating their tax liability. Therefore, it is always best to take professional advice before making any investment decision.