Does the tax on ULIPs reduce their edge over mutual funds?

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© Venkatasubramanian K Does the tax on ULIPs reduce their edge over mutual funds?

When Union Budget 2018 introduced a long-term capital gains (LTCG) tax on profits made from equity-oriented investments, it handed unit-linked insurance plans (ULIPs) a distinct advantage. Despite a majority of the investments flowing into their equity funds, ULIPs escaped this tax due to their status as life insurance policies.

Union Budget 2020, however, has sought to fix this ‘arbitrage.’ Redemption or maturity proceeds of ULIPs with aggregate annual premiums of over Rs 2.5 lakh will now be subject to capital gains tax, just as mutual funds are. However, if the policy pays out a claim due to the policyholder’s demise, the dependents will not have to pay any tax.

Last week, Moneycontrol had explained how the government must clarify doubts relating to how the holding period (for long-term or short-term gains) of ULIPs would be calculated, given that your money is locked in for five years. So, whether you withdraw in three months or three years, you will get your money only after five years.

Let us take a look at the bigger question now: After Budget 2021, which is the better investment – equity mutual funds or high-premium ULIPs?

Will switches between ULIPs also attract tax?

So far, mutual funds imposed capital gains tax during withdrawal or even switches. That rule continues. But ULIPs had a distinct advantage. Their exemption from the capital gains tax ambit also made switches – between ULIPs’ equity, debt and hybrid funds – tax-free.

That could now change. However, so far, there is no clear answer. Some tax experts believe the gains made will be taxed in the same financial year. “In the spirit of the law, such ULIPs should get the same treatment as mutual funds. In mutual funds, there is a tax incidence even when you switch between schemes of the same fund house. Whether there will be TDS or individuals need to report capital gains remains to be seen,” says Harshvardhan Roongta, Certified Financial Planner, Roongta Securities.

Vaibhav Sankla, Principal, Billion Basecamp Family Office, however, believes that gains booked on such switches will not be taxed. “Taxability arises on receipt of amount under a ULIP. There is no taxability on switch between equity and debt funds within the ULIP,” he says, emphasising that switch transactions among equity, debt, and hybrid fund options within ULIPs will continue to enjoy tax arbitrage.

Chetan Chandak, Director,, too, feels that the issue requires clarity. “Tax implication will arise only in the year when you finally receive the proceeds from the ULIP, irrespective of the year of switch. However, one can still argue that switching from one fund to another fund is similar to the ULIP making the payment to policyholder and then him buying another fund. Therefore, it is imperative that the CBDT clarifies on the tax implication in case of switches,” he says.

Will my gains attract 10 percent LTCG tax even if I invest entire amount in the ULIP’s debt fund options?

The memorandum to the Finance Bill, released soon after the Budget speech, indicated that ULIPs would now be included in the definition of equity-oriented funds under Section 112A. Their tax treatment, therefore, would be similar. So what’s the confusion?

In 2018, when the government decided to impose long-term capital gains tax of 10 percent on equity-oriented mutual funds, it did so by introducing a new Section 112A. It had no mention of debt funds, because their taxation structure was already in place. So, this year when Budget 2021 imposed capital gains tax on high-value ULIPs, it brought them under Section 112A, without explicitly recognising that some ULIPs are equity-oriented and some are debt-based.

Some experts take this to mean that the long-term capital gains tax of 10 percent (under Section 112A) covers all ULIPs – debt and equity. “It is absolutely clear that even if the taxpayer had kept the entire corpus in the ULIP’s debt fund, the same would be taxable at 10 percent. Interestingly, no consequential amendment is proposed in section 48, which means that the ULIPs would enjoy indexation benefits as well. However, it is likely that this anomaly will be eliminated while passing the final finance bill,” says Sankla.

Again, Chandak thinks otherwise. “Some tax experts feel that debt funds of a ULIP will be treated at par with equity funds owing to the explanation in the memorandum. But in our opinion, this (tax experts’ views) may not hold good because of corresponding proposed amendment to explanation (a) of section 112A which defines the equity-oriented mutual funds for the purpose of this section,” he says.

Put simply, to qualify as equity-oriented funds as per this provision, at least 65 percent of ULIP’s total proceeds must be invested in equity shares of domestic companies listed on a recognised stock exchange. “The definition of equity-oriented investments will be relevant for ULIPs too. If you are investing in a debt fund option, gains made on switches or redemption will attract STCG (slab rate) or LTCG (20 percent with indexation) tax applicable to debt mutual funds,” says Roongta.

A clarification from the CBDT could resolve these points of confusion.

Purely from the tax perspective, does this mean that ULIPs retain their edge over mutual funds?

Purely from an income-tax angle, ULIPs where premiums are lower than Rs 2.5 lakh work out better than mutual funds if you stay invested for the long run. “This is like a systematic investment plan (SIP) of Rs 20,000 per month, which is a substantial sum,” points out Roongta. Financial planners also feel investors will work their way around this limit by getting their family members to buy ULIPs with premiums of up to Rs 2.5 lakh.

The tax angle apart, they recommend mutual funds over ULIPs due to the flexibility of easy exits that mutual funds offer. Also, ULIPs necessitate regular premium payments, failing which policies can lapse. But in a mutual fund, you can stop your SIP at will.

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