Direct Tax Alert - Surplus/Deficit in Shareholder’s Account held to be part of the Life-Insurance Business

Background

Companies carrying out the business of life-insurance are required to adhere to rules and regulations stipulated as per the Insurance Regulatory and Development Authority Act, 1999 (IRDAI). As per the reporting format prescribed under the IRDAI regulations, insurance companies have to maintain a clear segregation between Shareholder’s Profit and Loss Account (Shareholder’s Account) and Policy Holder’s Surplus/Deficit Account (Policyholder’s Account). Additionally, these regulations permit transfer of funds from Shareholder’s Account to Policy Holder’s Account in case there is a deficit in the latter. In other words, where there is a shortfall/ deficit to honour the dues of policyholders, the owners/ shareholders of the company are required to bring in additional funds to meet the obligation towards policyholders. The regulations permit transfer of surplus in Shareholder’s Account.

Further, the Income-tax Act, 1961 (Act) prescribes a separate regime for taxation of Insurance companies. Section 44 of the Act states that incomes derived by Insurance companies from various sources shall be computed basis ‘First Schedule to the Act’. Rule 2 of the First Schedule is applicable to companies engaged in the business of life-insurance. Further, section 115B of the Act provides for a concessional tax rate of 12.5% for Life-Insurance Companies.

However, the revenue authorities in several cases have taken a stance that surplus/deficit from Shareholder’s Account do not form a part of life-insurance business and hence the concessional tax rate shall not apply to surplus, if any under the Shareholder’s Account. Various life insurance companies in the industry have contested the issue across the board as Shareholder’s Account is part of the overall life insurance business and not separate line of business.

We, at BDO in India, have summarized the ruling of the Karnataka High Court¹ (High Court) which recently upheld that surplus/ deficit under Shareholder’s Account arises out of life insurance business and have provided our comments on the impact of this decision hereunder.

Facts of the case

The taxpayer, a resident life-insurance company filed its Return of Income (ROI) declaring a loss for the year under consideration. The loss was computed by aggregating the surplus reported in the Shareholder’s Account and deficit as per Policyholder’s Account. However, on completion of assessment, surplus from the Shareholder’s Account was taxed at normal rates, treating the same as income from normal business and consequently charged to tax at higher rate. The assessing officer further  held that only the income from Policyholder’s Account pertains to life-insurance business and shall be subjected to concessional tax rates.

The First Appellate authority dismissed the taxpayer’s appeal and hence, an appeal was preferred before the Income Tax Appellate Tribunal (ITAT), Bengaluru. The ITAT duly allowed the taxpayer’s claim on the grounds that the said off-setting the surplus and deficit of the two accounts is permitted as per provisions of the Act as they arise from the same business. Reliance was also placed on a Mumbai ITAT ruling² in the case of ICICI Prudential Insurance Company Limited which was confirmed by the Hon’ble Bombay High Court³.

The Revenue, aggrieved by order of the ITAT preferred an appeal before the High Court of Karnataka.

High Court Ruling

• The Hon’ble High Court has placed reliance on two jurisprudence of the Hon’ble Supreme Court, wherein it was held as under:
  • The computation of surplus and profit and gains by a life-insurance company is computed as per the First Schedule of  the Act and one has no power to do anything not contained in it. Further, the same has to be accepted by the Income Tax Officer⁴;
  • Section 44 of the Act starts  with a non-obstante clause. In other words, it overrides all other provisions and mandates that the income of Insurance Companies be computed as per Rules laid down in the First Schedule to the Act⁵.
• Further, it was observed that the Explanatory note to Finance Act (No. 2) of 2009 clarifies the applicability of Rule 5 of First Schedule to the Act to non-life insurance companies, in contrast to prayer by the revenue authorities regarding its applicability to the taxpayer, which is a life insurance company;
• The Bengaluru ITAT, having ruled in favour of the taxpayer in earlier year, has confirmed that the taxpayer carries out only life-insurance business which is regulated by IRDAI and the same has been observed by the revenue authorities and submitted by them in the Memorandum of Appeal filed;
• Moreover, it has been categorically held that, provisions of the Insurance Act, 1938 state that the license of an insurer shall be subjected to cancellation if it carries out a business other than that of insurance or any other business as prescribed;
• The High Court has placed reliance on the judgement of Hon’ble Bombay High Court² in case of ICICI Prudential Insurance Company Limited wherein (the ruling of Mumbai ITAT was confirmed)  it was held as under:
  • Surplus/deficit from Shareholder’s Account shall be considered as arising from Life Insurance Business;
  • Further, there was no dispute regarding whether or not the taxpayer is in the business of life-insurance;
  • Thus, the very stand that surplus from Shareholder’s Account must not be taxed at concessional rates applicable to Life-Insurance Company is not sustainable;

            A Civil Appeal in the said matter is pending before the Apex Court.

• On application of ratio of the above ruling to the present case, it is perceptible that the position adopted by the taxpayer is tenable. However, since the ruling of Hon’ble Bombay High Court is sub judice, the Hon’ble Karnataka High Court has duly stated that its ruling is subject to result of the appeal before the Apex Court.

BDO Comments

The High Court, basis several jurisprudence have ruled in favour of the taxpayer. This provides a much-needed relief to taxpayers engaged in the business of life-insurance, which customarily does not yield much profit in the initial 7-10 years, requiring infusion of a lot of capital to balance the deficit in Policyholder’s account.

Considering the fact that a High Court’s ruling is binding on that particular state and the authorities having jurisdiction in that state, the litigation in other jurisdictions cannot be ruled out. However, it is to be noted that the ruling of Karnataka High Court in-line with the ruling of Bombay High Court will surely assist the life insurance companies to substantiate the fact that surplus/ deficit in Shareholder’s Account is part of life insurance business (subject to the pending appeal before the Hon’ble Supreme Court).

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