Keyman Insurance, Termination Compensation & Life Insurance Proceeds

Relevant Provision: Section 92(2)(d), (j) and (l)

1. Keyman Insurance Policy — Section 92(2)(d)

A Keyman insurance policy is taken by a business on the life of an employee/partner/director whose expertise is critical to the business, with the business as beneficiary. Any sum (including bonus) received under such a policy is taxable under Other Sources if it is not already taxed as business income or salary — relevant, for instance, if the policy is later assigned to the Keyman individual and matures in their hands.

2. Compensation on Termination of Employment — Section 92(2)(j)

Any compensation or other payment received in connection with the termination of employment, or modification of its terms, is taxable under Other Sources — unless it qualifies as "profit in lieu of salary" (taxed instead under Salaries). Retrenchment compensation, VRS payments and gratuity have their own specific exemption provisions and are generally not covered by this residuary clause to the extent exempt.

3. Life Insurance Policy Sums — Section 92(2)(l)

Where a life insurance policy payout (including bonus) is received and it is not a ULIP payout, does not fall under the Keyman policy clause, the sum exceeds aggregate premiums paid (not otherwise claimed as a deduction), and the proceeds are not otherwise exempt under the insurance-exemption schedule — then the excess over premiums paid is taxable under Income from Other Sources.

4. Taxability and Exemptions Summary

Most standard traditional life insurance policies remain exempt provided the annual premium does not exceed the prescribed percentage of sum assured (broadly 10% for policies issued after specified dates, or 20% for older policies, with specific caps for ULIPs). If a policy fails this ratio test, only the amount exceeding total premiums paid is taxable — not the entire maturity value. Retrenchment compensation up to a prescribed exempt limit is not taxable; only the excess, if any, is taxable typically as profit in lieu of salary rather than under this clause.

5. Illustrative Example

Mr. Bose holds a high-premium traditional policy where the annual premium is 15% of the sum assured (exceeding the 10% exemption threshold), pays total premiums of ₹18,00,000 over the term, and receives a maturity payout of ₹25,00,000. Since the policy fails the exemption ratio, the excess of ₹7,00,000 (₹25,00,000 − ₹18,00,000) is taxable under Income from Other Sources, and the insurer deducts TDS at 5% on this ₹7,00,000 at payout.

6. Case Laws

CIT v. Rai Bahadur Jairam Valji — on distinguishing capital receipts (compensation for loss of a source of income/agency) from revenue receipts (compensation for loss of profits), relevant in classifying termination payments.

Khanna & Annadhanam v. CIT — addressed the taxability of "non-compete" payments and their correct classification.

7. Precautions

Before assuming a maturity payout is tax-free, check the premium-to-sum-assured ratio for the specific policy year of issue.

For Keyman policies assigned to the employee, track the assignment date and premiums paid post-assignment carefully, as tax treatment can shift between employer and employee.

Termination settlements should be clearly documented distinguishing "profit in lieu of salary" components from independent third-party or goodwill/non-compete payments.

8. FAQs

Q1. Is a maturity payout from a standard LIC endowment policy always tax-free?

Not always — only if it satisfies the prescribed premium-to-sum-assured ratio. If it doesn't, the excess over premiums paid is taxable, subject to TDS at payout.

Q2. Is retrenchment compensation fully taxable?

No — it enjoys a specific exemption up to prescribed limits; only the amount exceeding the exempt limit is taxable, generally under profits in lieu of salary.

Q3. Does the insurer deduct TDS on taxable policy payouts?

Yes, insurers deduct TDS (currently 5% on the taxable component) where the payout is not exempt.

Disclaimer

This content is shared strictly for general information and knowledge purposes only. Readers should independently verify the information from reliable sources. It is not intended to provide legal, professional, or advisory guidance. The author and the organisation disclaim all liability arising from the use of this content. The material has been prepared with the assistance of AI tools.