At this stage, everybody knows what unit-linked insurance is. For those yet unaware of this remarkable product, we are talking about capitalization life insurance, wherein the sum insured is the (variable) value of a portfolio of dedicated underlying assets, such sum being represented by virtual units of value.

The 12th edition of FULLCOVER featured a dossier on this product, which covered several perspectives: An efficient investment; A flexible and transparent solution; A wealth-structuring solution; and more. We will not go over these again: the purpose of this article is to highlight the success of this product in the Portuguese market, which is mainly driven by its tax efficiency.

1. General and Legal

Life insurance in Portugal benefits from a long-lasting, stable legal and tax regime (which is unusual, by Portuguese standards).

Despite relatively recent changes in the legal framework governing the insurance contract (the General Regime was published in 2008), the main rules have not changed since the mid-twentieth century — its origin can be traced back to the Commercial Code of 1888. Similarly, the tax framework for life insurance regarding the taxation of natural persons remains virtually unchanged since 1992.

The Portuguese life insurance market is relatively limited. As most of the population has little to no inclination for savings, few purchase life insurance voluntarily, be it to cover the risk of their death to benefit a third party, or to start a long-term savings strategy. The largest share of life insurance sales pertains to home loans, as lending institutions require the purchase in order to grant a loan.

However, there is an interesting market for savings/capitalization insurance. Unit-linked insurance is still available and in high demand from two large groups of policyholders:

     a) Small/medium savers, who acquire products wherein investment assets are selected by insurance companies (offering different portfolios according to risk options and/or investment profile of policyholders);     

    b)  High-net-worth individuals, who seek custom solutions, usually offered by non-resident insurers operating in Portugal under the Free Provision of Services regime.     

From a legal standpoint, setting aside for now the security arising from the fact that a credit privilege is established in favour of the policyholder and that insured capital cannot be garnished, what one must bear in mind is that a unit-linked life insurance contract offers enormous flexibility and can be tailored to the policyholder’s intentions. As the policy is a private contract, if applicable legal and regulatory rules are not breached, then the principle of contractual freedom ensures that parties can establish anything which is not prohibited.

This applies to the designation of beneficiaries in the event of the policyholder’s death. The designation of beneficiaries, as well as the distribution of insured capital among them, is entirely free and can be changed at any time. Only two exceptions apply, namely when:

      a)  the policyholder expressly waives the right to change and/or revoke the clause naming the beneficiary;     

      b)  the policy depends on the survival of the beneficiary (i.e., that they are alive at the insured’s date of decease) if the beneficiary has joined the contract.

2. Tax highlights

However, it is from a tax point of view that unit-linked insurance appears as a desirable alternative, the Portuguese tax framework being the main reason for its appeal and success.

  2.1. Indirect taxation

It should be noted that in Portugal there is no general tax on movable assets.

Furthermore, Stamp Duty does not apply to the insurance policy itself or the insured capital (more correctly, to the economic transfer of value between the policyholder and the beneficiary) — which is to say that life insurance does not give rise to donation/inheritance tax.

  2.2. Personal Income Tax

With regard to income tax, advantages become more salient.

According to the provisions of article 5, paragraph 3, of the Portuguese Tax Code, life insurance income is taxed as follows (loose translation):

3 – The following are also considered capital income: the positive difference between amounts paid for the redemption, advance or maturity of insurance, and 'Life' operations and the respective premiums paid or amounts invested, (…), without prejudice to the provisions under the following paragraphs, when the amount of premiums, sums or contributions paid during the first half of contract duration represents at least 35% of their total:

    a)  One fifth of the income is excluded from taxation, if the redemption, advance, remission or another form of anticipation of availability, as well as expiry, occur after five and before eight years of contract duration;

   b)  Three fifths of the income are excluded from taxation if the redemption, advance, remission, or other form of anticipation of availability, as well as the maturity, occur after the first eight years of contract duration.

Considering that this type of (capital) income is subject to income tax at a special and liberating rate of 28%, then, if one goes by the 35% rule mentioned above:

    a)   redemptions or payments in life that occur after five years and one day from the expiration date are subject to a rate of 22.4%;

    b)    redemptions or payments in life that occur after eight years and one day from the expiration date are subject to an income tax rate of 11.2%.

But, if that tax rate reduction was not enough, there is more to take advantage of.

Thanks to the terms we just laid out, another great upside to unit-linked insurance is the tax deferral on income generated under the policy. Compared to other types of direct investment (e.g. shares, bonds, others), income from those assets, when held indirectly through an insurance policy, is not taxed when distributed, but only when the policyholder chooses to exercise their right of redemption or when a life capital payment is made.

Another less evident, sometimes overlooked advantage is the equilibrium between a possible negative balance of capital gains (negative capital gains) and capital income, which is possible because the assets, representing mathematical provisions, are owned by the insurer, not the policyholder. In Portugal, the offset between capital gains/losses and capital income is only allowed if the taxpayer chooses to add to their aggregate taxable income all of their capital gains and capital income — which would only benefit them in fringe cases. While capital income and capital gains are subject to an autonomous rate of 28%, the value of aggregated income may be subject to rates of 48% (in fact, with the additional solidarity rate enforced by the Portuguese Personal Income tax code, applicable from annual incomes of €80,000 and up, we can reach a marginal rate of 50.5%, and from €250,000 per annum it rises to a crushing 53%).

Now, if a given policyholder chooses to park a portfolio of financial assets “within” an insurance policy, all gains and losses regarding those assets affect either positively or negatively the value of the insured capital — but in the event of positive variation in that balance, such a balance (i) is negatively affected by capital losses and (ii) will only become taxable income on the date of redemption, payment or advance, thus allowing the effective offset between capital income and capital gains/losses.

Given the above, the success of unit-linked products in the Portuguese market now seems all but inevitable: no other financial product can offer high-net-worth-individuals a means to profit from an asset portfolio with:

   a)    significant tax rate reductions,

   b)    tax deferral to the moment of redemption or payment in life, and

   c)     an automatic and effective offset between capital income and capital gains/losses.