Insurance in Super versus Insurance outside Super - Buy-Sell Agreements

Transcription

1 Insurance in Super versus Insurance outside Super - Buy-Sell Agreements Jeffrey Scott SSA Acting National Manager, Life Insurance Products, BT Financial Group JEFFREY SCOTT 1

2 1 Introduction Insurance in Super versus Insurance outside Super Buy Sell Agreements In Australia, there are 2.1 million actively trading businesses, comprising of 1.3 million small businesses who are sole proprietors, 563,000 who employ 1-4 employees, and 198,000 who employ 5-19 employees, 1 of which most are deemed to be micro entities with a turnover of less than $2 million. 2 Only 2% of businesses employed employees, and less than 1% of all businesses employed more than 200 employees. 3 Small businesses employed approximately 4.5 million people in , with one third of the businesses owned by people over age Most small business owners view their business not only as a source of income while they are working, but also as a primary means for funding their retirement. 5 Almost 25% of all self-employed Australians have no superannuation. 6 This means that most small business owners will be looking to sell their business to fund all or part of their retirement, and to do this in the most effective manner they normally require a few things: someone to buy their business, appropriate valuation of the business, valid legal agreement, and a funding mechanism. There are a number of options when considering who to may buy a small business: existing business partners, family members, competitors, venture capitalists, or independent investors. Business may be valued in a number of ways: market value on the date of transfer, predetermined agreed value, multiple of recurring earnings, value of business real property, or any other method that the partners in the agreement determine appropriate. A valid legal agreement in the context of transferring the ownership of a business from one person (or entity) to another person (or entity) is commonly referred to as a buy-sell agreement. Funding mechanisms vary when considering the methods people may use to purchase a business entity. Often a potential owner will borrow money to purchase a business. Occasionally they will use accumulated savings to purchase a business. In the event of death or permanent incapacity of the existing business owner, life insurance is a common means of funding a buy-sell agreement. This paper will focus on the use of life insurance both inside and outside superannuation as a funding mechanism for a buy sell agreement, including recent clarifications to both superannuation and taxation rules and regulations regarding these arrangements. 1 ABS Cat. No Counts of Australian Business, including Entries and Exits June 2010 to June Australian Bureau of Statistics. Canberra, Australia. 2 Small Business Data Card 5 December The Treasury, Australian Government. Canberra, Australia. 3 ABS Cat. No Counts of Australian Business, including Entries and Exits June 2010 to June Australian Bureau of Statistics. Canberra, Australia. 4 ABS Cat. No ; ; and Australian Bureau of Statistics. Canberra, Australia. 5 Small business owners failing to plan for retirement with women less prepared: Study. 28 August Eloise Keating. Smart Company 6 JEFFREY SCOTT 2

3 2 Insurance Outside Super Buy-sell Life insurance takes on many forms, but the most common types of life insurance are: death cover, total and permanent disablement cover (TPD/permanent incapacity), trauma cover (critical illness/dread disease), and income protection (disability income/salary continuance). Prospective business owners have realised that it is often difficult to find available resources to fund the purchase of a business under the terms of a buy-sell agreement in the event of death, permanent incapacity, and in limited cases critical illness. Life insurance has become a common source of funding in these circumstances. There are two primary CGT events in a buy-sell agreement: disposal of the business interests (shares/equity) upon transfer from one business owner to another business owner; and the receipt of life insurance benefits (death, terminal illness, total and permanent disability, and/or trauma). In order not to trigger potential capital gains tax under CGT event D2, many solicitors will structure a buy-sell agreement using put-call options. A put-call buy-sell agreement allows the existing business owners (or some other buyer) to acquire a call option requiring the departing business owner (or his estate) to sell his proportion of the business in the event of death or permanent incapacity; while permitting the departing business owner (or his estate) to acquire a put option requiring the remaining business owners (or some other buyer) to purchase his proportion of the business when he dies or suffers a permanent incapacity. The ATO has determined that CGT event D2 does not occur at the time the agreement is entered into, but when the condition precedent to the grant (death or disablement of one of the business owners) occurs. 7 In a separate determination, the ATO also stated that a buy-sell arrangement with a condition precedent (such as death or permanent incapacity) triggers CGT event A1 only after the transfer in ownership occurs from one person (or entity) to another, rather than at the time of signing the contract. 8 The ATO has determined that when a life insurance policy is used for the purposes of funding a buysell agreement is was deemed to be a capital and not income. 9 Thus, there is no deduction under s8-1 ITAA 1997 for premiums paid, but are included in the cost base for calculation of CGT. 10 There are three common funding arrangements outside super using life insurance: self-ownership, cross ownership, and trust ownership. Self ownership involves an existing business owner purchasing life insurance policy(ies) on their own life, and when a claimable event occurs under the life insurance policy such as death, terminal illness, or permanent incapacity, the benefits are tax free if paid to themselves or a relative. 11 Cross ownership involves the individual who wants to buy the business purchasing insurance policy(ies) on the life of the existing business owner, then receiving the insurance proceeds when a claimable event occurs under the life insurance policy. In the event of death or terminal illness the 7 ATO ID 2003/1190; s ITAA ATO ID 2004/668; s ITAA ATO ID 2003/1189. Income Tax - CGT: buy - sell (business succession) agreement - life insurance proceeds - income or capital?; s6-5 ITAA 1997; s6-10 ITAA 1997; s6-15 ITAA 1997; s15-30 ITAA PR 2013/5; s8-1 ITAA 1997; s110-25(2) ITAA 1997; s110-55(2) ITAA s ITAA 1997; s ITAA 1997; s995-1 ITAA JEFFREY SCOTT 3

4 benefits will be tax free. 12 In the event of permanent incapacity (or trauma where applicable), the benefits will be taxed as a capital gain. 13 Trust ownership is an alternative administration structure that may have elements of either a crossownership or self-ownership, depending upon how the trust deed is structured, legal owner of the life insurance policy, beneficial owner of the life insurance policy, and absolute entitlements under the trust arrangement. In most circumstances, the ATO will treat a buy sell agreement that is administered via an insurance trust arrangement in a consistent manner to other arrangements; taxation of the life insurance proceeds will depend upon who is the beneficiary under the trust deed. 14 We have discussed the various options for buy-sell agreements outside superannuation using life insurance. In the next chapters we will examine life insurance inside super, and the implications of implementing a buy sell agreement via a SMSF. 12 s ITAA s ITAA s ITAA 1997; s ITAA 1997; s ITAA 1997; s108-5 ITAA 1997; s110-25(2) ITAA 1997; s110-55(2) ITAA 1997; s ITAA 1997; s ITAA 1997; s ITAA 1997; s ITAA 1997; TR 2004/D25; ATO ID 2004/121; TD 94/31 & TD94/31A; TD 2007/4; PR 2010/18 JEFFREY SCOTT 4

5 3 Insurance in SMSFs There is a tremendous shift in the focus of individuals to take control of their own retirement funding. Currently in Australia, there are more than 556,998 Self Managed Superannuation Funds (SMSFs), with more than 1,049,840 members. Over the past 12 months there has been an increase of 30,000 new funds and 58,000 new members. 15 Prior to legislation being passed in 2012, less than 13% of existing SMSFs had any life insurance. 16 Responding to concerns that in 2010, less than 13% of SMSFs held insurance cover for members, the federal government amended the SIS Regulations in 2012 to require trustees of SMSFs to consider whether to hold insurance for members as part of formulating or reviewing the fund s investment strategy. Superannuation Industry (Supervision) Regulation 4.09 states: Operating standard--investment strategy (1) This regulation: (a) is made for subsection 31(1) of the Act; and (b) applies to a superannuation entity that is a self managed superannuation fund. (2) The trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following: (e) whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund. 17 The Government also confirmed when implementing these changes that trustees should be self-reliant when determining the type and level of insurances required and that to meet this requirement the trustee should consider the personal circumstances of fund members as well as other legislative requirements, such as the sole purpose test. 18 ASIC Consultation Paper 216 has proposed disclosure requirements for SMSFs regarding life, TPD, and income protection insurance. 19 Therefore, when implementing or reviewing the fund s investment strategy, a trustee will need to consider a range of issues when determining each member s insurance needs and whether they should hold a death or disability policy for them. These issues include: 15 ATO Self managed super fund statistical report March Super System Review 30 June Superannuation Industry (Supervision) Regulations REG Explanatory Memorandum Superannuation Industry (Supervision) Amendment Regulations Australian Securities and Investment Commission Consultation Paper 216 Advice on self-managed superannuation funds: specific disclosure requirements and SMSF costs (September 2013). JEFFREY SCOTT 5

6 the members age, health, assets, liabilities, income level and whether they have any dependants whether the member has any existing insurance cover held inside the SMSF, in another super fund, or outside super and the level and type of those insurances whether the member, and/or their dependants, would be able to maintain their current quality of life in the event of the member s death or in the event that the member was unable to work due to their temporary or permanent invalidity. ASIC Report also stated that trustees and advisers need to consider the potential negative impact the cost of life insurance premiums within a superannuation fund may have on a member s long term retirement accumulation balance. The trustees should document their decision in the fund s investment strategy or alternatively in the minutes of a trustee meeting. Note - from a practical perspective it would generally be much simpler to document the trustees decision in the minutes of a trustee meeting otherwise the trustees would be required to amend the fund s investment strategy each year to specify whether the trustee will acquire a new policy or maintain, increase or decrease a member s existing level of cover. 3.1 Requirement to hold minimum level of insurance It is important to note that SIS Regulations only requires trustees to consider the need to hold insurances for member. It does not require a trustee of an SMSF to provide a minimum or default level of insurance for each member. For example, a trustee may decide not to hold any insurance policies for a range of reasons, such as: the members have adequate insurances in place elsewhere, i.e. outside of super or held via another super fund the members do not require insurance the members are willing to accept the risk of being uninsured and don t want the insurance premiums impacting their retirement savings the trustee would be unable to obtain affordable life insurances due to the members health or age. So long as the fund s investment strategy specifies that the trustee of the fund will consider the need to hold insurances for members and that the trustees can show they properly considered the issue and documented their decision in the minutes of a trustee meeting, they will generally have complied with their obligations under the SIS requirements. 3.2 Penalties for failure to properly consider the need to hold insurance for members The requirement to consider the need to hold insurances for members is included in the SIS operating standards. A trustee who intentionally or recklessly contravenes an operating standard is guilty of an offence punishable on conviction by a fine up to 100 penalty units (currently $18,000) Australian Securities and Investment Commission Report 413 Review of retail life insurance advice October JEFFREY SCOTT 6

7 Failure to properly consider the need to hold insurance could also result in the surviving trustees being sued by a deceased member s beneficiaries for any losses or damages they suffer as a result of the member being uninsured, or under-insured. 22 This becomes a significant risk where a deceased member s beneficiaries are not members or trustees of the SMSF themselves, and they have suffered significant losses due to the trustees failing to comply with their legal requirement to consider the member s insurance needs. In situations where a client declines the offer of insurance advice, the adviser may wish to consider discussing this further with the client to ensure they fully understand their obligations and the risks of not properly considering the insurance needs of the members. The adviser may also wish to record the details of the conversation and outline in the statement of advice that: they offered to provide insurance advice but that the client declined the advice it is the trustees responsibility to consider the need to hold insurances for members, and the risks of not complying with their legal obligation to do so. Ravesi v National Australia Bank Limited (2014) (FCA 99) reinforces the need for advisers to consider the insurance needs of their clients and appropriately document their recommendations, even where clients choose to decline life insurance cover. 3.3 Impacts on provision of investment strategy advice Under the best interest requirements an adviser engaged to formulate or review an SMSF s investment strategy will be required to discuss the trustee s obligation to also consider the need to hold insurance. The adviser should offer to undertake an insurance needs analysis and to make a recommendation in relation to each of the members insurance needs. In situations where a client declines the offer of insurance advice, the adviser may wish to consider discussing this further with the client to ensure they fully understand their obligations and the risks of not properly considering the insurance needs of the members. The adviser may then wish to record the details of the conversation in a file note and outline in their statement of advice that: they offered to provide insurance advice but that the client declined the advice it is the trustees responsibility to consider the need to hold insurances for members, and the risks of not complying with their legal obligation to do so. 21 Section 34 SIS Act; Section 4AA Crimes Act Section 55(3) SIS Act JEFFREY SCOTT 7

8 4 Ability to obtain policies of insurance When providing advice to potential SMSF trustee/members, issues that will need to be considered include: The fund s investment strategy Provision for members or their dependants Consideration of individual member circumstances Nomination of beneficiaries Conditions of release Taxation of benefits Premium deductibility Sole purpose test requirements Death core purpose and ancillary TPD ancillary purpose Income protection ancillary purpose Trauma special case Non-Recourse Loans Annual review of insurance (minuted by trustee) Currently, a trustee of a complying super fund, including an SMSF, is generally able to acquire a range of different types of life and disability insurance policies issued by a life insurance company. These may include: Life insurance Total and Permanent Disability (TPD) insurance (any occupation definition), and Income protection insurance. Superannuation funds that established insurance contracts prior to 1 July 2014, may also be permitted to have the following insurances: Total and Permanent Disability (TPD) insurance (own occupation definition), and Trauma insurance However, before acquiring a life insurance policy a trustee will also need to ensure the acquisition would not cause the fund to breach the acquisition from related party rules, the sole purpose test and would be allowed under the fund s governing rules July 2014 rule changes From 1 July 2014 amendments to SIS regulations 23 came into effect that prohibits a trustee of a complying super fund from providing members with a right 24 for their benefits to be increased on the realisation of a risk other than for those that satisfy the following conditions of release: death (including terminal medical condition) 23 SIS Regulations 4.07C and 4.07D 24 Other than an anti-detriment payment JEFFREY SCOTT 8

9 permanent incapacity, and temporary incapacity. Since 1 July 2014, trustees are prohibited from acquiring an insurance policy in respect of a member unless the proceeds from the occurrence of an insured event would be able to be released to the member under one of the specified conditions of release. Since 1 July 2014, trustees of SMSFs have not been permitted to acquire a trauma policy or an own occupation TPD policy in respect of a member, as the terms and conditions of these policies do not align with the permanent invalidity or temporary invalidity conditions of release. Trustees will also need to take care when acquiring income protection policies after 1 July 2014 to ensure the policy does not provide any lump sum ancillary benefits that would not align with one of the specified conditions of release. For example, a trustee would not be permitted to acquire an income protection policy that also paid a lump sum crisis, specific injury or home care benefits Death cover Post 30 June 2014 Death is not specifically defined under the SIS Act or SIS Regulations. While this would normally not be an issue, circumstances where people become clinically dead but later recover could pose a problem for trustees. It may be prudent for both trustees and insurance companies to confirm that death benefits will only paid/released upon declaration from a coroner, or where a Death Certificate issued by a relevant registering authority where the death took place. From a practical point of view, if the member of the superannuation fund presents themselves to the trustee (still alive) then it becomes difficult to justify a death benefit condition of release, even if they may have been clinically dead in the past Terminal Illness cover Post 30 June 2015 In the Budget, the Government announced that from 1 July 2015, it would amend the provision for accessing superannuation for people with a terminal illness. Under the previous provision for early access to superannuation, a person with a terminal illness was required to obtain a certification from medical specialist if they had less than 12 months to live. This has been extended to 24 months and the legislation received Royal Assent on 25 June A terminal medical condition exists in relation to a person at a particular time if the following circumstances exist: (a) two registered medical practitioners have certified, jointly or separately, that the person suffers from an illness, or has incurred an injury, that is likely to result in the death of the 25 Tax and Superannuation Laws Amendment (Terminal Medical Conditions) Regulation JEFFREY SCOTT 9

10 person within a period (the certification period) that ends not more than 24 months after the date of the certification; (b) at least one of the registered medical practitioners is a specialist practicing in an area related to the illness or injury suffered by the person; (c) for each of the certificates, the certification period has not ended. This is a significant change to existing insurance policy wording for this condition of release, as it means that a member may be able to access superannuation fund benefits up to 12 months earlier than under the previous legislation. It is best to check with your insurance provider to determine if they will be amending this definition in their policy documents Permanent Incapacity cover Post 30 June 2014 Permanent incapacity, in relation to a member, means ill-health (whether physical or mental), where the trustee is reasonably satisfied that the member is unlikely, because of the ill-health, to engage in gainful employment for which the member is reasonably qualified by education, training or experience (SIS Regulations 1994). Disability superannuation benefit is a superannuation benefit if: (a) the benefit is paid to an individual because he or she suffers from ill-health (whether physical or mental); and (b) 2 legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the individual can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training (ITAA 1997). The result of this more onerous definition is two-fold. Own occupation TPD will be prohibited for any new insurance cover issued to a member within a superannuation fund after 1 July Secondly, any other ancillary benefit such as loss of limbs or sight, loss of independent existence, inability to perform activities of daily work, or inability to perform activities of daily living, for any new insurance cover issued to a member after 1 July 2014 will need to meet the additional criteria that the member's ill-health (whether physical or mental) makes it unlikely that the member will engage in gainful employment for which the member is reasonably qualified by education, training or experience. Insurance that does not meet the second criteria, will not align with a condition of release. JEFFREY SCOTT 10

11 4.1.4 Temporary Incapacity cover Post 30 June 2014 In order to meet a temporary incapacity condition of release from a superannuation fund, the insurance policy definition must align with the condition of release. The SIS Regulations state (1.03c & 6.01): A non-commutable income stream cashed from the regulated superannuation fund for: (a) the purpose of continuing (in whole or part) the gain or reward which the member was receiving before the temporary incapacity; and (b) a period not exceeding the period of incapacity from employment of the kind engaged in immediately before the temporary incapacity Temporary incapacity", in relation to a member who has ceased to be gainfully employed (including a member who has ceased temporarily to receive any gain or reward under a continuing arrangement for the member to be gainfully employed), means ill-health (whether physical or mental) that caused the member to cease to be gainfully employed but does not constitute permanent incapacity Gainfully employed means employed or self-employed for gain or reward in any business, trade, profession, vocation, calling, occupation or employment The definition of temporary incapacity raises a number of issues regarding income protection policies owned by superannuation trustees. Over what period of time do you calculate the gain or reward which the member was receiving before the temporary incapacity (Schedule 1 Item 109 Part (a))? The life insurance industry standard is to calculate pre-disability income over the previous 12 months, but the Superannuation Regulations are not clear on this matter. The other more pressing question is what occurs if a member was between jobs when they suffer the temporary incapacity? In this circumstance, the gain or reward which the member was receiving before the temporary incapacity is nil on the date of disablement are they entitled to a benefit (Schedule 1 Item 109 Part (a))? Trustees will also need to take care that any income protection policies acquired after 1 July 2014 do not pay any lump sum benefits, such as genuine redundancy, crisis, specific injury or home care benefits Grandfathering of pre 1 July 2014 policies It is important to note that under the SIS Regulations 26 the prohibition will not apply to the continued provision of insured benefits to members who joined a fund before 1 July 2014 and were covered in respect of that insured benefit before 1 July Therefore, where a trustee took out a trauma or own occupation TPD policy for a member prior to 1 July 2014, they can continue to maintain that policy after that date. In addition, the Government has 26 SIS Regulation 4.07D JEFFREY SCOTT 11

12 also confirmed a trustee can vary their level of cover from 1 July For example, the cover could be increased or decreased, and associated premiums adjusted, after 1 July Split cover In order to have the best of the old legislation and the new legislation, some insurance companies are providing split insurance cover. This places the complying insurance definitions inside a superannuation fund (Death, Any Occupation TPD) and have it linked to ancillary benefits outside superannuation (Own Occupation TPD). In order for this structure to comply with both taxation and superannuation legislation, there are a number of stipulations that must be met. Normally this involves that only a proportion of the total insurance premiums may be sourced from the superannuation fund, and that there is a specified order of occurrence when determining how a potential TPD benefit is paid (inside super under any occupation is assessed first) Acquisition of life insurance policies from members and relatives prohibited Under the acquisition of assets from related party rules, a trustee is prohibited from acquiring a life insurance policy issued by a life insurance company from a member of the fund or a relative of a member of the fund 28. Therefore, a trustee would not be able to accept the assignment of a life or disability policy owned by a member or a relative of a member of the fund. However, where a trustee/member is seeking to locate their existing insurance cover in their SMSF they could consider approaching their insurer to inquire whether they would be prepared to cancel and issue an identical policy in the name of the trustee of the SMSF. Depending on the circumstances the insurer may agree to do so without any additional medicals or underwriting on the basis that they are already on risk for the life insured. 4.3 The sole purpose test and insurance Before acquiring any life or disability policy the trustees will need to consider the sole purpose test. The sole purpose test requires that the fund be maintained only for: one or more core purposes, or one or more core purposes and one or more ancillary purposes. Most insurance arrangements fall within either a core purpose or an ancillary purpose (or both). Table 1 (below) summarises how different insurance policies interact with the sole purpose test. Table 1 Insurance and the sole purpose test 27 PR 2014/13 - Income tax: CommInsure Protection - Split TPD Cover; PR 2014/13A. 28 SIS Act section 66(2A)(a)(iii) JEFFREY SCOTT 12

13 Type of insurance Type of purpose (Core/Ancillary) Purpose Life Core Provision of benefits in the event of death prior to either retirement or preservation age. Source: s62(1)(a)(iv)&(v) SISA 1993 Life Ancillary Provision of benefits in the event of death after retirement or preservation age Source: s62(1)(b)(iii)&(iv) SISA 1993 TPD Ancillary Provision of benefits after cessation of work due to ill-health Source: s62(1)(b)(i)&(ii) SISA 1993 Income protection Ancillary Provision of benefits after temporary cessation of work due to ill-health Source: s62(1)(b)(ii) SISA 1993 Given that TPD and income protection insurance policies are only considered to align with ancillary purpose, an SMSF would also need to hold some other assets (retirement benefits) or hold a life insurance policy (death cover) for the members. Failing this the fund would be considered to have breached the sole purpose test as it would not be being maintained for at least one core purpose. It is also important to note that while there is no core or ancillary purpose specifically aimed at terminal illness benefits, it is likely to meet the sole purpose test due to its close alignment to death benefits and because many who suffer from a terminal illness will also have ceased work due to ill-health. The fact that terminal illness benefits are provided with a specific condition of release under the SIS Regulations supports this view. JEFFREY SCOTT 13

14 4.3.1 Trauma insurance and the sole purpose test There had long been questions as to whether it was possible for a trustee of a complying superannuation fund, including SMSFs, to acquire trauma insurance policies under the sole purpose test. This issue was originally addressed via APRA Superannuation Circular III.A.4 (Sole Purpose Test February 2001): The trustee must determine whether the provision of trauma insurance by a superannuation fund is acceptable, having regard to all the circumstances of the fund. This must be able to be substantiated if challenged by the auditor or APRA. Matters to be considered include the design of the trauma insurance and the manner and time in which the trustee intends to distribute any proceeds of the policy. In determining whether to offer trauma insurance, trustees should consider their obligations to members generally and factors such as the proportion of contributions applied to purchase insurance cover. An unreasonable diversion of contributions as premiums for the contingent trauma cover would be difficult to reconcile with the sole purpose test and the fundamental retirement objective of superannuation. The question that arose from the APRA guidance was how does a trustee determine what is an unreasonable diversion of contributions? In 2010 the ATO released an SMSF determination 29 which specifically addressed the sole purpose test question. In the determination, the ATO outlined that a trustee acquiring a trauma insurance policy will not automatically breach the sole purpose test, provided that: the trustee is the only party that would receive the proceeds the member will not have access to the proceeds until a condition of release has been met the member or any other party would not receive any other benefit as a result of the acquisition (eg a discount on any other insurance policy). However, it is important to note that trustees are generally prohibited from acquiring trauma policies since 1 July Trauma policies do not meet the provisions under the new SIS regulations 30 which prohibits a trustee of a complying super fund from providing members with a right 31 for their benefits to be increased on the realisation of a risk other than for those that satisfy the following conditions of release: death (including terminal medical condition); permanent incapacity; and temporary incapacity. Trauma policies that were in-force prior to this date (on or before 30 June 2014) are still permitted to remain within an SMSF. 29 SMSF Determination 2010/1 Self-Managed Superannuation Funds: can a trustee of a self-managed superannuation fund purchase a trauma insurance policy in respect of a member and still satisfy the sole purpose test in section 62 of the Superannuation Industry (Supervision) Act 1993? 30 SIS Regulations 4.07C and 4.07D 31 Other than an anti-detriment payment JEFFREY SCOTT 14

15 4.4 Trust deed considerations The ability of a trustee to acquire policies of life and disability insurance is also subject to the governing rules of the fund. Therefore, before acquiring any policy the trustee should check the fund s trust deed for any rules or restrictions that relate to holding insurances and the payment of benefits. Some important considerations in relation to the trust deed include: Does the trustee have a specific power to take out the relevant insurance policies and to pay the premiums? Is the trustee permitted to enter into group insurance arrangements where the trustee is not the owner of the policy? Does the trustee have the ability to pay benefits to members in the event of death, terminal illness, permanent disability or temporary disability? How member death or disability benefits are calculated and whether the trustee has any discretion to retain some or all of any proceeds and to allocate them to a reserve. This may be important where the proceeds are intended to be used for purposes other than paying benefits, such as to extinguish a loan under a limited recourse borrowing arrangement (LRBA). Where the trust deed does not include the required power for a trustee to obtain insurances and to pay premiums, the trustee may wish to consider arranging for the deed to be amended. JEFFREY SCOTT 15

16 5 Policy ownership and allocation of insurance premiums and proceeds 5.1 Policy ownership Where a trustee of an SMSF wishes to acquire an insurance policy for a member it is important that the policy is owned by the trustees on behalf of the fund, they pay the premiums from fund assets and the trustee receives the proceeds. On a number of occasions the author has seen situations involving a member holding an insurance policy in their own name but arranging for the premiums to be paid from fund assets on the basis that the fund has been nominated to receive the proceeds. In at least one of these situations the member was also able to produce a letter from the insurance company confirming the arrangement. However, it is difficult to see how such an arrangement would not involve the trustee paying a member s personal expense and therefore constitute a breach of the sole purpose test as well as the prohibition on a trustee providing any form of financial assistance to a member or a relative at a minimum. 5.2 Allocation of premium costs Under SIS Regulation 5.02 trustees are required to determine the costs to be charged against a member s interest in the fund on a fair and reasonable basis. These costs include the cost of any insurance policies held by the trustee for particular members. For example, where a trustee held a life insurance policy to provide death benefits for a particular member, the trustee would be required to deduct the cost of those premiums from that particular member s account. Alternatively, where the trustee has acquired a policy over a member for the fund s own purposes and it would not want to allocate any proceeds to the members account, the trustee would need to treat the premiums as a general fund expense. 5.3 Allocation of insurance proceeds Under SIS Regulation 5.03, where a trustee receives the proceeds from an insurance policy held in respect of a particular member, the trustee will be required to allocate those proceeds on a fair and reasonable basis. In relation to this, the ATO has confirmed that the proceeds of an insurance policy should be added to the interest against which any premiums payable under the policy were charged as a cost National Tax Liaison Group Superannuation Technical minutes, June 2012 JEFFREY SCOTT 16

17 Therefore, where the cost of any insurance premiums held by a trustee are deducted from a particular member s benefit in the fund, any proceeds received in respect of that policy must be allocated to that particular member s interest in the fund and could not be allocated to another member or to a reserve. Alternatively, where the premiums are treated as a general fund expense and do not relate to any particular member, the trustee, subject to the provisions of the fund s trust deed, could allocate the proceeds to a reserve, but would be unable to allocate to another member s account (other than the life insured) (Last updated 28 October 2015). JEFFREY SCOTT 17

18 6 Tax and insurance at the fund level 6.1 Deductibility of insurance premiums Under section of the Income Assessment Act 1997 (the Tax Act) a fund can deduct the part of any insurance premium that is specified as being wholly for the liability to pay: a superannuation death benefit (including a terminal illness benefit) a disability superannuation benefit a temporary disability benefit paid in the form of an income stream. This means trustees will generally be able to claim 100% of the cost of any life, total and permanent disability (TPD) or income protection policy held to provide insurance cover for one or more members Special rules for deductibility of TPD own occupation policies In July 2012 the ATO released Tax Ruling TR 2012/6 34, which confirms that a super fund will only be able to claim a tax deduction for a TPD insurance premium where: there is a connection between that payment and a current or contingent liability of the fund to provide a disability superannuation benefit, and upon the occurrence of an insured event the trustee would have a current or contingent obligation to pay a disability superannuation benefit under the terms of the fund s trust deed. A disability superannuation benefit is defined in the Tax Act as a super benefit paid to an individual because they suffer ill-health and two legally qualified medical practitioners have certified that they are unlikely to ever become gainfully employed in a capacity for which they are reasonably qualified through education, training or experience. Importantly, TR 2012/6 confirms that the degree of ill-health that must be suffered in order to qualify for a disability superannuation benefit under the Tax Act is identical to the degree of ill health that must be suffered to satisfy a condition of release under the grounds of permanent incapacity under the SIS Regulations. Therefore, the premiums for a TPD insurance policy which covers events that align with the permanent incapacity condition of release will generally be deductible. Meaning of permanent incapacity Permanent incapacity means ill-health (whether physical or mental), where the trustee is reasonably satisfied that the member is unlikely, because of the ill-health, to engage in gainful employment for which the member is reasonably qualified by education, training or experience. 34 Taxation Ruling TR 2012/6 Income tax: deductibility under subsection (1) of the Income Tax Assessment Act 1997 of premiums paid by a complying superannuation fund for an insurance policy providing Total and Permanent Disability cover in respect of its members JEFFREY SCOTT 18

19 However, the ruling also confirms that certain policies may cover a range of events, only some of which would align with the definition of a disability superannuation benefit. For example, an own occupation TPD policy which also covers any occupation TPD events would cover a range of events, of which only some would align with the definition of a disability superannuation benefit. In these situations, the ruling confirms that the fund will only be able to claim part of the premium as a deduction as follows: where the insurer has identified the part of the premium that relates to a liability to pay a disability superannuation benefit that part of the premium, or by applying a set percentage depending on the type of policy (and inclusions) as specified in the Tax Regulations see Table 2, or o by obtaining an actuarial certificate which identifies the part of the premium that is attributable to events that would give rise to a liability to provide a disability superannuation benefit. Table 2 Standard deductions available for TPD insurance Insurance policy Specified deduction % TPD any occupation 100% TPD any occupation with one or more of the following inclusions*: activities of daily living, cognitive loss, loss of limb, domestic (home) duties 100% TPD own occupation 67% TPD own occupation with one or more of the following inclusions*: activities of daily living, cognitive loss, loss of limb, domestic (home) duties 67% TPD own occupation bundled with death (life) cover 80% TPD own occupation bundled with death (life) cover with one or more of the following inclusions*: activities of daily living, cognitive loss, loss of limb, domestic (home) duties 80% *To qualify for a deduction under the Tax Regulations the definition of any inclusions, ie loss of limb etc must have substantially the same meaning or be more restrictive than the conditions described in Tax Regulation Deduction for a future liability to pay benefits Alternatively, a trustee can claim a deduction under section of the Tax Act for the future liability to pay benefits based on the actual cost of providing the death or disability benefits which arise in each year. However, the deduction allowable under section is only available if the trustee chooses not to claim a deduction for the cost of death or disability insurance premiums in respect of that year and the fund pays a superannuation death or disability benefit in consequence of a member s termination of employment (or pays a benefit because of a temporary inability to work). That is, for the fund to be eligible to claim a deduction the member must have been employed and the payment must have been made in consequence of their termination through death or their inability to work. The deduction available to a fund is calculated using the following formula: JEFFREY SCOTT 19

20 Where: Benefit amount = the value of the super interest used to pay a lump sum or pension, or in the case of income protection benefits paid to the member, the amount of payments received during the financial year Future service days = days from the date of employment terminating to the member s last retirement date (generally age 65) Total service days = future service days plus the member s existing service days. Where an event has occurred which may entitle a trustee to make the choice to claim a future liability to pay benefits deduction they may wish to consider the following: the deduction will generally not be available where the relevant member was over age 65 where the trustee elects to claim the deduction they will not be able to claim a deduction for any insurance premiums paid by the fund in that year or future years as the deduction reduces with age it may be better to claim the cost of the premiums where the member is approaching age 65 where the member s benefit is large compared to the level of insurance, the future liability deduction should provide a relatively larger deduction than claiming the premiums Where the future liability deduction exceeds the fund s assessable income in that year, the resulting tax loss can be carried forward to future years. Therefore, this deduction could benefit funds where the deceased member s beneficiaries, such as the member s children, were able to become members and utilise the carry forward deduction to offset tax on the fund s future assessable contributions and investment income. 6.3 Taxation of insurance proceeds Under the Tax Act insurance proceeds will generally be subject to tax under the capital gains tax (CGT) provisions and will be included in a taxpayer s assessable income. However, certain exemptions apply, including for the trustee of a complying superannuation fund Taxation of life insurance proceeds Under section of the Tax Act any capital gain or loss made by the trustee of a complying super fund on a life insurance policy held on the life of an individual is disregarded. Taxation Determination 2007/4 35 confirms that this applies to both life insurance and terminal illness proceeds. Recent legislation reinforces this determination. 36 Therefore, trustees will not be required to pay capital gains tax on the receipt of any life insurance proceeds. 35 Taxation Determination TD 2007/4 Income tax: capital gains tax: is a policy of insurance on the life of an individual in section of the Income Tax Assessment Act 1997 limited to a life insurance policy within the common law meaning of that expression? 36 Tax and Superannuation Laws Amendment (2014 Measures No. 7) Act JEFFREY SCOTT 20

21 6.3.2 TPD and trauma insurance This exemption now also applies to the receipt of total and permanent disability (TPD) insurance proceeds. TPD proceeds were originally exempt under section of the Tax Act where the proceeds are received by the member or their relative. They are now also exempt for trustees of superannuation funds under section of the Tax Act. 37 Therefore, so long as the proceeds of a TPD or trauma policy are allocated to a member s account they will not be subject to CGT. However, if a trustee allocated any TPD or trauma insurance proceeds to a reserve instead (maybe as part of a strategy to extinguish a borrowing), the exemption under or would not apply and the proceeds would be subject to CGT (See section 9.1 below for more information). Again it should be noted that no new trauma insurance policy may be placed in a SMSF from 1 July Insurance and segregated current pension assets on death In Tax Ruling TR 2013/5 38, the ATO expresses the view that a superannuation income stream ceases as soon as a member in receipt of the superannuation income stream dies, unless a dependant beneficiary of the deceased member is automatically entitled to receive an income stream on the death of the member. As a result, this could potentially have meant significant CGT implications when selling or transferring super fund assets to pay a deceased pensioner s death benefit from the fund. However, the Income Tax Assessment Regulations 1997 (the Tax Regulations) were amended 39 (effective for the and future financial years) to allow a deceased member s nonreversionary pension interest 40 to continue to be treated as a pension for tax exemption purposes between the date of death and the date a lump sum death benefit is paid or a new pension commenced (provided this happens as soon as is practicable). The pension tax exemption will then apply to the deceased member s balance at the date of death, plus any investment earnings that accrue on this balance up until the payment of the death benefit as a lump sum or income stream. However, the following amounts are specifically excluded from being part of the pension assets: insurance proceeds amounts arising from self-insurance anti-detriment payments Therefore, where the fund uses the segregated assets method any cash or other assets purchased with the proceeds of an insurance policy will not be included as part of the fund s exempt current pension assets and any investment earnings on those proceeds will be fully assessable. Alternatively, where the fund uses the unsegregated assets method, the insurance proceeds will be excluded from the average value of the fund s pension liabilities as per the exempt pension income 37 Ibid. 38 TR 2013/5 Income tax: when a superannuation income stream commences and ceases. 39 Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation Account based, allocated and term allocated pensions only JEFFREY SCOTT 21

22 calculation in section in the Tax Act. However, the proceeds would be included in the average value of the fund s superannuation liabilities under that section. As a result, the receipt of insurance proceeds in this situation would result in a reduced tax free percentage. JEFFREY SCOTT 22

23 7 Insurance and superannuation benefits tax 7.1 Taxation of life insurance proceeds included in death benefits accumulation phase Where the proceeds of a life insurance policy are allocated to the deceased member s superannuation interest they will form part of the taxable component of that interest. This occurs by default as the insurance proceeds are not included in the calculation of the tax-free component (i.e. contributions segment or crystallised segment) and therefore must form part of the member s taxable component. Where a deceased member s interest is then paid as a lump sum death benefit to a tax dependant, such as a spouse or minor child, the whole of the amount of the payment (including the insurance component) will be tax free (i.e. non-assessable non-exempt income). Therefore, a trustee will generally not be required to calculate the tax components or withhold any tax from the payment. However, where a fund pays a death benefit as a lump sum from accumulation phase to a non-tax dependant, the trustee will need to withhold tax from the taxable component included in the payment as per Table 3. Table 3 Taxation of lump sum death benefits paid to a non-tax dependants Tax component Tax free component Tax rate Nil (non-assessable non-exempt income) Taxable component (taxed element) 15%* Taxable component (untaxed element) 30%* * Medicare levy is also payable on the amount except where the death benefit is paid to the member s estate. Where the trustee has, or will, claim a deduction for the cost of the insurance premiums (or claim a deduction for a future liability to pay benefits), the taxable component will also include untaxed element. The process to calculate untaxed element is specified in section of the Tax Act and is as follows: Step 1 Calculate the taxable component (taxed element) JEFFREY SCOTT 23