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Adverse ATO Advice on Super Buy/Sell Cover

Partnership and Trust Loan Accounts

Effect of Debt Reduction Cover on Buy/Sell Cover

Prioritising Needs

Simultaneous Deaths

Mutual Will Strategies

Joe Hockey on Trusts

Tax Treatment of Self-Ownership Agreements

Vested and Indefeasible Interest

Gross or Net Value?

Henry Report

Deemed Dividends

Super Buy/Sell Cover

Bamford in the High Court

Trauma Cover in Super

Origins of Self-Ownership

Fact-Finding

Methods of Aggregation

Valuing the Business

Duty to Give Tax Advice

Equity vs Loan Capital

Horses for Courses

Commercial Debt Forgiveness

Choice of Trustee

Simplifying the Valuation Issue

Hybrid Succession Strategy

Hedge and Wedge Strategy

Sole Proprietors and Families

Free Teleconference

Simple or Complete Succession?

Contemporaneous Agreement

Geared Premium Funding

Super Fund Ownership

Business Family Will

 

 

 

 

 

 

 

Alternative Methods of Aggregation: Trust Ownership or Self-Ownership?

 

One of the commercial justifications of Trust Ownership is its suitability as a vehicle for aggregation of Cover onto One Policy (i.e., the One Page, One Policy Strategy).

This Strategy aggregates Cover for multiple purposes onto One Policy instead of holding the Cover on multiple Policies owned by multiple Policy Owners.

Many lawyers who question or oppose the use of Business Insurance Trusts either don't understand them or are simply trying to justify their own historical preference for Self-Ownership.

On the other hand, there have been attempts to use Self-Ownership to mimic this functionality of Trust Ownership (sometimes called a "Hybrid Business Succession Strategy").

These attempts aggregate different Cover onto one policy held by the Life Insured, on the basis that the Life Insured (or their Executor) has a legal obligation to distribute the Insurance Proceeds to the different recipients.

This page examines some of the implications of using Self-Ownership as a method of aggregation.

 

The Origins of Self-Ownership of Business Insurance

It is helpful to understand how Self-Ownership came to be used a method of ownership of Business Cover.

Self-Ownership of Personal Cover

Self-Ownership is and always has been an appropriate method of holding Personal Cover.

In most circumstances, the only question will be whether the Life Insured wants to hold some or all of their Personal Cover in the Superannuation environment, so that they can effectively obtain a tax deduction for the Premium.

Policy Ownership Before Capital Gains Tax

Before the introduction of Capital Gains Tax, it was not common for Self-Ownership to be used as a method of ownership for Business Insurance.

It was accepted practice for:

  • the Continuing Proprietors or Purchasers to own the Buy/Sell Cover; and

  • the Business to own the Debt Reduction or Key Person Cover.

We now describe these methods of ownership as Cross-Ownership.

Policy Ownership After Capital Gains Tax

The introduction of Capital Gains Tax caused a major re-consideration of the methods of ownership of Business Insurance.

The most immediate concern was the ownership of Buy/Sell Cover.

Different Tax Treatment of Death and Non-Death Benefits

Many Lawyers and Advisers recognised that, while Cross-Ownership would obtain a CGT exemption for the Death Benefit, it would not qualify for an exemption for any Non-Death Benefit (such as a TPD or Trauma Benefit).

The reason is that the exemption in section 118-37 effectively requires the Non-Death Benefit to be paid to the "Injured Person" (or a Relative).

Because Death and Non-Death Benefits are usually bundled on the one Policy, it was not practical to split the Cover into:

  • a Death Benefit owned by the Purchasers; and

  • a Non-Death Benefit owned by the Life Insured.

Lawyers and Advisers had to come up with an alternative method of ownership, in order to qualify for a CGT exemption for both Death and Non-Death Benefits.

"Self-Ownership" of the Non-Death Benefit

The narrow definition of the exemption for Non-Death Benefits really dictated that the method of ownership had to be a form of Self-Ownership.

This could include direct Self-Ownership, where the Life Insured is the Policy Owner.

However, as a result of the 1991 CGT Tax Determination TD14, it could also include indirect Self-Ownership, where a Trustee owns the Policy for (or on trust for) the Life Insured or Injured Person.

Ultimately, the Business Insurance Trust Structure takes advantage of TD14, while Self-Ownership takes advantage of the literal wording of section 118-37 itself.

Exchanging the Purchase Price for a Transfer of the Equity

Both methods of ownership qualified for CGT exemptions for both Death and Non-Death Benefits.

However, in the context of Buy/Sell Cover, it was necessary to solve another problem.

Self-Ownership must pay the Insurance Proceeds to the Life Insured (or their Estate).

Unlike Cross-Ownership, it does not pay the Purchase Price to the Purchasers, who can then pay it to the Vendor in exchange for a transfer of the Equity in the Business.

Self-Ownership effectively by-passes the Purchasers and pays the Purchase Price directly to the Life Insured or Vendor.

Now that the Life Insured or Vendor has both the Equity and the Insurance Proceeds, we need a mechanism to make sure that the Purchasers receive a transfer of the Equity.

The Purchasers need recognition of the fact that the Purchase Price has been paid directly to the Life Insured or Vendor.

This was achieved by a novel method of legal drafting.

Crediting Provision

A modern Self-Ownership Agreement doesn't provide for a traditional "exchange".

Instead, it contains a "Crediting Provision" that gives the Purchasers "credit" for the funds paid to the Vendor by the Insurance Company and therefore requires the Vendor to transfer the Equity without any additional payment by the Purchasers.

Market Value Substitution Rules

The ATO treats the Buy/Sell Agreement as a "non-arm's length" agreement, which entitles it to apply the Market Value Substitution Rules under section 116-30.

As a result:

  • the Purchasers will be deemed to have paid market value for the Equity; and

  • the Vendors will be deemed to have received the market value.

Thus, the Purchasers will have a substantive Cost Base, but the Vendors will incur a CGT liability with respect to the sale, as if they had received the market value.

Summary

It is clear from this history that Self-Ownership is a solution to one particular issue: the different CGT treatment of Death and Non-Death Benefits in the context of Buy/Sell Cover.

To a certain extent, it is a band-aid.

The ATO recognises that Lawyers and Advisers use Self-Ownership as a method of avoiding the CGT on Non-Death Benefits that would have applied if the Buy/Sell Cover was owned by the Continuing Proprietors or Purchasers.

It recognises that Self-Ownership is non-arm's length.

However, for the moment, it allows the practice to continue, on the basis set out in a non-binding Statement of Principles issued in 2001.

The issue now is whether Self-Ownership of the Buy/Sell Cover is an appropriate foundation for a One Policy Strategy that includes Key Person or Debt Reduction Cover.

In other words, is Self-Ownership a cure, not just a band-aid?

 

Self-Ownership of Key Person or Debt Reduction Cover

In most cases, the Self-Ownership of Buy/Sell Cover was a practical solution to the CGT problem, because the Insurance Proceeds ended up with the Life Insured or Vendor.

In other words, at the end of the normal chain of transactions, the Life Insured or Vendor was supposed to receive the Purchase Price.

Assuming that the Life Insured owns the Equity in the Business, the Life Insured or Vendor is the correct destination for the Insurance Proceeds.

It didn't matter that the method by which this was achieved required a payment from the Insurance Company directly to the Life Insured or Vendor.

The tax treatment and journal entries by which this was achieved could be sorted out by Lawyers and Accountants as a separate exercise.

However, this was fortuitous.

It should not be assumed that the solution will be this easy in the case of Key Person or Debt Reduction Cover.

 

Key Person Cover

Normally, it will be expected that the ultimate recipient of the Key Person Cover will be the Business itself.

In most cases where there is Buy/Sell Cover that enables the Life Insured's Equity to be bought by the Continuing Proprietors, the new owners of the Business will be the remaining or Continuing Proprietors.

Any Key Person Cover needs to be paid to or received by the Business.

This entity will now be associated more with the Continuing Proprietors than with the Life Insured.

If the Cover is self-owned, then the Insurance Company need only pay it to the Life Insured (or their Estate).

So far, the Insurance Proceeds have not ended up with an appropriate recipient.

They have not yet arrived at the correct destination.

There needs to be a legal or other mechanism by which the Insurance Proceeds move from the Life Insured (or their Estate) to the Business.

 

Debt Reduction Cover

Similar issues arise in the case of Debt Reduction Cover.

Normally, it would be expected that the ultimate recipient of the Debt Reduction Cover will be:

  • the Business (or Debtor); or

  • the Bank (or Creditor).

Again, the Business will be associated more with the Continuing Proprietors than with the Life Insured.

If the Cover is self-owned, then the Insurance Company need only pay it to the Life Insured (or their Estate).

So far, the Insurance Proceeds have not ended up with an appropriate recipient.

They have not yet arrived at the correct destination.

There needs to be a legal or other mechanism by which the Insurance Proceeds move from the Life Insured (or their Estate) to the Business.

 

Payment to Third Party

The issue is now: what arrangements need to be in place to get the Insurance Proceeds to the Business or its Creditor?

What are the commercial, legal and tax implications of these arrangements?

These issues are not generally understood by Advisers.

As a result , it is not normal for Business Key Person or Debt Reduction Cover to be owned by the Life Insured.

However, if Self-Ownership is used, there can be serious commercial, legal and tax implications for all of the parties to the arrangements.

Below is an analysis of some of the implications of these arrangements.

 

CGT Liability with respect to Contractual Obligation

As mentioned above, upon the occurrence of an Insured Event, any Insurance Proceeds would be received by the Life Insured or their Estate (not the Business or the Creditor).

It would be necessary to impose a contractual or legal obligation on the Life Insured or Estate to pay the Insurance Proceeds to the Business or its Creditor.

The contractual or legal obligation would be a "chose-in-action", which is itself a CGT Asset.

Unfortunately, the discharge or performance of this obligation itself (i.e., by the payment of the Insurance Proceeds to the Business or Creditor) would create a CGT liability.

Click here to read more about this CGT liability.

This liability would be additional to the tax liability that arises under the Commercial Debt Forgiveness provisions discussed below.

 

Hybrid Business Succession Strategy

The Hybrid Business Succession Strategy is an example of this type of Self-Ownership Structure.

This Structure requires the Life Insured to own the Debt Reduction (or Key Person Capital Cover) on the basis that they will be contractually obliged to pay the Insurance Proceeds to the Business, the Continuing Proprietors or the Creditor.

Unfortunately, the discharge or performance of this obligation itself would create a CGT liability.

IGS Discussions with ATO

IGS investigated the Self-Ownership model in its discussions with the CGT Cell of the ATO in 2001 and confirmed the above interpretation of the CGT Provisions.

As a result, IGS discontinued its attempts to solve the problem with Self-Ownership and developed a solution that uses the Business Insurance Trust Structure.

 

Payment to Third Party as a "Gift"

When pressed, some advocates of this type of structure describe the payment as a "gift".

However, this is both misguided and misleading.

In reality, the CGT test is not whether there was a "gift", but whether there was a contractual obligation.

However, in any event, it is not legally correct to describe the payment under these provisions as a "gift".

In the High Court case of FCT v. McPhail (1968) 117 CLR 111; (1968) 15 ATD 16; (1968) 10 AITR 552, Owen J stated:

But it is, I think, clear that to constitute a "gift", it must appear that the property transferred was transferred voluntarily and not as the result of a contractual obligation to transfer it and that no advantage of a material character was received by the transferor by way of return.

This case is authority for the proposition that, to be a gift, a payment must be made voluntarily and not as the result of a contractual obligation.

If there is no contractual obligation to make the payment to the Third Party, then there is no legal framework to ensure that it happens.

This subjects the parties who rely on the payment being made (the Business, the Continuing Proprietors and the Creditor) to the risk that the Life Insured (or the Executor of their Estate) will not make the payment.

In the absence of a contractual obligation, they would have no legal remedy to enforce the payment.

Therefore, under this structure, there is either:

  • a gift (which is unenforceable and cannot be remedied in the case of default); or

  • a contractual obligation (the performance of which is subject to CGT).

There is no middle ground in the case of Self-Ownership of Debt Reduction Cover.

 

Right of Contribution

In addition, the repayment of a Debt by a Guarantor (or party other than the Debtor) creates a "Right of Contribution".

A Right of Contribution entitles the Guarantor to be reimbursed by the Debtor (and any other Guarantors) for the payment it has made on their behalf.

This Right creates a new Debt or Loan Account between the Life Insured (or their Estate) and the Business.

In effect, it creates a new Loan Account in substitution for the Debt owing to the Bank.

Thus, future profits of the Business would have to be used to pay principal and interest to the Outgoing Proprietor (or their Estate).

In effect, the Business now has to pay funds to the Outgoing Proprietor rather than the Bank.

In other words, it has not provided any net financial benefit to the Business.

This frustrates the Succession Plan.

If the Buy/Sell Strategy was intended to exit the Life Insured from any financial interest in the Business, the failure to structure the Debt Reduction Cover adequately undermines the strategy.

It creates a new financial interest and burden (rather than extinguishing a pre-existing one).

This problem can be avoided by the use of a Business Insurance Trust Agreement (i.e., Trust Ownership).

 

Commercial Debt Forgiveness Provisions

Many Advisers believe that this Debt or Loan Account can simply be ignored or "forgiven".

Unfortunately, any attempt to "forgive" the new Debt or Loan Account would incur a tax liability under the Commercial Debt Forgiveness provisions.

As a result, while the payment of the Insurance Proceeds would be CGT-exempt, other commercial elements of the transaction attract a tax liability.

This problem can be avoided by the use of a Business Insurance Trust Agreement (i.e., Trust Ownership).

 

Security of Repayment of Creditor?

Self-Ownership means that the Life Insured (or their Executor) will be responsible for distributing the funds of the Business to the Creditor.

There is therefore a commercial risk that there will be a default or delay in the performance of their obligation.

 

Lawyers' Reluctance to Recognise Ability of Insurance Trusts to Aggregate

The Business Insurance Trust Structure has been designed to aggregate different Cover onto One Policy.

Many advocates of Self-Ownership oppose the need for aggregation and prefer to hold the Buy/Sell Cover on a dedicated Buy/Sell Policy owned by the Life Insured.

In other areas of practice, lawyers embrace trusts as "aggregators".

In the investment context, trusts are a perfect vehicle to aggregate investors, investors' funds and investment opportunities.

Many opponents of Trust Ownership use trusts in this context.

Many of them advocate Testamentary Trusts as well.

But when it comes to Insurance Trusts, they sing a different song.

Many opponents don't understand Trusts.

On the other hand, many advocate Self-Ownership so strongly that they cannot now back down and embrace Insurance Trusts.

This stand-off causes much of the misunderstanding of the Business Insurance Trust Structure that frustrates Advisers and Clients.

 

Reasons for Using Self-Ownership to Aggregate Insurance Cover

The impetus behind a "Hybrid Business Succession Strategy" is two-fold:

  • it recognises that aggregation of cover onto One Policy makes sense to clients; and

  • Self-Ownership means that an Adviser only has to get the Life Insured to sign the Insurance Proposal (whereas Trust Ownership means that the Trustee or Business has to sign the Proposal as the Policy Owner).

The Hybrid Business Succession Strategy is a response to the intuitive marketing appeal of the "One Page, One Policy Succession Plan" made possible by the Business Insurance Trust Structure.

However, by abandoning the Trust Structure, it loses other advantages and results in other disadvantages.

 

Security Concerns

Trust Ownership means that someone other than the Life Insured must own the Policy.

Usually, the Trustee will be the Business itself.

On the other hand, Self-Ownership means that the Life Insured must own the Policy.

It's interesting that a key goal of the Hybrid Strategy is to avoid Trust Ownership and embrace Self-Ownership.

However, ironically, the Hybrid Strategy not only mimics the functionality of Trust Ownership, it will ultimately constitute a trust in its own right.

The problem for the Hybrid Strategy is that it is less secure than Trust Ownership.

The trust (and therefore the Insurance Proceeds) is controlled by the Life Insured (or someone on their behalf).

The practical concern is that, if you control the trust, you control the Insurance Proceeds.

You only have to look at what would happen in the case of a Death or TPD to understand how a trust of the Insurance Proceeds is created and the adverse practical implications of a Hybrid Strategy.

 

Death

In the case of a Death Benefit, the Policy and the Insurance Proceeds will form part of the assets of the Life Insured's Estate.

The person who controls the assets of the Estate will be the Life Insured's Executor.

The Executor is a Trustee appointed by the Life Insured to administer their Estate in accordance with their Will.

The Executor owes its principal duty of care to the Life Insured and members of the Life Insured's Family or the Beneficiaries of the Estate.

The Executor is not a Trustee appointed by all of the members of the Business Family.

It is a Trustee appointed by just one member of the Business Family to administer their own Estate in the interests of their own Family and Beneficiaries.

So, despite the desire to avoid the concept of a Trust, the Hybrid Strategy actually involves a Trustee in the case of Death Benefits.

Unlike the Business Insurance Trust Structure, this Trust does not exist and the Executor does not become a Trustee, until the Death of the Life Insured.

However, even when the Life Insured has died, there is scope for uncertainty and doubt.

Before the Executor or Trustee is in a position to take any action, a number of steps have to be taken first:

  • the Will has to be found;

  • the Executor has to be identified; and

  • the Executor has to consent to act as Executor.

Only when all of these steps have been taken can the Trustee make a claim and ultimately distribute the Insurance Proceeds.

All this assumes that there is no dispute with respect to the administration of the Estate.

 

TPD

The situation could be similar in the case of a TPD.

If the Life Insured is seriously disabled, they might not have the physical or mental capacity to make a claim or distribute the Insurance Proceeds.

If they have granted an Enduring Power of Attorney, then the Attorney might perform these functions.

However, the Attorney does so as Trustee for the Life Insured.

If the Life Insured does not have a valid Power of Attorney, it might be necessary to apply to the Court to appoint a Trustee of the Life Insured's affairs.

Once again, a Trustee appointed by the Life Insured (or in the interests of the Life Insured) is in control of the Insurance Proceeds, not a Trustee appointed by all of the members of the Business Family.

 

Selective Imitation

Imitation is the sincerest form of flattery.

However, it's ironic that the Hybrid Strategy is selective - it only mimics the aggregation function of Insurance Trusts.

It consciously avoids the ability of Trust Ownership to offer all members of the Business Family security and certainty.

It places temptation in the hands of the deceased or disabled Life Insured and jeopardises the interests of the surviving Lives Insured.

In other words, it plays favourites. It sides with one Proprietor over the others.

Ironically, it will always be the "others" who own the Business after the Insured Event.

The ones who are jeopardised by the choice of Trustee (or Policy Owner) are the Proprietors who the Adviser hopes will remain clients in the future.

They are unlikely to remain clients if the real reason Self-Ownership or the Hybrid Strategy was used is that the Adviser thought it was administratively inconvenient to get the Trustee to sign the Proposals.

Ultimately, we all have to work together to "get the right money to the right people at the right time".

Insurance Trusts are designed to do justice to this adage.

Nothing more, nothing less.

 

Hybrid Business Insurance Trust Agreement

Please note that the Hybrid Business Succession Strategy is different to the IGS Hybrid Business Insurance Trust Agreement discussed here.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

The One Page Strategy is designed to help you simplify Succession Planning.

It helps you understand your needs, it helps you quantify them, it helps you cost them, and it helps you prioritise them.

See more Adviser Tips

 


Current Marketing Schedule

Current Marketing Schedule

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