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Taxation Implications: Taxation Implications of Policy Ownership
CGT Exemptions:
Methods of Policy Ownership:
Buy/Sell Cover: Implications for Buy/Sell Cover
Debt Reduction Cover: Implications for Debt Reduction Cover
Third Party Payments: Implications for Promises to Distribute Insurance Proceeds to Third Parties
Commercial Debt Forgiveness:
Super Fund Ownership:
Aggregation onto One Policy:
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Super Fund Ownership of Buy/Sell Cover
4 June, 2014 Adviser Alert Adverse SMSF Specific Advice re Super Buy/Sell Cover and Agreement On 12 March, 2014, the ATO issued a private SMSF Specific Advice which effectively concludes that the practice known as “Super Buy/Sell” contravenes the Sole Purpose Test under section 62 of the Superannuation Industry (Supervision) Act. Ian Gray from Clover Law has always expressed concerns about this practice: Click here to read more about the ATO Advice.
Reasons for Super Fund Ownership The Premium with respect to most Business and Personal Cover is not tax-deductible (apart from Key Person Income or Revenue Cover). In effect, the Premium is paid out of "after tax dollars". In return, the Insurance Proceeds are not assessable. However, one important exception is Cover owned by a Superannuation Fund. Where the Premium is paid out of a Contribution to the Super Fund that was deductible, the Premium is indirectly deductible to the Life Insured or Member of the Fund. Alternatively, if the Premium is paid out of accumulated funds (which results in a reduction of the value of the investments in the Fund), it might be paid out of funds that have already been taxed at 15% in a previous year. However, the Premium will be deductible to the Fund in the year in which it is paid. As a result, it is common for Personal Cover to be owned by Super Funds, in order to obtain a deduction for the Premium.
Super Buy/Sell Cover In recent years, it has become increasingly common for a Super Fund to own Buy/Sell Cover. This practice is known as "Super Buy/Sell". Super Buy/Sell has some characteristics in common with both Trust Ownership and Self-Ownership.
Super Fund as a Form of Trust A Superannuation Fund is a Trust. The terms of the Trust Deed set out the rights and obligations of the Trustee with respect to distribution of the Insurance Proceeds. A Super Fund is not an Absolute Entitlement Trust under which the Beneficiaries have a fixed entitlement to the Insurance Proceeds. Instead, the Trustee has a discretion, subject to the terms of any binding Nomination by the Member. Section 118-300 expressly grants an exemption with respect to Death Benefits to a Complying Super Fund. Section 118-37 does not expressly grant an exemption with respect to Non-Death Benefits to a Super Fund. However, until recently, the practice of the ATO has been to grant an exemption with respect to TPD Benefits. The ATO recently realised that this practice was not justified by a literal interpretation of the section, and is taking steps to have the legislation amended.
Super Fund as a Form of Self-Ownership Self-Ownership requires the Insurance Proceeds attributable to the Purchase Price to be paid to the Life Insured. A modern Business Succession Agreement must contain a "Crediting Provision" that gives the Purchasers credit for this amount against the Purchase Price that would otherwise have been payable by them. Super Fund Ownership is a variation on the concept of Self-Ownership, which relies on a Crediting Provision that states that the Vendor will give the Purchasers credit for the Insurance Proceeds paid to the Super Fund (as opposed to the Life Insured).
Sole Purpose Test Section 62(1) of the Superannuation Industry (Supervision) Act sets out various requirements with respect to Superannuation Funds that together constitute the "Sole Purpose Test". There are both civil and criminal consequences with respect to a breach of the Sole Purpose Test. The required purposes are effectively the provision of Retirement and Death Benefits to the Member or their Dependants. The Retirement Benefits include a Benefit payable on the cessation of work on account of ill‑health (whether physical or mental).
Incidental, Remote or Insignificant Benefits In SMSFR 2008/2, the ATO states:
The ATO is prepared to accept that some benefits can be provided to other parties that are merely incidental, remote or insignificant to the Sole Purpose and therefore are not in breach of the Test. However, the issue is: what is merely incidental, remote or insignificant in the eyes of the ATO?
Relevance to Super Buy/Sell Cover It is not disputed that the Proceeds of a Super Buy/Sell Policy will be paid to the Member or their Dependants (if an Insured Event occurs). The issue is whether the provision of these Benefits is the Sole Purpose of the investment in the Policy by the Fund. Reduction of Purchase Price Payable by Purchasers When the Policy is used for Business Succession or Buy/Sell purposes, the Insurance Proceeds are also intended to relieve the Purchasers of the Life Insured's Equity in the Business from the obligation to pay the Purchase Price they would otherwise have had to pay to the Vendors. If the Purchase Price or Value of the Equity was $400K and the Super Buy/Sell Cover was $400K, then the intention is that the payment of the Benefit to the Member or their Dependants will relieve the Purchasers from having to pay $400K to the Vendors under the Business Succession Agreement. The Vendors are not necessarily the Member or the Life Insured (or their Estate). They could be Related Party Vendors (such as a Spouse, Family Company or Trust). Whatever the identity of the Vendors, it is intended that they not receive the Purchase Price, as a result of the Superannuation Benefit being paid to the Member or their Dependants. Non-Arm's Length Transaction This arrangement is not a normal commercial arrangement and cannot be said to be "arm's length". The Vendors are being asked to forego a Purchase Price they would otherwise be entitled to and therefore, in the language of some Agreements to "forfeit" their Equity in the Business. The Purchasers are being excused from having to pay a Purchase Price they would otherwise have had to pay. The Deductibility Motive What is the explanation for this arrangement? It comes down to the deductibility of the Premium. The arrangement is being entered into, essentially, because the Premium payable under any alternative method of structuring the Buy/Sell Insurance Arrangements would be non-deductible. It therefore has to be recognised that the parties are asking the ATO to exercise its discretion in favour of defining the Benefit as incidental, remote or insignificant, when the overall transaction:
Significance of Benefit to Purchasers In order not to breach the Sole Purpose Test, the Benefit to the Purchasers would have to be merely incidental, remote or insignificant. It is not enough that the payment of the Benefit to the Member or their Dependants is the dominant or principal purpose out of a total of two or more purposes. There is a risk that, if the second purpose is intentional and significant, the Fund will breach the Sole Purpose Test. If the Purchase Price was $400K, the arrangement will relieve the Purchasers of the obligation to pay $400K. One condition of this arrangement is that the Super Fund incur the responsibility for the Super Buy/Sell Premium. Therefore, while not denying that the Member or their Dependants will receive the Insurance Proceeds, the Super Fund has incurred a cost in order to provide a $400K Benefit to the Purchasers upon the occurrence of an Insured Event. It is difficult to see how a Benefit of these dimensions and of this importance to the parties to the Business Succession Agreement could be said to be incidental, remote or insignificant. Indeed, both the Statement of Advice and the Business Succession Agreement could be the source of evidence that the Benefit is both intentional and significant. Personal Need for the Super Cover It might also be relevant to consider whether the Cover would have been obtained, but for the Business Succession arrangements. For example, did the Life Insured have Personal Cover to this extent before taking out the Super Buy/Sell Cover? Did they reduce other Personal Cover, when they took out the Super Buy/Sell Cover? In other words, did they recognise that the level of their Personal Cover could be reduced, because some of their Personal Needs would now be met by the Superannuation Benefit? "Net Opportunity Cost" Incurred by Fund If it was suspected that the Cover would not otherwise have been obtained, then the ATO could argue that the Super Fund had acted to its financial detriment by investing in the Policy. The ATO takes into account the "opportunity cost" associated with the assets in the Fund: paragraph 124 of SMSFR 2008/2. For example, the ATO might consider that the SMSF has incurred a "net opportunity cost" if, by pursuing the provision of a particular Benefit, it is unable to undertake another course of action that objectively would provide a higher return. In this context, if it didn't pay the Super Buy/Sell Premium, it might have been able to invest the funds in a substantive asset, which could provide a substantive Retirement Benefit. In a sense, if there is never a Claim on the Super Buy/Sell Policy, the Accumulated Fund has been reduced by the aggregate of the Premiums instead of being invested in assets that might provide a substantive Retirement Benefit. Differing Views Ultimately, however, it should be noted that there are differing and strongly held views on the question whether Super Buy/Sell Cover is a breach of the Sole Purpose Test. It is not clear to what extent these views are based on a consideration of the above issues.
ATO's Views To date, the ATO has not formally stated whether this practice will breach the Sole Purpose Test. Instead, an internal minute of a meeting of an ATO Liaison Committee on 1 September, 2003 suggests that the "Crediting Provision" would not compromise the deductibility of the Premium paid by an Employer to the Super Fund. The minute states that "the fact that the life insurance policy is held by the super fund as part of a buy/sell arrangement should not affect the employer's ability to claim a deduction". It should be noted that this statement is concerned with the deductibility of the contribution in the hands of the employer, not the appropriateness of the Buy/Sell arrangements entered into by the Members or the Super Fund itself. The minute indicates that the ATO will monitor this practice for evidence of abuses. If found, there is a risk that the practice will be rejected by the ATO. Unfortunately, the Minute does not mention the Sole Purpose Test at all. Thus, it is questionable whether any reliance can be placed on these views. At least one Insurance Company represents that it has received correspondence as far back as 1 May, 2002 which indicates that the predecessors of the ATO (i.e., the Insurance and Superannuation Commission (ISC) and Australian Prudential and Regulatory Authority (APRA)) did not regard their Super Buy/Sell Facility as a breach of the Sole Purpose Test. However, this correspondence does not constitute a formal binding ruling that Clients can rely on. More importantly, it has not been sanctioned by the ATO since it assumed responsibility for these issues. SMSFD2010/1 Click here for a more recent discussion of an ATO Determination that contains a Compendium of Comments, one of which casts doubt on whether a Super Buy/Sell Strategy would comply with the Sole Purpose Test. Conclusion Clients and Advisers must therefore accept that there is an element of administrative and/or legislative risk attached to the practice of Super Buy/Sell (not to mention the civil and criminal consequences with respect to a breach of the Sole Purpose Test). Given that the ATO has definitively stated its views about the Sole Purpose Test in SMSFR 2008/2 as recently as 16 July, 2008, it is important that parties wishing to rely on this practice seek the formal views of the ATO.
Statements of Advice Advisers who recommend the practice should ensure that there are adequate provisions in their Statement of Advice that set out a reasonable basis for their Advice and explain the civil and criminal consequences with respect to a breach of the Sole Purpose Test. They should also ensure that their Professional Indemnity Insurance extends to this recommendation.
Hybrid or Multiple Policy Owner Agreement The desire to obtain a deduction is a reason why some Clients consider a "One Page, Two Policy Strategy" or a Multiple Policy Owner Strategy. In effect, the desire to obtain a deduction for the Premium for one component of the total Need requires the Life Insured to obtain at least two separate Policies for the different Needs. In the case of a Business that wishes to utilise a Super Buy/Sell Strategy, it would be possible to combine the Buy/Sell Cover and the Personal Cover on the one Policy. However, it would be necessary to have at least one Policy to deal with the Liability or Key Person Cover. This Strategy can be achieved by the use of a Hybrid or Multiple Policy Owner Agreement. However, the Business must assume the risk that the Super Buy/Sell Strategy could ultimately be rejected by the ATO. Disclaimer of Liability While Clover Law is able to document a Super Buy/Sell Strategy that requires the Vendors to sell their Equity for no consideration, it is unable to endorse the practice of Super Buy/Sell Cover in the absence of a Product Advice from the appropriate section of the ATO. In the meantime, the Business and Lives Insured must rely solely on the Product Ownership advice of their Adviser, if they wish to utilise Super Buy/Sell Cover. This means that the Business and Lives Insured may have recourse solely to the Adviser and Professional Liability Insurance Cover of the Adviser (provided the Insurer accepts responsibility under the Cover), not Clover Law or its Professional Indemnity Insurer.
Disadvantages of Super Fund Ownership In addition to the above considerations, the Business must recognise that there are disadvantages with respect to Super Fund Ownership, whether it is used for Buy/Sell or Personal Cover. These disadvantages are not widely understood by the advocates of Super Buy/Sell or Super Fund Ownership. Overview of Super Fund Ownership Click here for an overview with respect to Super Fund Ownership. Tax Issues Click here for an analysis of some of the Tax Issues with respect to Insurance Cover held in the Superannuation environment. Cost Issues Click here for an analysis of some of the cost implications and disadvantages with respect to Super Fund Ownership of Insurance Cover. Other Issues Click here for an analysis of some of the commercial, personal, family and other implications and disadvantages with respect to Super Fund Ownership of Insurance Cover. The "Geared Premium Funding" Alternative Please see here for an alternative cash flow strategy ("Geared Premium Funding"), which is designed to overcome most (if not all) of the disadvantages of Super Fund Ownership (in particular, the potential taxation of the Insurance Proceeds in the hands of the Super Fund or the Beneficiaries).
Equity Owned By Life Insured The Life Insured (or their Estate) will be deemed to have sold the equity in the Business under the "market value substitution rules", regardless of whether the Purchasers gave any consideration for the purchase. The Life Insured (or the Estate) might therefore incur a CGT liability with respect to any Capital Gain. If they have received the Insurance Proceeds, then they will be able to satisfy any CGT liability out of the Insurance Proceeds. However, if the Insurance Proceeds have been paid to another Beneficiary of the Super Fund (e.g., as a result of a Nomination of Beneficiary), then the Insurance Proceeds might not be available to the taxpayer who has the ultimate CGT liability. It should not be assumed that the Insurance Proceeds will inevitably end up in the hands of the taxpayer who has the CGT liability under the market value substitution rules. In these circumstances, the CGT liability would erode the personal assets of the taxpayer.
Equity Owned By Related Party Proprietors If the Cover owned by the Super Fund is in fact attributable to the value of the Member's equity in the Business, the Insurance Proceeds will have to be distributed in accordance with the Trust Deed of the Fund, regardless of whether the Member owns the equity in their own name. Thus, if the equity is owned by a Related Party of the Member (such as a spouse or a Family Company or Family Trust), the Related Party Proprietor will have to transfer the equity without receiving any Sale Proceeds. In effect, the equity is stripped from the Vendor's balance sheet. CGT Liability of Vendor Even though the Vendor has failed to receive any Sale Proceeds, it will incur the same Capital Gains Tax liability that would have applied to the Sale Proceeds, because of the application of the "market value substitution rules". Unfortunately, not only will the asset be stripped from its balance sheet, it will have to fund the CGT liability from other assets. Thus, Super Buy/Sell arrangements can inappropriately diminish the financial status and creditworthiness of the entity that actually owns the equity in the Business. Tax Rate Applicable to CGT Liability In the case of a Family or Discretionary Trust, there will be no actual Trust Income attributable to the Sale Proceeds that can be distributed to a Beneficiary of the Trust. There is therefore a risk that no Beneficiary might be "presently entitled" to the deemed Capital Gain under the market value substitution rules. If this is the case, the Trustee might be personally liable for the CGT liability at the higher tax rate applicable to Trustees. The increased tax liability would significantly erode the tax benefit of the deductibility of the premiums. It might be difficult for the Trustee to satisfy the liability, if the Beneficiary of the Super Fund who has received the Insurance Proceeds does not indemnify the Trustee for the tax liability. Even if the Beneficiary cooperates, the indemnity might create a new legal obligation between the Trust and the Beneficiary (such as a loan), which might have adverse commercial, legal, tax or CGT implications for the Trust or the Beneficiaries of the Trust. Breach of Fiduciary Duties In the case of Family Companies and Trusts, a sale of an asset for no consideration could lead to claims that the Directors or Trustee have breached their fiduciary duties to the Shareholders or Beneficiaries. Inability to Obtain Release of Security If the Vendor has granted a mortgage or other security over the equity, the failure by the Vendor to receive any Purchase Price could frustrate the release of the security that is required to give clear title to the equity to the Purchasers. This could be a serious issue where the Vendor has borrowed funds to acquire the equity in the Business and has granted a mortgage or other security over the equity in favour of the lender. In this case, the Vendors could not give clear title to the Purchasers, until the beneficiaries of the Super Fund effectively agreed to pay the Insurance Proceeds to the Vendor, so that it could repay the lender and obtain a release of the security. It is not necessarily inevitable that the Beneficiaries of the Super Fund would want to disgorge the funds paid to them (particularly if they were different from the Shareholders of the Company or the Beneficiaries of the Trust).
Apportionment of Premiums Where the Cover is held outside the Super environment, it is normally recommended that the Buy/Sell Premiums be pooled and split proportionately to each Life Insured's equity in the Business. Thus, if the Premiums for three equal Proprietors were $1,500, $2,000 and $2,500, each Proprietor would pay $2,000. In the case of Super Buy/Sell, each Fund will have to pay the Premium with respect to its own Member's Super Buy/Sell Policy. Thus, it is not as straightforward to spread the cost proportionately across the Proprietors. One option would be to make a contribution of $2,500 (i.e., the highest Premium) to each Fund. This would equalise the cost of the strategy. However, it would also increase the total cost to $7,500 (instead of $6,000). Thus, the desire to equalise the cost would partly counteract the benefit of tax deductibility.
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Adviser Tip There are circumstances in which Insurance Cover held by a Super Fund will be taxable, even though it would have been tax-free if held in the name of the Life Insured. The Life Insured must determine whether it makes sense to get a deduction for a premium of say 0.3% of the Sum Insured, but be liable to pay tax on 100% of the Insurance Proceeds at the time of a claim. This tax liability will be additional to any CGT payable with respect to the sale of Equity in the Business.
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