Once the Life Insured or their Estate has received the Insurance Proceeds, there must be a legal and accounting framework within which the Debt can be repaid on behalf of the Debtor.

Unfortunately, this framework can encounter tax problems.

Contractual Obligation to Repay the Debt

While the payment of the Insurance Proceeds to the Life Insured or their Estate would be exempt from CGT, it is not normal for Business Debt Reduction Cover in a Multiple Proprietor Business to be owned by the Life Insured.

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.

Unfortunately, this obligation itself can create a CGT liability upon the performance of the obligation.

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

Methods of Repayment of Debt

There are two alternative methods by which the Debt could be repaid:

the Life Insured can pay the Creditor directly; or
the Life Insured can pay the Insurance Proceeds to the Debtor (which would then repay the Creditor itself).

Direct Payment to Creditor

If the Life Insured makes a payment directly to the Creditor, the situation is analogous to the repayment of a Debt by a Guarantor.

As far as the Creditor is concerned, the Debt has been repaid.

It is not particularly concerned about the source of the payment, as long as it has been repaid.

On the other hand, the Debtor is no longer under any obligation to repay the Debt owing to the Creditor, for the very reason that the Debt has now been repaid.

The problem is that the repayment of a Debt by a party other than the actual Debtor creates new legal rights and obligations that did not exist before the Debt was repaid.

"Right of Contribution"

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 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.

The Business still has the same total Debt. All that has changed is the identity of the Creditor.

Direct Payment to Debtor

Instead of paying the Insurance Proceeds to the Creditor directly, the legal arrangements could require the Life Insured or their Estate to pay the Insurance Proceeds to the Debtor.

In turn, the Debtor would repay the Debt to the Creditor.

However, this alternative would also create a new Loan Account or Debt pursuant to which the Debtor had to repay the Life Insured or their Estate.

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

The Business still has the same total Debt. All that has changed is the identity of the Creditor.

"Forgiving" the New Loan Account

The new Loan Account is a Debt for the purposes of the Commercial Debt Forgiveness provisions.

Any attempt to "forgive" this Loan Account or Debt 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 would attract a tax liability.

Context of Buy/Sell Strategy

In order to repay the new Loan Account , future profits of the Business would have to be paid to the Outgoing Proprietor.

This is a problem if the parties have implemented a Buy/Sell Strategy that is intended to exit the Life Insured from any financial interest in the Business.

The anomaly of the Self-Ownership arrangements is that they create new rights and obligations in favour of the Outgoing Proprietor, rather than satisfying or extinguishing them.

If the parties wish to extinguish these rights (e.g., by forgiving the new Loan Account) so that nothing needs to be paid to the Outgoing Proprietor or their Estate, then the Commercial Debt Forgiveness provisions will apply.

Insurance Trust Solution

The above problems can be avoided by the use of Trust Ownership (i.e., a Business Insurance Trust Agreement).

Adviser Tip

Trust ownership is an indirect form of self-ownership.

The Life Insured is the "beneficial owner" for legal and tax purposes under the roof of the Trust.

See more Adviser Tips

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