Bluecare Financial Services

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Key man and Buy and Sell insurance policies and tax consequences relating thereto

Introduction

A number of companies and close corporations choose to conclude insurance policies over the lives of the directors of the business to ensure the financial stability of the business in the event of the unexpected death of the key person concerned.

The tax rules relating to the treatment of premiums paid on such policies and indeed the proceeds received therefrom are often overlooked. 
 

Deductibility of insurance premiums paid by a company

Section 11(w) of the Income Tax, Act 58 of 1962, amended ("the Act"), allows for a company or close corporation to claim insurance premiums paid on the life of a director or member of a close corporation or in the case of a taxpayer, over the life of an employee, so long as the policy is what is referred to as a "conforming policy". In order to claim the premiums paid on the policy in question the policy must contain a number of conditions and particularly:

· A prohibition on the substitution of the life assured.

· The premiums must be actually paid.

· The policy must be owned by the company, close corporation or taxpayer, as the case may be.

· The policy shall provide for a death benefit which shall not be less than an amount arrived at by multiplying the death benefit period of the policy by the lowest premium factor relevant to the particular policy year and any preceding policy year.

· The policy issued must comply with the regulations issued by the Minister of Finance under paragraph (dd)(C) of the proviso to section 11(w) of the Act.

Typically, a policy that conforms to the provisions of section 11(w) of the Act specifically provides that the policy complies with the regulations issued by the Minister. Furthermore, it is important to ensure that the specific policy contains all the conditions required in section 11(w) of the Act and the regulations issued by the Minister. It is only the premiums paid on a conforming policy that can be deducted for income tax purposes.

Where, for example, a life insurance policy has been contracted such that the life assured may be substituted or premiums are payable at irregular intervals, or the minimum death benefit is not in conformity with the regulations issued by the Minister, the taxpayer cannot claim the premiums paid under section 11(w) of the Act.

Those companies, close corporations and individuals that are claiming insurance premiums on key personnel should ensure that the policies conform to the provisions of section 11(w) of the Act. The insurance company should issue a certificate to the policyholder confirming that the policy complies with the statutory provisions thereby confirming that the premiums are indeed deductible for tax purposes. If the policy does not conform to the rules set out in section 11(w) of the Act, the premiums will not be deductible for tax purposes.

Nature of proceeds received

In the event that the policyholder receives a benefit under the policy as a result of the death of the insured, it is necessary to determine the nature of those proceeds for income tax and capital gains tax.

In the event that the premiums were deductible under section 11(w) of the Act, any proceeds received from such a policy are specifically regarded as falling into "gross income" by virtue of paragraph (m) of the definition thereof contained in section 1 of the Act.

In principle therefore, where the premiums paid on a conforming policy are deductible for tax purposes, any proceeds received under such a policy on maturity thereof or disposal thereof, will be regarded as "gross income" liable to normal tax.

Where the premiums were not deductible, it is submitted that the proceeds received will constitute a receipt of a capital nature and thus not liable to income tax.

It is necessary to consider whether such proceeds constitute proceeds as envisaged in the rules regulating capital gains tax contained in the Eighth Schedule of the Act. Where the company is the first owner of the policy and receives the proceeds on the maturity thereof, such proceeds will be excluded from capital gains tax in accordance with paragraph 55 of the Eighth Schedule of the Act.

Where the policy proceeds are received by a company or close corporation from a non-conforming policy, no tax will be payable on the proceeds received. If, however, the company wishes to distribute those proceeds to the company’s shareholders or members of a close corporation, the secondary tax on companies ("STC") will become payable thereon. This is by virtue of the fact that such distribution will be regarded as an ordinary dividend fully liable to STC imposed under section 64B of the Act at the rate of 12,5% of the net amount of the dividend declared.

If a company owning insurance policies wishes to award those policies themselves to the company’s shareholders, that award also will give rise to STC.

Estate duty

Section 3(3)(a) of the Estate Duty Act, Act 45 of 1955 deems any proceeds due and recoverable under certain policies of insurance to constitute property of the deceased for estate duty purposes.

In the event that the policy constitutes a "domestic policy" taken out over the life of the deceased and the amount received exceeds the amount of any premiums or consideration proved to the satisfaction of the Commissioner to have been paid by any person who is entitled to the amount due under the policy, together with interest at 6% per annum calculated upon the amount of premiums or consideration from date of payment to date of death, shall be deemed to constitute property of the deceased.

Where the policy was taken out or acquired by a person, who on the date of death of the deceased was a partner of the deceased or held any share or, like interest in a company, in which the deceased at the time of concluding the policy held any share or similar interest, and the policy was concluded in order to acquire the deceased’s interest in the partnership concerned or the deceased’s share or similar interest in that company, no premium on the policy was paid by the deceased, any proceeds will not form part of the deceased and estate.

Where the Commissioner is satisfied that the policy was not effected by or at the instance of the deceased and that no premium on the policy was paid by the deceased, the proceeds of the policy will also be excluded from estate duty if the further conditions contained in 3(3)(a)(ii) of the Estate Duty Act are complied with. That sub-section requires that the deceased's estate is not entitled to any amount payable upon maturity of the policy, no amount will be utilised for the benefit of any relative of the deceased or any person dependent on the deceased for their maintenance, or any company which was at any time a family company in relation to the deceased will benefit.

If it can be shown that the policy under consideration complies with the abovementioned requirements, no portion thereof will be treated as property for estate duty purposes. Where the company owned by the deceased together with others, took out a policy over the life of the deceased, it would appear that the proceeds to be received under the policy will constitute a part of the estate for estate duty purposes. Where, however, the policy was taken out over the life of an employee and such person is not a shareholder of the company the proceeds received by the company upon the death of the employee, will not be regarded as part of the estate of the deceased employee’s estate for duty purposes.

Conclusion

It is therefore important to determine the nature of the insurance policy under consideration in order to establish whether or not the taxpayer is entitled to claim the premiums paid as a deduction for tax purposes. In the event that the policy conforms to the provisions contained in section 11(w) of the Act, the proceeds received from such a policy, will constitute income fully liable to normal tax. The proceeds received from such a policy will, upon their award to the company’s shareholders also attract STC. Where the policy does not conform with the provisions of section 11(w) of the Act no normal tax or CGT will become payable so long as the company was the first owner of the policy concerned. Any award by the company to its members of the proceeds of such a policy will attract STC.
 
 
 

 

 

                
 
 
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