This section deals with the circumstance in which proceeds of life insurance policies can be received CGT free. But the section is silent on whether it deals not only with life insurance policies (i.e. death benefits) but also total and permanent disability and trauma benefits (i.e. non-death benefits).
In fact the ATO has indicated, and professionals practising in this area accept, that s118-300 only applies to death benefits. The only exception to this is that the ATO will treat payments made under a terminal illness policy as if it were a death benefit.
Whilst s118-300 does not apply to non-death benefits, s118-37 expressly does apply to non-death benefits and the ATO accepts this as being the case.
Section 118-37(1)(b) is to the effect that CGT will not apply to any payment (including “compensation or damages”) received by a person who suffered any “wrong, injury or illness”, or whose “relative” suffered any “wrong, injury or illness”.
You can see that this definition makes no reference to insurance proceeds, and there is no reference to legal or beneficial ownership of the policy.
By contrast, the exemption in s118-37 is described by reference to the type of payment made: “compensation or damages”, the reason it is made “for any wrong, injury or illness”, and the person it is made to: the taxpayer or any “relative” of the taxpayer.
A close reading of the section makes it clear that the only person who can receive the insurance proceeds CGT free is the taxpayer who suffered the wrong, illness or injury or his or her relative.
So unless the taxpayer is in business with a family member (“a relative”), insurance policies which are “cross-owned” will not receive the benefit of this section.
What does the ATO think?
The ATO agrees with the above analysis and has stated that TPD policies (i.e. total and permanently disablement policies) and trauma policies will be subject to the s118-37 CGT exemption only if the policy owner is the life insured or a relative of the life insured. A relative could include a spouse, for example. This clearly suggests that self-ownership of such policies is usually desirable.
The ATO has stated that the s118-37 CGT exemption will also apply if the policy owner is the trustee of a trust but only if the life insured or their relative is “absolutely entitled” to the policy and its proceeds under s 106-50. This clearly suggests that a trust can own a policy.
Of course there are various types of trusts where “absolute entitlement” applies. One common trust used very frequently for estate planning and asset protection is the self managed superannuation fund (SMSF) which is countenanced under the Superannuation Industry (Supervision) Act 1993.
So in addition to self ownership and ownership by a relative, super-fund ownership is a third ownership structure alternative available when considering s118-37. However, for reasons mentioned later in this article, we do not support the use of such a structure for ownership of these types of policies (TPD and trauma).
How does the exemption operate?
In considering the above issues in the context of buy-sell agreements, it is clear that cross ownership of insurance policies for trauma and TPD (unless you are in business with your spouse or some other “relative”) will not attract the CGT exemption.
Even if the insurance is for debt reduction cover or key person capital insurance, cross ownership (unless owned by your “relative”) will not attract the exemption.
A bank cannot be the insured’s “relative”. So insurance taken out by the bank or other business financier will not attract the CGT exemption either.
What do up-to-the-minute buy-sell agreements provide for?
Taking into account the problems with the cross ownership of policies, a well drafted business succession agreement (a.k.a. buy-sell agreement) will contemplate self ownership of life insurance policies or life insurance policies owned by a trust whose beneficiary is “absolutely entitled” to the policy and the proceeds. At Leigh Adams Lawyers, both are available.
Nevertheless, self-ownership or trust ownership is not appropriate for debt reduction cover nor for key person capital cover. The reason for this is that by necessity it is the business that will need to receive the proceeds, and it is not appropriate for the life insured or their relative to do so.
The rationale for s118-37
This section insures that “compensation or damages” received by a taxpayer for any “wrong, injury or illness” suffered by that taxpayer or their “relative” are received CGT-free.
The section was written into law with motor vehicle accidents and workers compensation claims in mind. Parliament was also considering sickness and accidental policies.
So if a person received damages or compensation payments after a sickness, illness or accident that they suffered, then they would receive them tax free. And if damages or compensation payments were to be received by the spouse of an injured person after their death, it would be tax-free too.
However, there is no section in the tax legislation dealing specifically with non-death benefits (i.e. total and permanent disablement and trauma benefits) under life insurance policies. Because of this, the ATO has accepted that s118-37 applies to such benefits as well.
Policy ownership and s118-37
How does s118-37 apply to the various ways life insurance policies can be owned? The following choices are available:
(i) Self ownership
This is where the policy is owned by the taxpayer, being the person who will receive the benefit if he or she suffers any wrong, injury or illness. This is the norm for business succession agreements.
(ii) Ownership by relative
This is where the policy is owned by a taxpayer who is a relative of the person who suffers any wrong, illness or injury. This is not usually suitable for business succession agreements.
(iii) Trustee ownership
In TD14, the ATO stated that s118-37 will also apply to exempt from CGT, insurance policy proceeds received by a trustee whose beneficiary receives the proceeds. Indeed in the May 2012 Federal budget announcement, the Federal treasurer indicated that this determination would now become law.
Leigh Adams Lawyers Insurance Trust Deed
Our insurance trust deed utilises a fixed trust, and the life insured is the beneficial owner of the policy under the agreement. This means that TD14 and its replacement legislation announced by the Federal government in May 2012 will ensure that the beneficiary under our insurance trust deed will receive non-death benefits tax free.
(iv) Ownership by a trustee of a discretionary trust
Neither TD14 nor the Federal Government’s recent announcements specifically refer to discretionary trusts as being included in the CGT tax exemption. Moreover the ATO has not issued any ruling or determination on the issue. However the ATO has stated that s118-37 will only apply to a beneficiary of a trust if the beneficiary is “absolutely entitled” to the policy (and its proceeds) under s106-50. This clearly suggests that a discretionary trust (as opposed to a fixed trust) will not pass muster. Discretionary trusts should be avoided.
Leigh Adams Lawyers Insurance Trust Deed
Our insurance trust deed utilises a fixed trust arrangement.
(v) Ownership by trustee of self managed super fund
Since 2005, the ATO has held the view that it will apply TD14 to superannuation funds. However, there are some very good reasons why TPD and trauma insurance should notbe held by a trustee of a superannuation fund.
The first is that with reduced contribution thresholds as from 1 July 2012, taxpayers need to be able to contribute as much into super as they can without the contributions being eaten up by insurance premiums.
Secondly, the payment by an insurance company into the SMSF may well be CGT free as regards s 118-37, but does the holding of the trauma and TPD policies cause the fund to breach the “sole purpose” test in section 62 of the Superannuation Industry (Supervision) Act 1993?
The general consensus is that the holding of a TPD policy will not cause a SMSF to breach the sole purpose test. However, SMSFD 2010/1 must be strictly complied with to ensure that the test is not breached when holding a trauma policy.
Thirdly, since July 2011, the costs of TPD insurance premiums are only deductible to the SMSF to the extent that the policy definition applies to “any occupation” rather than “own occupation”. Premiums for trauma policies are not tax deductible.
Fourthly and arguably most importantly, merely because the SMSF receives the money, does not necessarily mean the taxpayer can access it. In order to access the payments received, the taxpayer must meet a “condition of release”.
If you are over 65 years, then that is okay but if you are under 65, then the tax payer currently has to meet the “ not fit for any occupation” threshold. There may be jobs that he or she can do, and in such circumstances, they would be unable to access the funds they so desperately need.
Fifthly, the s118-37 exemption only applies as regards the payment of the proceeds to the fund. The payment of those proceeds from the fund to the member/taxpayer will be governed by the normal rules applicable to superannuation payments.
So it is quite possible for some of the s118-37 tax benefits to be lost by the time the member/taxpayer or their relative actually receives the proceeds.
Sixthly, the decision of the Federal Court in Kafataris v Deputy Commissioner of Taxation FCA 1454 is relevant. In that case, the Federal Court likened a superannuation fund to a discretionary trust and not a fixed trust. The Court held that the concept of “absolute entitlement” did not apply to a superannuation fund because conditions of release applied. Accordingly, holding TPD and trauma policies in super funds is particularly perilous.
Until the May 2012 Federal Government announcement becomes law, the CGT status of TPD and trauma insurance payments is uncertain, despite CGT TD 14. However, many argue that a Binding Death Benefit Nomination can overcome the problem as regards life insurance policies at least. We agree.
(vi) Cross ownership of insurance policies
The discussion above clearly leads us to conclude that trauma and TPD policies held by a business, a business financier or the continuing partner of a business entity (unless a ‘relative’), will not be able to access the s118-37 non-death exemption. They could, however, access the 118-300 (death) exemption.
Should you include a death benefit policy with a non-death benefit policy? Common sense dictates that cross ownership of such a policy could put the whole proceeds at risk of being taxed.