Deductibility of premiums on key-man insurance policies
09 March 2012
Posted by: SAIT Technical
Deductibility of premiums on key-man insurance policies
PWC Synopsis - RC Williams
New requirements present a trap for the unwaryThe loss of a key employee or director through death, disability or serious illness can have a substantiallydetrimental impact on the business. For this reason, "key-man” insurance is widely usedin the commercial community to provide a financial cushion should such a tragedy come to pass.
Since it is the employer that is taking out insurance against the expenses and losses that may be incurred, it is the employer who pays the premiums. Section 11(w) of the Income Tax Act allows the premiums on such policies to be claimed as a deduction and the proceeds of a claim under such a policy are included in the employer’s gross income. Such deductibility is a concession, since the premiums might otherwise have been regarded as of a capital nature and hence not deductible. SARS has been concerned that some key-man insurance plans, ostensibly designed to cover the employer against losses, have in reality been taken out for the benefit of employees, in that payouts under such policies were immediately passed on to the employee or surviving relatives. The employer then claimed a deduction for the amounts so paid, thereby neutralising the inclusion of the payout in the employer’s gross income. In order to incorporate anti-avoidance provisions in this regard, s 11(w) was revised in respect of premiums on such policies incurred on or after 1 January 2011. SARS has now thought fit to secure a complete redrafting of s 11(w) and this provision has been replaced in its entirety in respect of premiums incurred on or after 1 March 2012.
The newly-amended s 11(w)
In its new format, s 11(w), read with the introductory words of s 11, provides for the deduction of expenditure incurred by a taxpayer in respect of any premiums payable under a policy of insurance (other than a policy of insurance solely against an accident as defined in s 1 of the Compensation for Occupational Injuries and Diseases Act 130 of 1993) of which the taxpayer is the policyholder, where -
· the policy relates to the death, disablement or severe illness of an employee or director of the taxpayer; and
· the expenditure on the premiums incurred by the taxpayer is a taxable fringe benefit in terms of para 2(k) of the Seventh Schedule; or where
· the taxpayer is insured against any loss by reason of the death, disablement or severe illness of an employee or director of the taxpayer;
· the policy is a risk policy with no cash value or surrender value;
· the policy is not the property of any person other than the taxpayer at the time of the payment of the premium, provided however that any premium paid will not be disallowed as a deduction by reason of the fact that the policy is held by a creditor of the taxpayer as security for a debt of the taxpayer; and
· in respect of any policy entered into—
· on or after 1 March 2012, if the policy states that this provision of the Act applies in respect of premiums payable under that policy; or
· before 1 March 2012, if an addendum to the policy states by no later than 31 August 2012 that this provision applies in respect of premiums payable under that policy.
Notably absent from the new provision are the explicit anti-avoidance provisions that s 11(w) used to previously contain which negated any deduction where the policy was part of a transaction, operation or scheme designed to give benefits to the employee or director in question,rather than to the employer company. The newly-drafted provision now provides that the premiums will be deductible where they are a taxable fringe benefit for the employee. Where the premiums were not a taxable fringe benefit for the employee or director, it is now clearly implicit that they will be deductible for the employer provided that the risks covered by the policy are as stated in s 11(w), that the policy has no cash or surrender value, and that the insured party is the employer. As to the use of such policies as a stratagem to provide benefits to the employee, the director, or his family, SARS presumably believes that the decision in CSARS v NWK Ltd 2011 (2) SA 67 (SCA) (which gave a wide interpretation to the expression "simulated transaction” as including transactions which lack a "real and sensible commercial purpose”) in combination with the new GAAR in Part IIA of Chapter III of the Act render specific anti-avoidance provisions in this context unnecessary.
The policy must now contain an explicit statement or addendum
For premiums incurred after 1 March 2012 to be deductible, s 11(w)(dd)(A) requires that a policy entered into on or after 1 March 2012 must state explicitly that it is one to which s 11(w) applies. Where the policy was taken out before that date, s 11(w)(dd)(B) requires that the requisite statement must be made in an addendum to the policy and that this must be done by no later than 31 August 2012. The latter requirement presents a trap for the unwary for, by clear implication, if that deadline for effecting the requisite addendum to the policy is not met, premiums paid after 1 March 2012 will not be deductible and any subsequent addendum to the policy will not retrospectively secure their deductibility - even if the policy in fact satisfies the requirements imposed by s 11(w). Every tax consultant should be drawing this important matter to the attention of clients. There is presently no indication as to the nature and form of the required endorsement. It would be beneficial for SARS to provide comprehensive guidance on the form of the addendum to be made to pre- 1 March 2012 policies. The provision would appear to imply that the addendum must be a term of the policy, and not merely a statement added to the policy by the employer. Clarity in this regard would be most welcome.
The consequences of non-compliance
The language of the amendment makes it clear that an addendum affixed to a pre-1 March 2012 policy after the 31 August 2012 deadline will be completely ineffective and that premiums paid after 1 March 2012 will then not be deductible, for it is stated that, in respect of "any policy entered into … before 1 March 2012", the requisite statement must be made in an addendum to the policy by no later than 31 August 2012. If this statutory deadline is not met, it will apparently be necessary to take out an entirely new policy and ensure that it contains the requisite statement that it is one to which s 11(w) applies. In the meantime, any premiums that had been paid on the old policy after 1 March 2012 will not be deductible. If it were subsequently to come to light that deductions have been allowed in respect of premiums where the statutory requirements have not been met, SARS would be within its rights to issue a revised assessment, disallowing the deductions.