Whilst this is not a specific issue for trustees of SMSF’s, however, if you are a business owner with TPD or trauma cover in place for the purpose of debt reduction or have third party owned insurance you may wish to read on.
I find it quite a typical business lending requirement that a client’s bank may impose a requirement to evidence the existence of a life insurance policy to repay debt upon the death or disablement of the business owner or key person. Also common is that a business will implement life insurance for the purpose of debt reduction or other capital items (such as reduced business value) upon the loss of a keyperson or business owner.
Whilst capital gains tax will not usually be payable on Life Insurance proceeds (death only) did you know that capital gains tax will be payable on the proceeds of any TPD or Trauma cover that are paid to the business.
S118-37(1)(b) of ITAA 1197 states that the proceeds received from a TPD or Trauma policy are exempt from CGT if paid to the life insured or defined relative of the life insured. As such should a company or trust own TPD or Trauma cover for a capital purpose the proceeds will be subject to CGT as a company or trust is not a relative of the life insured.
The proceeds of such a claim would have the cost base deemed to be the premiums paid on the policy up to the date of claim. As such for those with this ownership structure they may be a shortfall of debt reduction funding as a result of this CGT liability.
For example, XYZ Pty Ltd implements a $1mil TPD policy on John’s life to reduce debt and pays an annual premium of $2,000. 12 months later John is rendered permanently incapacitated in an accident. The business receives the policy proceeds of $1,000,000 with the following tax liability:
Insurance Proceeds ($1,000,000) – Premiums Paid ($2,000) = Capital Gain ($998,000)
Tax Liability = $998,000 x 30% = $229,400
In this example by inappropriate policy ownership XYZ Pty Ltd has a debt funding shortfall of $229,400.
There are a number of options available to handle this scenario such as grossing up the sum insured to cater for the potential tax liability or the use of absolute entitlement trust structures backed by the appropriately drafted legal agreements depending of the specific circumstances of the client.
So ask yourself does my TPD and trauma cover have a potential CGT liability hiding in the background and get the appropriate advice.
