Michelle Human, Legal Marketing Consultant, Liberty Life
Changes in circumstances often require changes in the ownership of risk-only policies, for example changes to buy and sell agreements. Changes in ownership often resulted in capital gains tax being levied on the proceeds of these policies. The Taxation L
When capital gains tax (‘CGT’) was introduced on 1 October of 2001, it was labelled as a “wealth tax”. Second-hand policies by their very nature were regarded as speculative and thus included in this new tax regime. However the legislation was so broad that it included not only second-hand investment policies and endowment plans, but also pure-risk policies.
CGT exclusions
We are given some exclusions to allow for relief from CGT. These can be found in paragraph 55 of the Eighth Schedule to the Income Tax Act. They include policy proceeds which are paid to the original beneficial owner of the policy, their spouse or nominee and even in certain circumstances their former spouse. Another exclusion relates to policies taken out on the lives of persons and provided to them in consequence of their membership of a retirement fund.
The impact on business assurance
The exclusions in paragraph 55 also extend to policy proceeds received by an employee, whose life is insured and for which section 11 (w) deductions were claimed e.g.: keyperson policies. Therefore if a keyperson left the business, and the policy on his life was ceded to him he will receive policy proceeds without incurring CGT (this of course, does not preclude the policy proceeds being subject to income tax).
However it was not so simple in the case of buy and sell agreements. Assume that there is a business with three partners and there is a buy and sell agreement in place funded by life assurance. When a partner leaves the business it is customary for the former partners to cede the policy on the existing partner’s life to the exiting partner - he becomes a second owner. If the buy and sell agreement was set up in such a way that it met the requirements of the estate duty exemption, it would qualify for the CGT exclusion, but only insofar that the proceeds were paid to the second owner. The exclusion was therefore limited in application as only the surrender benefits payable to the life assured would be free from CGT- all other policy proceeds would accrue when the life assured has passed away and would not be payable to the second owner but rather to his estate or beneficiary. These benefits would therefore not fall within the exclusion and would be subject to CGT.
In the event that a new partner entered the partnership or an existing partner left the partnership, the buy-and-sell exclusion did not allow the existing partners to use the remaining policies for the new partnership structure without incurring CGT. The reality is that a change in ownership caused the policies to be regarded as second hand, and they tend to be replaced to avoid the possible risk of a CGT bill.
Other problematic changes in ownership
Another scenario which potentially created a CGT liability for owners of risk only policies is where a life policy was ceded absolutely to a trust. This could happen where for example a shareholder transferred his shareholding from his own name to that of his share trust. The proceeds would then not be payable to the original beneficial owner and do not meet the requirements of any of the other exclusions, therefore making the proceeds subject to capital gains tax (assuming that the trust was not the original beneficiary).
A second chance: The Taxation Laws Amendment Act 2011
The Taxation Laws Amendment Act 2011 was passed into law on 10 January 2012 and cleans up these provisions by adding an extra capital gains tax exclusion. The new paragraph, Paragraph 55(1)(e), excludes all proceeds from risk only policies with no cash or surrender value from, CGT. This amendment is a welcome change, as clearly risk-only policies are not speculative in nature.
This amendment is effective immediately and hence applies to any risk only policies that have already been issued, and where the death of the life assured occurs after the legislative change was passed.
What is the impact of the change for financial planning?
The following examples illustrate the effect of this new exclusion
Example 1
A, B and C are shareholders in Company X. They have a buy and sell agreement in place, funded by pure-risk life cover. Shareholder C leaves the business and sells his shares to D. What are the implications on the policies funding the buy and sell agreement?
A new buy and sell agreement must be concluded between the new shareholders, A, B and D.
The policy on C’s life can be absolutely ceded back to him. He will be the new owner of the policy and there will be no CGT implication, even though this is now a ‘second-hand’ policy. He will consequently be able to surrender the policy proceeds, free of CGT (as before), but in addition, his beneficiary or estate will also receive the proceeds from CGT in their hands.
A new policy will be taken out on D’s life. A and B will be the owners and beneficiaries C will absolutely cede his ownership of the policy on A’s life to D. Although D is not an original beneficial owner, and this is clearly now a second hand policy, there will be no CGT as a result of the new exclusion.
Example 2
X, Y and Z are partners in a business. X and Y’s shares are held in their share trusts. Z holds his shares in his own name. They have a buy and sell agreement in place, funded via a pure-risk life assurance policy. Z now transfers his shares to a trust as well.
What is the impact on their buy and sell agreement?
A new buy and sell agreement must be concluded to reflect the new ownership of the company.
The policy on Z’s life will not be affected as there is no change in ownership on that policy.
The portion of the policy on X’s life owned by Z will be ceded to his trust via absolute cession. In the past this would have rendered the policy second hand and would not qualify for any of the original exclusions.
However, due to the changes in the Taxation Laws Amendment Act 2011, the absolute cession will no longer result in CGT being levied on the proceeds as the policy is a risk only policy and this is now specifically excluded.
The same situation will apply on the portion of the policy on Y’s life, owned by Z.
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