Medical contributions for retired employees

Peter Surtees, Director, Deneys Reitz Tax Services

A recent insertion of section 12M into the Income Tax Act clarifies an uncertainty regarding the deductibility of retirement medical funding that in recent time has become increasingly common.

It is a commercial reality that employers often undertake to fund medical cover for employees and their dependants after retirement. This obligation can be expensive and can have a serious negative impact on published financial results, since current accounting practice (IFRS) requires the employer to quantify and provide for the long term impact of this obligation. Accordingly, employers often seek to escape from these obligations by either paying lump sums directly to the retired employees or dependants, or by taking out policies with life insurers to cover the future expenses.

The tax problem associated with this commercial reality is that it is not clear in terms of general tax principles whether or not these payments are deductible: they might not pass the capital/revenue test on the grounds that they have been incurred in order to escape a long term obligation; and, even if they do pass that test, they might fail the “purposes of trade” test, which requires that, in order to be deductible, an expense must have been incurred for the purposes of trade and in the production of income. It has been argued that amounts paid to persons who are no longer employees can hardly be seen as part of trading operations.

A new section 12M recognises the commercial reality and resolves the tax uncertainty by providing that such lump sum payments may be deducted, whether they are paid directly to the employees or dependants or to an insurer. The lump sum must be intended to cover medical expenses contemplated in section 18 of the Act (contributions to medical schemes and payments to doctors, dentists, optometrists, physiotherapists and other health care professionals, prescribed medicines and hospitalisation) and it must absolve the employer of any further liability for mortality risk. In other words, the employer may, for example, undertake to make further payments necessitated by medical inflation running ahead of general inflation; but the employer may not retain any risk if the employee or dependant lives longer than the actuarial mortality tables predict.