Over the past few weeks, I have been looking at keyperson cover for businessowners on businessowners. In most private businesses, the keypersons (and often the only keypersons) are the owners who usually also work (devoting considerable amounts of time) in the business. But in some cases employees will also be key, in that their loss will cause serious financial damage to the business that cannot be easily provided for by available funds in the business.
In most cases, where the keyperson is an employee (who is not also an owner), regardless of who the emp-loyer is (that is, a company, partnership, LLP or a sole trader), the cover on the life of the employee will be founded on a life of another policy on the life of that employee. This is true for both death and critical-illness cover. The policy will be held on the balance sheet and, for most businesses, this will be the natural, most straightforward solution. Where the business is a company, the company will be the proposer and the policyholder. No trust will be needed.
For a partnership, it will be usual for either all the partners to effect the policy, in which case no trust will be necessary, or for one or more partners to effect the policy subject to a special trust to hold the policy for all the partners for the time being.
The tax implications of this solution have not changed since the relatively well known Anderson rules were first articulated in 1944. According to these (and the official guidance and commentary that has followed since), the tax deductibility of the premiums will be determined by reference to the relationship between the employer and the life insured, the type of policy, its purpose and the reasonableness of the sum assured.
In relation to the policy, the term should be appropriate to the duration of the risk. The sum assured should be “reasonable” (in other words, justifiable) in relation to the risk. The purpose of the cover must be a revenue purpose as opposed to a capital one. This means that premiums under loan cover plans cannot qualify for deductibility.
So, how about the relation-ship between the employer and the life insured? For the premium to be deductible, it is essential that the life insured does not have a major shareholding in the company. The rationale behind this is that when the company pays premiums under a policy on the life of such a person, it is effect-ively laying out money for the shareholder’s own benefit. In its general guidance on the “wholly and exclusively” test in section 74 ICTA 1988, HMRC states:
“Circumstances in which there may be a non-trade purpose for taking out a ’key person’ policy are where the policy is in respect of directors who are major shareholders but not other employees.”
As far as we are aware, HMRC has not commented on the meaning of “major” in this context.
It seems likely that a share-holding of 5 per cent or less would be treated as not being major for this purpose but, no doubt, experience will vary between local tax inspectors. This position on any particular case should be confirmed by the relevant local inspector.
Ultimately, it will be the local tax inspector who will decide whether to allow the prem-iums as a deduction. It is not possible to forego the tax ded-uction (assuming the premiums are eligible for deduction in the first place) to ensure the more favourable tax treatment of the policy proceeds.
Where an employee is a shareholder, it is imperative to get an advance indication of how the premiums will be treated for tax. In such a case, it would be unwise to rely on premiums being deductible, regardless of the policy type.
The local tax inspector should be asked to confirm the deductibility of the premiums but is unlikely to commit himself to stating how the proceeds will be taxed because he cannot bind his successors. However, generally speaking, if premiums are deductible, it will normally follow that the proceeds are taxable and if the premiums are not deductible, the proceeds will normally not be taxable.
Where the proceeds are likely to be assessable, the sum assured under the policy should itself be increased so that there is sufficient to meet the tax as well as provide the required amount of cover.
In connection with the assessment or tax freedom of the proceeds of a corporate business continuation policy, it is important to note that, generally speaking, it is the proven purpose of the policy when the contract is first entered into that will deter-mine the tax treatment of the sum assured. This means that it is not necessary to contin-ually test and retest the purpose of the cover when each premium is paid, nor is what the sum assured is used for relevant to its tax treatment.
This is made clear in HMRC’s business income manual and the Greycon case which reaff-irmed the importance of the “original purpose” when determining the tax treatment of the sum assured. In this case, HMRC tried unsuccessfully to assess the company on the proceeds of a keyperson policy on the lives of shareholders under which the premiums had not been deductible. This was on the basis of what the funds were used for.
However, the correct app-roach is to determine, based on the evidence, what the purpose was when the policies were effected. The case was also helpful in reaffirming the validity of the “general rule” that if the premiums are non-deductible, the sum assured should not be assessable.