Business protection companies tax implications
There’s no specific provision in the tax legislation that guarantees corporation tax relief for the company. Instead, principles for the tax treatment were set out back in 1944 by the then Chancellor of the Exchequer, Sir John Anderson.
- A key person is someone whose death, critical illness or disability would have a serious effect on the future profits of the business.
- Taxation treatment depends on the facts of a particular case and the practice of the local inspector of taxes.
- The proceeds will generally be taxable and the premiums tax deductible where:
- The person covered is an employee.
- The insurance is to meet a reduction in profits resulting from the loss of services of the key person.
- It is annual or short term insurance.
The key person
On the basis that the company is the owner, and the key person is simply the person covered, then there are no benefit in kind or other taxation implications. However, if the company subsequently chooses to pay out or distribute any of the proceeds to the person covered or their family, then there would be tax implications.
There are two aspects to consider – paying the premiums and receiving the proceeds.
Tax implications on paying the premiums
There’s no specific provision in the tax legislation that guarantees corporation tax relief for the company. Instead, principles for the tax treatment were set out back in 1944 by the then Chancellor of the Exchequer, Sir John Anderson. In answer to a parliamentary question, he made the following statement.
‘Treatment for taxation purposes would depend upon the facts of the particular case and it rests with the assessing authorities and the Commissioners on appeal if necessary to determine the liability by reference to these facts. I am, however, advised that the general practice in dealing with insurances by employers on the lives of employees is to treat the premiums as admissible deductions, and any sums received under a plan as trading receipts if:
- the sole relationship is that of employer and employee
- the insurance is intended to meet loss of profit resulting from the loss of services of the employee, and
- it’s an annual or short term insurance’
What does this mean in practice?
Taxation treatment depends on the facts of a particular case and the practice of the local inspector of taxes. So we recommend that the company accountant or corporate tax adviser writes to the local inspector of taxes to gauge their views on the tax treatment.
A binding decision may not be forthcoming, but perhaps they’ll gain an insight into the likely tax outcome.
For example, if the inspector considers that the premiums are trading expenses, then ultimately the proceeds are likely to be viewed as a taxable trading receipt.
What else can we learn from Sir John Anderson’s statement?
The proceeds will generally be taxable and the premiums tax deductible where:
1. The person covered is an employee
In other words, no tax relief is likely on the premiums where the person covered is a shareholder. Working directors can be considered as employees (though not shareholding directors). However, the inspector may accept that a plan written on the life of a minority shareholder might pass this particular test.
The logic behind this test is that for expenses to be tax allowable they must be ‘wholly and exclusively for the purpose of trade...’. Where a plan is written on the life of a significant shareholder, they consider there to be an element of self interest in taking out the plan (that is, preserving your own shareholding value) and so the wholly and exclusively test can be failed.
2. The insurance is to meet a reduction in profits resulting from the loss of services of the key person
Consider a company which borrows money to buy a factory. If a company then takes out a key person plan to repay a loan on that person’s death, then the plan wouldn’t meet this criteria.
Any plan with a surrender value will similarly fall outside this rule because some part of the premium is going towards investment, rather than solely to meet the loss of profit.
Premiums paid towards whole of life plans with a surrender value or endowment plans will therefore not qualify for tax relief.
3. It is annual or short term insurance
Short term is not clearly defined, but is generally considered to refer to non-convertible term plans of no more than five years. Longer terms could be justified provided they don’t exceed the period of usefulness of the employee to the company.
Many, if not most, plans will fail one or more of these tests and so the premiums won’t be deemed to be tax deductible for the company.
If the plans fail to qualify for tax relief, does this mean that the proceeds will be received tax-free?
Unfortunately not. The belief that no tax relief on premiums equates to tax-free proceeds is a rule of thumb, but no more than that.
HM Revenue & Customs manuals state that they reserve the right to tax the proceeds, even if the premiums are not allowable. An example of this would be a plan on the life of a shareholder where the purpose of the insurance is to cover for loss of profit. HM Revenue & Customs (HMRC) could deny tax relief on the grounds that the employer/employee relationship is not met but still treat the proceeds as taxable.
Their reasoning may be that if the key person had not suffered the critical illness or died then the company would have earned higher profit which would have been taxed.
So they tax the plan proceeds intended to make up that shortfall.
Loan relationship rules
The 2008 Budget brought company owned protection plans within the scope of the ‘loan relationship’ rules. The only types of plan excluded from these provisions are protection plans where there can’t be a surrender value (for example, term assurance policies).
This means that any increase in the value of the plan, shown in the company’s accounts, in excess of the premiums paid would be subject to corporation tax.
Where a company holds an existing protection plan which is not a term plan, it will be treated as surrendering that plan on the first day of the accounting period.
The Finance Act states that ‘if the amount or value of a lump sum payable under an investment life contract by reason of death or the onset of critical illness, exceeds the surrender value of the contract
immediately before the time when the lump sum becomes payable, the excess is not to be brought into account as a credit...’. In other words, any gain from death or critical illness is excluded from the loan relationship tax provisions (this mirrors the chargeable event legislation).
The loan relationship rules are complex and generally the company’s accountant will advise.
What about the chargeable event legislation?
Company owned whole of life plans generally fall within the loan relationship rules and so this section is only relevant for term assurance plans or whole of life plans that don’t have a surrender value.
Protection plans fall under the same chargeable event legislation as investment bonds. This may give HMRC an opportunity to tax a chargeable event gain arising in circumstances when the proceeds might otherwise escape tax under the above principles.
Firstly, critical illness is not a chargeable event under tax legislation and so can’t give rise to a chargeable event gain. This means it’s not taxable under chargeable event legislation, but may be taxed under the general corporation tax principles outlined earlier.
If a plan pays out on death of the person covered, that does give rise to a chargeable event. The calculation is based on the surrender value of the plan immediately before death (less premiums paid). It’s not based on the proceeds actually paid out which may be considerably higher. So, in most cases, no chargeable event gain will arise.
In the unlikely event that a chargeable event gain does arise, then it would be assessable on the company but with no credit given for the internal tax suffered by the life fund. Clearly, a term plan which has no surrender value can’t give rise to a chargeable event gain on death. Despite no chargeable event gain arising, the proceeds may still be taxable under the general corporation tax principles.
In the past it may have been possible to reduce the impact of tax by arranging for cover to be paid in instalments over a number of years. However, under current generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) requirements it’s unlikely that this would be successful as the liability to tax will rise in full on claim.
These plans don’t fall under the above chargeable event legislation. The general corporation tax principles outlined earlier will govern the tax treatment of both premiums and proceeds.
If the proceeds are going to be used for sick pay, they’re likely to be taxable for the company. But when paid out to the person covered, this will be a deductible expense cancelling out the corporation tax liability. They will of course be taxed on this ‘pay’ in the same way as normal.
So, if this cover is intended to be used for sick pay, it may be better for the key person to take the plan out personally. If the company pays the premiums on behalf of the person who owns the plan, these payments would be taxable as benefits in kind (P11D benefit) on the individual but the benefit could then be paid to them tax-free.
Taking your plan with you
In many instances, a key person will leave or retire from the company before the plan has paid out. The company may then decide to cancel the plan, as it’s not then needed. Alternatively, they could gift the plan to the key person, who then takes on the responsibility of paying the premiums.
What are the tax implications of this?
The assignment could be treated as a benefit in kind for the key person and may give rise to a capital gains tax liability in the event of a claim, depending on the circumstances of the assignment. So we recommend taking professional tax advice.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.