A guide to insurance ownership options

Stephen Kunz looks at the insurance ownership options available to clients.

The tax applying to life insurance proceeds can sometimes be complex. This article provides a review of ownership options and their tax consequences.

Outside of superannuation fund ownership there are five main ownership options:

• Self-ownership;
• Cross ownership;
• Joint ownership;
• Tenants-in-common ownership; and
• Business entity ownership.

Under Section 118-300 of the Income Tax Assessment Act 1997 (ITAA) the proceeds of a “policy of insurance on the life of an individual” held for a capital purpose will be free of capital gains tax (CGT) where an entity is the original beneficial owner or if the entity acquired ownership of the policy without consideration.

The Australian Taxation Office (ATO) interprets a “policy of insurance on the life of an individual” to mean a policy that makes a payment contingent on the duration of a human life. In Tax Determination 2007/4 the ATO makes the point that this could even include a payment from a trauma policy paid because of the death of the insured.

Because Section 118-300 refers to the ownership of the policy and not the recipient of the proceeds, it is applicable to all forms of life policy ownership.

Under self-ownership the insured person controls the policy. It allows the owner to add or remove any beneficiaries. It also allows the owner to retain the policy even if the original purpose, say as part of the funding plan of a buy/sell arrangement, no longer exists.

Cross ownership

Cross ownership was a common form of ownership before the introduction of CGT. Section 118-37 of the ITAA, which imposes CGT on compensation for injury and illness where a person or entity other than the insured or a relative receives it, has significantly reduced its appeal.

The effect of this section and Section 118-300 is that while the proceeds of a cross-owned life policy may be received CGT free, the proceeds of a cross-owned trauma or total and permanent disablement (TPD) policy will not be CGT free if received by other than the insured or a relative.

For this reason it is rare to see cross ownership of trauma or TPD policies outside of domestic situations. Cross ownership of these policies in business situations is now rare.

Cross ownership is generally restricted to spouses.

However, even then complications can arise. Should a marriage or a de facto relationship end, the recipient will no longer be a spouse and a relative of the insured – hence, CGT will apply to the receipt of the trauma or TPD proceeds.

Joint ownership

The distinguishing features of joint tenancy are that on the death of one of the owners the policy reverts to the remaining owner(s) and on the death of the insured the proceeds are received direct by the remaining owner(s) bypassing the estate.

This option can be useful in some situations. If a client is in a second marriage with substantial assets, they and their second spouse could jointly own a life policy.

However, should the client die, the proceeds would go direct to the second spouse bypassing the estate while the other assets fall through to the estate to be dealt with under the will. By avoiding the estate it is likely that the insurance proceeds will be received earlier than if they were received via the estate.

Tenants in common

Policies can also be owned as tenants-in-common. Proceeds of policies owned as tenants-in-common are received by the owner in proportion to his or her share in the policy.

However insurance policies are not often issued under tenants-in-common ownership because insurance companies maintain that the ownership outcomes can be mimicked by self-ownership.

Business entity ownership

Policies for key person insurance held for a revenue purpose are often owned by the business entity.

This allows the business to claim a tax deduction for the premium – whether it is for a life, trauma or TPD policy – and have the proceeds under its control.

As the proceeds are intended to compensate the business for a loss of revenue or increased expenses they form assessable income in the year of receipt.

Superannuation fund ownership

Holding life, TPD and income protection policies inside a superannuation fund is a popular option since the premiums can be funded by tax-deductible contributions and are tax deductible to the fund.

Although the ATO announced earlier this year that trauma policies could now be held by a self-managed superannuation fund without breaching the sole purpose test, a deduction cannot be claimed for trauma premiums.

What financial advisers need to know

Advisers should also be aware that the ATO will not allow a deduction for that part of an insurance premium that does not meet a condition of release after 30 June, 2011.

That means the ‘own’ occupation portion of a TPD policy will not be tax deductible to a super fund from 1 July, 2011, although like trauma insurance the holding of such policies will not necessarily breach the sole purpose test.

To avoid conflict with the sole purpose test, policies designed for superannuation ownership are ‘stripped down’. Income protection is particularly affected with features such as ‘cancer cover’, ‘agreed value’, ‘specific injury’ and ‘return to work’ missing from those designed for superannuation funds.

Most importantly, advisers should make their clients aware of the tax that may apply to payments containing insurance proceeds from superannuation.

Death benefits paid to a non-tax dependant that include insurance proceeds will usually contain an untaxed element subject to tax at 31.5 per cent and the balance of the taxable component subject to tax at 16.5 per cent.

Various strategies exist to minimise this tax, including forsaking tax deductions for insurance premiums or holding the insurance in a fund with a long-service period.

However, for many, the tax is unavoidable and can run into hundreds of thousands of dollars if significant levels of insurance are held.

At the very least advisers should be talking to clients who have life insurance inside their funds and no tax dependants to ensure they understand the potential tax impact. For many such clients a better option may be to hold life insurance outside the super regime.

Holding TPD insurance inside superannuation raises two issues. First, to gain access to the proceeds the member will usually need to satisfy the permanent incapacity condition of release.

This definition is very narrow – the number of appeals to the Superannuation Complaints Tribunal is a testament to the difficulty in meeting the terms of the condition.

Secondly, the tax payable on the taxable component needs to be calculated. Rates range from 21.5 per cent for those under preservation age, to 16.5 per cent after the first $160,000 (2010-11) for those 55 to 59, and no tax for those over 60.

Again there are strategies to minimise this tax. Paradoxically, these involve holding the insurance in a fund with a recent service date, rather than an earlier service date as in the case of life insurance. Again such strategies may be unavailable to many clients.

Over the past three decades governments have moved to shift financial responsibility to individuals. Insurance has a key role in protecting clients’ assets and the welfare of their dependants.

In talking with clients advisers should be mindful of the various insurance ownership options and the tax treatment of premiums and proceeds.

This information does not take into account your personal circumstances. You should consider the appropriateness of the information having regard to your own circumstances, financial objectives and needs.

Stephen Kunz is technical services manager, advice solutions at Suncorp Life.