Taxation laws amended: A new dispensation for employer-owned policies
The Taxation Laws Amendment Act 24 of 2011 (the Act) was promulgated on 10 January 2012. It withdraws all pre-existing dispensations for “employer owned policies,” typically referring to policies used in funding group life benefits, keyperson assurance, and deferred compensation schemes.
The provisions of the Act apply to all "employer owned/funded policies" with effect from 1 March 2012, irrespective of when they were entered into.
At a high level
Where a policy benefits an employee, the new dispensation concerns itself more with whether or not a premium was included in the income of an employee, rather than whether the premium “is or was deductible."
Where the policy proceeds find their way to an employee or his beneficiary/nominee, the proceeds will be taxable, unless the premiums were included in the income of the employee.
For pure risk policies which benefit the employer (keyperson policies), the proceeds will only be taxable where the employer has expressly indicated that the premiums are to be deductible. Where the employer has not elected to deduct the premiums, the proceeds will usually be tax free.
The impact of the changes on existing policies as well as the implications for new policies will require careful attention by financial advisers in order to advise their clients.
Practical application
Group life schemes
Group life schemes can generally be divided into approved and unapproved schemes.
The amendments do not apply to the premiums or proceeds of policies forming part of an approved group life scheme. With approved schemes the group life policy is owned and funded by the fund. The proceeds are fund benefits which will be dealt with as “retirement fund lump sum benefits.”
The cash equivalent of the premiums paid by an employer under an unapproved group life scheme will be included in the employee’s income. Because the premium is included in the employee’s income, the employer will be able to claim a tax deduction. On the death / disability/ severe illness of the employee, the proceeds will be included in the employee’s (deceased employee’s) gross income.
Despite the benefit having been included in the employee’s gross income, it will not be taxed. The amount will be exempt from tax, the reason for the exemption being that the premiums were included in the employee’s income as a taxable fringe benefit.
Keyperson assurance
Keyperson assurance refers to policies taken out on the life/lives of key individuals in the organisation to protect it against losses it would sustain in the event of the sudden death, disability or severe illness of that individual.
After 1 March, 2012 the premiums will only be deductible where the policy meets set requirements. For existing, formally “conforming policies”, the premiums will continue to be deductible provided the required addendum is added to the policy contract before 31 August 2012.
The proceeds of keyperson policies will fall into the gross income of the employer. However, where the premiums were not deducted because of non-compliance with the provisions of certain sections, and specifically where the employer has not elected to deduct the premium, the proceeds will be exempt from income tax.
Contingent liability insurance
In this context, contingent liability insurance refers to a policy taken out by an employer on the life of an employee/director to cover a loan debt owing by the employer, usually to a bank.
From an income tax perspective, the obligation to repay a loan debt will usually not be regarded as a loss and, as a result, premiums under a contingent liability policy should not qualify for a tax deduction. However, it appears from the approach adopted in the Explanatory Memorandum that the Revenue Authorities will allow a deduction in these circumstances.
Application to deferred compensation schemes
Deferred compensation schemes relied on tax deductible premiums for the employer, with no concomitant accrual to the employee. Tax in the hands of the employee was deferred to the stage where the proceeds were received. These proceeds qualified for concessionary treatment.
Under the new regime, the employer will only be able to claim a tax deduction where an equal amount is included in the income of the employee. Where the premiums are included in the employee’s income, the proceeds accruing to the employee will be exempt from tax.
The inability to defer tax under these arrangements makes it unlikely that deferred compensation schemes will continue to be viable. In all likelihood, deferred compensation arrangements will be replaced by so-called preferred compensation schemes - which rely on taxed premiums and tax free proceeds to retain the services of valued employees.
The Explanatory Memorandum makes reference to a “legislative exit route” for existing employer-owned deferred compensation policies.
When compared to the previous dispensation, the new legislation introduces a far simpler regime for employer funded policies. It is reasonable to expect that there should be a matching of deductions and the taxation of benefits received as a consequence of the deductions. In this regard the amendments have merit.
The amendments do, in some instances, create the opportunity for additional tax relief via tax deductible contributions to a retirement annuity fund.
Reducing the employee’s tax liability
Policy proceeds, as well as premiums which are included in the employee’s gross income as a taxable fringe benefit, will be regarded as non-retirement funding income, and will qualify for the deduction allowed for under the 15% leg of the retirement annuity deduction formula.
The 15% deduction is calculated on taxable income. Amounts exempt from tax in the employee’s hands will therefore not qualify to be taken into account for the purposes of the deduction. Severance benefits have been specifically excluded from the 15% leg of the formula in terms of an amendment to the Act.
