Edited version of your written advice

Authorisation Number: 1013029982879

Date of advice: 7 June 2016

Ruling

Subject: Life Insurance Payment

Question 1

Are the insurance proceeds received by the Partnership, as a consequence of the death of one of the Partners, not assessable income to the Partnership as ordinary or statutory income under section 15-30 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the capital gain that arises from the receipt of the insurance proceeds by the Partnership pursuant to section 106-5 of the ITAA 1997 be disregarded under section 118-300 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period

01/07/2015 - 30/06/2016

The scheme commences on

20AA

Relevant facts and circumstances

You are a Partnership that has been in operation for many years.

As at a specific date the partners of the Partnership comprised of what are commonly referred to as equity partners and fixed profit share partners. Total staff of the Partnership, including partners is XX people.

The Partnership accounts on an accrual basis for income tax purposes.

The Partnership effected a Group Life Insurance Policy over the lives of all of its partners with the risk commencement date of during the 20AA income year.

The Policy is a group life policy.

The owner of the policy is the partners in the partnership at the time it was taken out.

One of the lives insured under the policy died in 20CC. They were XX years of age when they died and at that time, they had been a partner in the Partnership for over 20 years.

The role of the partner changed significantly due to illness but was still a valued one within the organisation and the industry. Over the time of their illness their fee contribution to the organisation diminished significantly.

The sudden and unexpected diagnosis of the partner in 20BB left the Partnership ill prepared to manage the loss.

The Partnership affected the Insurance Policy for the purpose of benefiting the equity partners.

The Partnership did not document its reasons or purposed for affecting the insurance. The Partnership submits that the purpose for the insurance was a revenue purpose with respect to the insurance cover over the fixed profit share partners and some of the equity partners but was a capital purpose with respect to this partner.

The Partnership did claim all of the premiums paid on the policy as a tax deduction in respect of the 20AA, 20BB and 20CC income years by reference to a predominant revenue purpose.

Insurance Proceeds were paid to the Partnership in 20DD. The full amount of the insurance proceeds was credited to the capital of the Partnership. Amounts were then credited to the capital accounts of the persons who had been equity partners over the period, on a time weighted average of the equity share held by the Partners over that period. The amounts were then recorded to the credit of the equity partners were drawn from the Partnership.

This application of the Insurance Proceeds was not pursuant to any formal or informal agreement but rather, was a matter determined by the equity partners by agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 15-30

Income Tax Assessment Act 1997 Section 118-300.

Reasons for decision

Issue 1

Question 1

Summary

Proceeds from the insurance policy received by the partnership is not assessable income.

Detailed reasoning

The assessable income of a partner in a partnership includes the distribution of income or loss from the partnership in terms of section 92 of the ITAA 1936. The net income or loss of a partnership is calculated by deducting the allowable deductions attributable to the partnership from the assessable income attributable to the partnership.

Section 6-5 of the ITAA 1997 provides that the assessable income of Australian residents includes the ordinary income derived directly or indirectly from all sources.

Ordinary income includes income from rendering personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

• are earned

• are expected

• are relied upon, and

• have an element of periodicity, recurrence or regularity.

Although the proceeds from an insurance policy can be said to be expected and relied upon, this expectation arises from taking out an insurance policy, rather than from a relationship within which personal services are performed. The payment is made in a lump sum so it does not have an element of periodicity, recurrence or regularity. The proceeds from an insurance policy do not relate to personal services, property or the carrying on of a business. Therefore, the proceeds are not considered to be income according to ordinary concepts under section 6-5 of the ITAA 1997.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income. Payments made under an insurance policy may come under insurance for loss of assessable income under section 15-30 of the ITAA 1997. This applies if the lost amount would have been included in your assessable income and the amount you receive is not assessable under section 6-5 of the ITAA 1997.

The amount paid out from an insurance policy generally bears the character of that which it is designed to replace. The purpose for which the policy was taken out may be a consideration. Taxation Ruling IT 155 discusses the assessability of the proceeds of a key man insurance policy. In general it is said that where insurance moneys are received to replace a revenue receipt then it is revenue. IT 155 paragraph 10 states that the minutes or book entries may assist in establishing the purpose of the policy. The purpose for which the proceeds are used is also relevant.

Also, in paragraph 16 of Taxation Ruling IT 2504, insurance policies acquired by an employer on the life of a key employee for income producing purposes are discussed. It makes it clear that any proceeds received in consequence of the premiums paid under these arrangements are assessable under subsection 25(1) of the ITAA 1936, which has been replaced by section 6-5 and section 6-10 of the ITAA 1997.

Key man insurance

The term key man insurance denotes insurance on the life of a director, partner, employee or other key person associated with the taxpayer in business. The types of policies involved are whole of life, endowment, term life assurance, sickness and accident insurance. The Policy, as a life cover policy over the life of all of its partners, would be considered a key man insurance policy.

Taxation Ruling IT 155 looks at the Commissioner's treatment of the two categories of key man insurance policies which exist. The view of the Commissioner is that

• premiums on key man life or endowment policies will not be deductible under section 8-1 of the ITAA 1997 and the proceeds will not be assessable under 6-5 of the ITAA 1997. This view is partly due to the fact that the proceeds of the key man life or endowment policy will usually be used for a capital purpose. The view adopted in Board of Review decisions is that the payment of the premium builds up an asset in the form of a policy, which consequently should be considered to be an investment. There may be circumstances where it can be shown that the payment under the policy will be applied for revenue purposes, but there still will be the difficulty that the policy will be viewed as an asset and the premium payment a capital investment

• premiums on key man accident or term policies where the purpose of the insurance was to fill the place of a revenue receipt which the event insured against prevented from arising or of outgoing which has been incurred on revenue account in consequence of the event insured against will be deductible under section 8-1 of the ITAA 1997 and the proceeds will be assessable under 6-5 of the ITAA 1997.

IT 155 provide the following example of a situation in which policy proceeds would not represent income:

..insurance taken out by a company in respect of a director for the purpose of providing, in the event of death by accident, funds for the payment to his estate of a debt owing to the director

In determining the purpose of a revenue policy, there needs to be a realistic assessment of the loss of profits likely to result from the death of the insured person. The insurance company is likely to require a statement from, say, the accountant, to support the contention that the death or disablement of the insured would in fact result in such a loss of profits.

IT 155 states in paragraphs 10-11:

With regard to the type of evidence which would be required to establish the purpose for which an accident or term insurance policy has been effected and kept in force, information about the taxpayer's minutes or book entries would be of some value but should not necessarily be regarded as conclusive. All the surrounding circumstances may properly be taken into account in seeking to determine the purpose for which a policy was effected. The purpose for which the proceeds are used is relevant not because this governs the issue directly but because it provides some indication of what the purpose of taking out the policy is likely to have been.

It could not be conceded that any particular method of declaring the taxpayer's intentions in advance would be conclusive for income tax purposes. Apart from anything else, the taxpayer might change his plans from time to time and renew the same policy from year to year for varying purposes. For example, a company that has received an insurance payment as a consequence of the death of a director may contend that the insurance was taken out in respect of a director for the purpose of providing, in the event of death by accident, funds for the payment to his estate of a debt owing to the director, though no debt was owing to the director when the proceeds were received. This type of situation would call for enquiries to ascertain whether the debt was in existence at the time of the latest renewal. If the debt had been cleared beforehand, evidence such as minutes indicating that the insurance was originally taken out for the purpose stated by the company could be discounted as being irrelevant in the changed circumstances.

In Carapark Holdings Ltd v FC of T (1967) 14 ATD 402 at p 405, the Full High Court stated that, in general, insurance moneys are to be considered as received on revenue account where the purpose of the insurance was to fill the place of a revenue receipt which the event insured against has prevented from arising, or of any outgoing which has been incurred on revenue account in consequence of the event insured against, whether as a legal liability or as a gratuitous payment actuated only by considerations of morality or expediency.

Similarly, an amount will generally be income if it is received in substitution for income, especially if it is received periodically.

In relation to the Policy:

• the PBR application indicates that the Partnership effected the insurance policy for the purpose of benefiting the equity partners

• the partnership did not document its reasons or purpose for effecting the insurance. But it does submit that the purpose for the insurance was a revenue purpose (within the Carapark Holdings formulation) with respect to the insurance cover over the fixed profit share partners and some of the equity partners but was a capital purpose with respect to the deceased partner

• the Partnership did claim all of the premiums paid on the policy as a tax return deduction in respect of the period the policy was held by reference to a predominant revenue purpose. This was on the basis that on balance the insurance premium was considered to be funding life insurance which would compensate the Partnership for loss of income from the permanent loss of a partner.

• Insurance proceeds were paid to the Partnership. The full amount of the Insurance Proceeds was credited to the capital of the Partnership. Amounts were then credited to the capital accounts of the person who had been equity partners over the period. The amounts then recorded to the credit of the equity partners were drawn from the Partnership.

• The above application of the Insurance Proceeds was not pursuant to any formal or informal agreement but rather, was a matter determined by the Equity Partners, by agreement.

The deceased partner's role in the partnership had diminished due to reaching the age of retirement from the firm in addition to the terminal diagnosis which no longer enabled the continued performance of a normal role. The firm believes that the loss of the partner has had the following effect on the partnership:-

• A loss to the Partnership of a material component of its income earning structure as distinct from mere income which may have been generated if they had survived and continued to work;

• The damage to the income earning structure of the Partnership business is evidenced by the clients and income being lost permanently. The Partnership declares it has not been able to find a replacement.

• Since the partner was diagnosed the Partnerships gross annual revenue has deteriorated. The partnership considers this a permanent change as distinct from merely a "period of recovery".

• The death of the partner has caused damage to the business and associated goodwill. This is evidenced by the permanent loss of income and the departure of work colleagues.

With the above facts in mind it is necessary to determine if the payout received from the insurance company is to be categorized as either income or capital. The fact that the compensation was payable in a lump sum is usually not a decisive factor in favour of it being capital.

Generally speaking, if compensation is paid for the loss of the basis or foundation of trading activities, the compensation will generally be for loss of a capital asset. In your facts and argument your discussions focus on loss of earning capacity rather than loss of income to the partnership.

It has been the Commissioner's practice as stated in IT 155 in relation to insurance policies taken out by employers in respect of their employees to treat the premiums as non-deductible under section 8-1 if a life policy is involved. Life insurance premiums are considered to be outgoings of a capital nature.

In this case the life insurance policy is owned by the partnership. The insured persons are company partners. The life insurance is payable if the insured persons die or becomes terminally ill. Therefore, IT 155 would apply to the taxpayer because insurance premium expenses are in relation to key man life insurance policies.

Based on the facts supplied, the expenses relating to the premiums are not deductible under section 8-1 of the ITAA 1997 as the premiums are considered to be outgoings of a capital nature.

In absence of evidence to the contrary, it is considered that all other factors indicate that this is a "key man" insurance policy.

Conclusion

The insurance policy in this particular case is a key man insurance policy. The purpose of the policy is to benefit the equity partners and to compensate for the loss of business caused to the partnership by the death of the partner rather than to replace potential lost income. It will therefore be regarded as a capital receipt. Accordingly, the lump sum payment received by the partnership for a prescribed event occurring to the life insured is not assessable under section 15-30 of the ITAA 1997. For completeness, amendments to the IT returns to exclude insurance premiums as a business deduction will need to be completed for the relevant years.

Question 2

Summary

Yes the capital gain made by receipt of the life insurance proceeds will be disregarded.

Detailed reasoning

Subsection 118-300(1) of the ITAA 1997 provides that any capital gain or capital loss you make from a CGT event happening in relation to a CGT asset that is your interest in rights under a general insurance policy, a life insurance policy or an annuity instrument is disregarded in the situations set out in the table.

The meaning to be given to the expression 'policy of insurance on the life of an individual' includes, but is not limited to, life insurance policies within the common law meaning of that term. It can apply to other life insurance policies as defined in subsection 995-1(1) but only to the extent that those policies provide for a sum of money to be paid if an event happens that results in the death of an individual (Taxation Determination TD 2007/4).

Item 4 of the table in subsection 118-300(1) of the ITAA 1997 provides that a capital gain or capital loss made from a CGT event happening in relation to a CGT asset that is an interest in rights under a life insurance policy is disregarded where that CGT event happens to the entity that acquired the interest in the policy or instrument for no consideration.

The insurance policy in question, includes insurance on the lives of the respective policy owners within the terms of item 4 of the table to section 118-300 of the ITAA 1997.

As the original beneficial owners of the policy of insurance on the life of the partners, any capital gain or capital loss under section 104-25 of the ITAA 1997 upon payment of a death benefit under the terms of the insurance policies will be disregarded pursuant to item 4 in the table in subsection 118-300(1) of the ITAA 1997.

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