Edited version of your written advice

Authorisation Number: 1051436998930

Date of advice: 17 October 2018

Ruling

Subject: Key person insurance

Question 1

Where the Company took out a key person insurance policy (Policy) on the life of each of its directors, and

(a) each of the directors was a lead member in the practice operated by the Company;

(b) the Policy was taken out to fund the loss of revenue and to pay the outgoings likely to be incurred if one or more of the Company’s directors became totally and permanently disabled (including terminally ill) or died;

(c) the Company failed to claim a deduction for the premium on the Policy in the income tax return of the Company for each of the income years ended 30 June 20XX, 20XX, 20XX and 20XX:.

(d) the Company claimed a deduction for the premium on the Policy in the income tax return of the Company for the income year ended 30 June 20XX;

(e) following the terminal illness of one of the directors, the sum insured under the Policy was paid to the Company in the income year ended 30 June 20XX and was applied to fund the operational costs of the Company;

can the Company deduct the premium in respect of the Policy for each of the income years ended 30 June 20XX, 20XX, 20XX and 20XX in the income year ended 30 June 20XX pursuant to section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

The scheme has commenced.

Relevant facts and circumstances

1. In 20XX, a term life policy (Policy) was taken out by the Company. The Policy was on the life of each director of the Company where each was a lead member of the practice operated by the Company. The policy was to fund any loss or outgoing of the Company that was likely to be incurred in the event one or more of the directors became totally and permanently disabled (including terminally ill) or died.

2. No part of the Policy was able to be split so as to be payable to a director or payable to the estate of a director.

3. A separate policy on the life of each of the other directors was acquired by each of the directors. These policies were intended to fund a buy out of the interest in the Company of a totally or permanently disabled (including terminally ill) director or a deceased director. The premiums on these policies were not paid by the Company.

4. The sum insured under the Policy was determined having regard to the annual income generated for the Company by each of the directors, and the likely recruitment, staffing and overhead costs which would need to be funded in the event that one or more of the directors became subject to a total and permanent disability or died.

5. Each year the sum insured was reviewed by the directors. It was increased solely in line with the Consumer Price Index.

6. The Policy was paid for and owned by the Company and was to be retained in all circumstances for the funding requirements of the Company. This was in accordance with a resolution of the directors.

7. Although the Company paid the premiums in each of the income years ended 30 June 20XX, 20XX, 20XX and 20XX no deduction for the premiums was claimed in those years. This was the consequence of an error by an employee who treated the premium as being on capital account and accordingly not deductible in the income tax return of the Company.

8. No director claimed a deduction in their personal income tax return in respect of the premium paid by the Company for the Policy in each of the income years ended 30 June 20XX, 20XX, 20XX, or 20XX.

9. In the income year ended 30 June 20XX Director X was diagnosed with a terminal illness and ceased to work for the Company.

10. As a consequence of the departure of Director X from the Company there was a loss of revenue and an increase in overhead costs.

11. A claim under the total and permanent disability component of the Policy was made in the income year ended 30 June 20XX. However, it was not approved or paid until the income year ended 30 June 20XX.

12. In the income tax return of the Company for the income year ended 30 June 20XX a deduction was claimed for the premium paid on the Policy in that income year. However, in the income year ended 30 June 20XX the directors realised that a deduction for the premium paid in each of the income years ended 30 June 20XX, 20XX, 20XX and 20XX had not been claimed in the income tax return of the Company for each of those income years.

13. In the income year ended 30 June 20XX Director X passed away.

14. The amount received under the Policy has been treated as an assessable revenue receipt of the Company in the income year ended 30 June 20XX.

15. The Company has applied the payout received to cover the lost revenue and the outgoings resulting from Director X ceasing to work for the Company due to the terminal illness. The bulk of the payout was applied against the costs incurred by the Company in the handover of clients to new staff. The costs included:

● a substantial write off of fees for the transition of clients to new staff;

● recruiting and training of new staff;

● general trauma and stress management amongst staff:

● refinancing; and other business costs in rearranging accounts and authorities; and

● overheads incurred in having substitute and additional supports generally, due to the illness and subsequent death of Director X.

16. None of the insurance payout has been paid to Director X or to the estate of Director X nor is it intended that any part of the payout will be paid to the estate of Director X.

17. The Policy premium history has been provided.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 6-5

Section 8-1

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Question 1

Summary

The Company cannot deduct the premium in respect of the Policy for each of the income years ended 30 June 20XX, 20XX, 20XX and 20XX in the income year ended 30 June 20XX pursuant to section 8-1 of the ITAA 1997. The outgoing for each of those premiums was not incurred in the income year ended 30 June 20XX and consequently the outgoing is not an allowable deduction in the income year ended 30 June 20XX.

Detailed reasoning

The question of a deduction for the premium incurred on the key person insurance policy upon the life of each director of the Company for each of the income years ended 30 June 20XX, 20XX, 20XX and 20XX falls for consideration under the general deduction provisions of section 8-1.

The exclusions in subsection 8-1(2) do not apply to deny a deduction for the expenditure for the key person insurance policy.

Therefore paragraph 8-1(a) is relevant and consideration of that provision is required.

However, before undertaking that task, the nexus between the expenditure upon the key person insurance policy and the derivation of assessable income will be considered with respect to the decision in Carapark Holdings Ltd v FC of T (1967) 115 CLR 653; (1967) 14 ALJR 506; (1967) 14 ATD 402; (1967) 10 AITR 378; (1967) HCA 5 (Carapark Holdings).

In Taxation Ruling No. IT 155 “Key man insurance - Assessability of proceeds and deductibility of premiums” at paragraph 7 there is a relevant discussion of Carapark Holdings in the following terms:

7. In deciding whether the proceeds of an accident or term policy are assessable income under section 25 of the Act it would be appropriate to work on the broad proposition, as the High Court did in the Carapark Holdings case, 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 consideration of morality or expediency.”

The proposition may also be used as a basis for the determination of claims for the deduction of premiums under section 51.

In the present case the decision in Carapark Holdings will be applied so that the proceeds of the insurance policy on the life of the director who was diagnosed with a terminal illness, being an insured risk, is assessable income of the Company in terms of section 6-5 of the ITAA 1997. The proceeds are assessable in the income year ended 30 June 20XX being the income year in which the payout was made by the insurance company and received by the Company.

It is now necessary to return to consideration of the relevance of the outgoings upon the insurance premiums in terms of subsection 8-1(a) of the ITAA 1997.

The term “incurred” is not defined in the ITAA 1997 or in the Income Tax Assessment Act 1936 (ITAA 1936) and thus it is necessary to look elsewhere for the interpretation of this term. Taxation Ruling TR 97/7 titled “Income tax: section 8-1 - meaning of ‘incurred’ – timing of deductions” (TR 97/7) is of assistance.

TR 97/7 commencing at paragraph 4 contains a discussion of the term “incurred” which relevantly states:

Incurred

4. There is no statutory definition of the term ‘incurred’.

5. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are summarised below.

6. The courts have been reluctant to attempt an exhaustive definition of a term such as ‘incurred’. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitely committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remained unpaid, provided the taxpayer is ‘completely subjected’ to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum.

(b) a taxpayer must have a presently existing liability, even though the liability may be defeasible by others;

(c) a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities).

(d) whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e) in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer’s funds) the expense is incurred when the money is paid.

7. For the purposes of section 8-1 it is sometimes not enough that a loss or outgoing has been incurred. The outgoing must also be properly referable to the year of income in which the deduction is sought – refer Coles Myer Finance Pty Ltd v FC of T 93 ATC 4214 at 4222; (1993) 23 ATR 95 at 105 (Coles Myer). The matter of the taxpayer’s accounting system may be indicative, but not determinative of the income year to which an outgoing is properly referable.

In the present case none of the general rules discussed in paragraph 6 of TR 97/7 applies to the Company in the income year ended 30 June 20XX with respect to the premium on the Policy in each income year ended 30 June 20XX, 20XX, 20XX and 20XX.

Therefore the outgoing for the premium on the Policy that relates to each income year ended 30 June 20XX, 20XX, 20XX and 20XX respectively was not incurred in the income year ended 30 June 20XX.

Thus the outgoing for each of those premiums is not an allowable deduction in relation to the income year ended 30 June 20XX and consequently the outgoing is not deductible in the income year ended 30 June 20XX.