IOOF TechConnect Technical Insurance Guide Adviser use only.
IOOF TechConnect Technical Insurance Guide Contents Introduction 2 Term life insurance 8 Terminal illness benefit 16 Total and permanent disablement insurance 17 Income protection insurance 22 Trauma insurance 26 Expats, inpats and insurance 27 Centrelink and insurance payments 28 Business insurance 30 1
Introduction The principal legislation and regulations concerning matters relating to life insurance policies are the Life Insurance Act 1995 (LIA 1995), Life Insurance Regulations 1995 (LI Regs), the Insurance Contracts Act 1984 (ICA 1984) and the Insurance Contracts Regulations 1985 (IC Regs). What is life insurance? Life insurance is a contract between two parties (the policyholder and the insurer) where, contingent on the payment of premiums and as agreed within the contract in the event of death, disablement, temporary disablement or a critical illness, a payment will be made to the policy owner. The primary references are contained in the LIA 1995 (in particular sections 9 and 9A). Section 9 provides a definition of a life policy, whereas section 9A outlines continuous disability policies. Section 9A envisages benefits payable in the event of accident injury or sickness but it specifically excludes health insurance. Duty of disclosure Section 21 of the Insurance Contracts Act states; An insured has a duty to disclose to the insurer, before the relevant contract of insurance is entered into, every matter that is known to the insured, being a matter that: a the insured knows to be a matter relevant to the decision of the insurer whether to accept the risk and, if so, on what terms; or b a reasonable person in the circumstances could be expected to know to be a matter so relevant. On 28 June 2013, Parliament passed the Insurance Contracts Amendment Act 2013 amending the duty of disclosure requirements and misrepresentation. The new provisions are phased in between 28 June 2013 and 28 December 2015. The key changes for life insurance are amendments to the following sections: Section 21 clarifies the duty of disclosure test and extends it via sections 21A and 21B for eligible contracts of insurance. Section 22 amends the notification to the prospective insured to include a clear written explanation of the duty of disclosure and how long it applies. Section 27A enables insurers to unbundle a policy where non-disclosure or misrepresentation occurs. To treat each type of cover as if they comprised of two or more separate contracts. Section 29 extends the insurer s ability to alter the sum insured beyond the three year limit where the insured fails to comply with their duty of the disclosure, or is found to have made a misrepresentation at any time on discovery of the non-disclosure or misrepresentation. Section 32 clarifies when the duty of disclosure applies to a member of a super or other group scheme and when the life insurance cover takes effect. If an insured breaches their duty of disclosure or makes a misrepresentation after joining, but prior to life insurance cover being provided to them by the group, the non-disclosure or misrepresentation is deemed to have occurred prior to the commencement of the contract. 2
IOOF TechConnect Technical Insurance Guide Case Study: Duty of disclosure remedies Any failure to disclose (even if unrelated to the claim) can be enough to void an insurance contract. But what do you do if a client comes to you and says that they didn t disclose a condition on an old insurance policy that has been in place for years? This example illustrates the correct procedure. Peter the plumber meets with Mark the financial planner. Peter has an old insurance policy (for life, TPD, trauma and income protection) and is wondering if it s worth keeping. Mark is about to say most definitely (as the insurance company underwriting the policy has a good reputation and has won insurer of the year several times since the policy has been written). However, Peter lets him know that he failed to disclose that he had Hepatitis C (Hep C) at the time of the policy being written. Peter got the Hepatitis C as a result of the blood transfusion. Peter still wants cover if he knows that he will be paid in the event of a claim. Mark lets him know that had he disclosed his Hep C status at the time the conditions may have been quite different. As a result Peter wants to cancel the policy because he realises his non-disclosure would void the policy. Mark has a better idea. He rings around several insurance companies and finds out that they would over Peter cover at a 300 per cent loading. He suggests that Peter applies for the cover, gets it and then consider what to do with the old policy. Peter agrees and they put the new policy in place. Mark then drafts a letter to the old insurance company for Peter to sign stating that he failed to disclose his Hep C at the time of the application. They aren t sure what the old insurance company will do. Might they offer a third of the level of cover? Might they say we will continue to cover you so long as you pay what you should have paid (as we would have loaded the policy)? Might they refund the policy? Might they just cancel and offer no refund? Much to both Mark and Peter s surprise, the old insurer voids the policy and gives a full refund of all premiums paid to date. This amounts to several thousands of dollars. Both Mark and Peter are extremely pleased at the outcome because it s an unexpected windfall and Peter now has some extra cash to pay for the policy. Lesson to be learned: Have an alternative strategy in place before cancelling a pre-existing policy. Don t assume that an insurer won t offer an agreeable outcome if a case of non-disclosure is corrected. Correct cases of non-disclosure by writing to the insurer. Don t let such a situation continue. Replacement Policy Advice Advisers should also remember to fulfill the requirements under the Corporations Act 2001 section 947D when replacing one insurance policy with another whether inside or outside super. These include documenting in the Statement of Advice: any charges the client will or may incur as a result of the disposal or reduction any charges the client will or may incur as a result of the acquisition or increase any pecuniary or other benefits that the client will or may lose (temporarily or otherwise) as a result of taking the recommended action information about any other significant consequences for the client. As a result of the stringent best interests requirement, in addition to s947d, undertaking research into all facets of the from fund has become more important than ever. It is now not just a case of know your client, know your product but know the existing product as well as the new product. Some of the impacts of replacing the client s policy include: 13 month suicide clause may begin to run again wait period on the new TPD policy may be longer new policy may not have a TPD buy back on it new policy may be a standard not a premier policy new policy may be an indemnity not agreed policy new policy may mean that the client has to wait longer for their benefits due to longer waiting periods automatic indexation of the sum insured may be lost premium type may change (stepped or level premiums) benefit period may not be as long under the new policy as the old policy new policy is via super and the cover stops at age 65 or 70 3
new policy is via super and once the member turns 65 they must be eligible to contribute to maintain the policy new policy is in a super fund with an older ESP start date. This means that the taxation on the TPD benefit may be higher new policy is in a SMSF and this means if the clients are married and choose to get divorced and separate their assets there may be tax implications of moving the insurance policy that are adverse. The policy may not be able to be assigned to a new fund or may be able to be assigned but subject to higher premiums insurer has a right to cancel the new policy for non-fraudulent non-disclosure within the first three years of the policy. CFP v Couper replacement policies and what can go wrong Case study: Cheaper cost to client does not mean it is in the best interests of client The recent case of Commonwealth Financial Planning Ltd v Couper [2013] NSWCA 444 illustrates that merely recommending a policy that is cheaper will not satisfy the best interests requirements of section 961B of the Corporations Act 2001 (Cth). That case involved a bank planner recommending that a client replace another bank s life insurance policy with their own. The new policy was, without a doubt, cheaper however, the insurer attempted to void the new policy for non-fraudulent nondisclosure pursuant to s 29(3) of the Insurance Contracts Review Act 1984 (Cth) (ICRA84). The new planner was unaware of section 29(3) ICRA84, which allows an insurer to void a policy for non-fraudulent non-disclosure. As a result, because they were unaware of the section they were unable to disclose this on their replacement policy advice record as required under section 947D of the Corporations Act. The facts The existing policy had been in place for many years. Had the insured retained the old policy they would have been paid out under the policy. The insured had pre-existing conditions that were not disclosed on the new electronic application form. The planner did not provide the client with a paper based copy of the application form so that they could check their answers. The planner didn t disclose the existence of section 29(3) ICRA84 and the consequences of replacing one policy that was no longer subject to that Act with a policy that was subject to that section. The planner and their employer were held liable for misleading and deceptive conduct and negligence. The court found that had the insured been fully informed of the consequences of cancelling the policy then they wouldn t have cancelled it. What can we learn from CFP v Couper? The obvious lesson from this case is the ability of an insurer to cancel a policy in the first three years of its existence. This then always makes a pre-existing policy of more than three years in duration more valuable than a new one. However, a number of other salient lessons can come from this case: Make sure the client knows about section 29(3) of the Insurance Contracts Review Act. Make sure the existence of section 29(3) is disclosed in the SoA. Print out the application form and medical statement of the applicant and give them a copy. Explain the duty of disclosure and impact of failing to disclose both in writing and verbally. Make sure that the client understands that it is their duty not yours. Don't base reccomendations on cost alone. Ensure that you are acting in the clients best interest when dealing with a recommendation for insurance which involves replacing one policy with another. 4
IOOF TechConnect Technical Insurance Guide Stamp duty and life insurance Life insurance policies are generally subject to stamp duty levied by individual states. Insurance duty is levied on the life insurer and is reflected in premium rates. Each state s definition of life insurance varies as does the rate of duty if the life insurance is risk-only or has an investment component. With reference to the following table we are illustrating risk only policies. Death cover is clearly insurance, but standalone TPD may be treated as a life insurance rider, along with income protection and trauma insurance. Most states will treat life insurance riders as general insurance. Duty on general insurance is a percentage of the premium and paid on an ongoing basis. Life insurance duty, except for those who reside in South Australia, is applied at the start of the policy (or individual cover if under a group policy). State Life insurance duty General insurance duty (ongoing) NSW 5% first year s premium (includes TPD) 5% premium includes trauma and income protection. VIC Nil (death cover but all riders treated as general insurance) 10% premium includes bundled TPD, trauma, and income protection. Qld 5% first year s premium 9% premium includes separate TPD, trauma and income protection. SA 1.5% premium ongoing 11% premium includes bundled TPD, trauma and income protection. WA Nil (death cover and bundled TPD) 10% premium includes TPD if separate premium, trauma and income protection. Tas 5% first year s premium 10% premium includes trauma, income protection and standalone TPD. ACT 2% first year s premium (including TPD) 4% premium includes trauma and income protection. NT 5% first years premium 10% premium include trauma and income protection. New developments in Victoria Victoria recently abolished duty on life insurance from 1 July 2014. Life insurance is restricted to death cover only, and any TPD or trauma benefit attached to the death cover is defined as a life insurance rider and treated as general insurance. In the past in Victoria bundled TPD and/or trauma with death cover was an ancillary benefit and treated as life insurance. The effect of this could mean a jump in premiums for Victorians taking out new policies or cover that includes TPD. In WA, duty on life insurance has been abolished for some years, however the TPD component of a policy is only treated as general insurance if the premium is separately identifiable. 5
Life insurance ownership A life insurance policy may be owned by one or more legal entities. The owner and nominated beneficiary do not have to be original parties to the contract. The LI Act 1995 (LIA) section 10 defines the policy owner as either: the person to whom the policy is issued if the rights of that person under the policy have been assigned under the LIA or transferred by the operation of the policy, the person who has those rights. The policy owner may cash, convert or assign the policy and direct to whom payment of the proceeds are to be paid (for example to the nominated beneficiary). The policy beneficiary is the person who will receive the proceeds and need not be the policy owner. Assignment of ownership An assignment takes place when a dated memorandum of transfer is completed by the transferor and transferee, and registered by the life insurance company. Some life insurance policies, cannot be assigned. Ownership options Self-ownership Joint tenants Tenants in common Equitable interest Third party ownership Description The life insured is named as the policy owner. This is the most popular form of ownership and minimises potential capital gains tax issues. Jointly owned by two or more legal entities. Where one of the owners dies ownership vests absolutely or equally between the surviving joint tenants. There cannot be disproportionate shares. Each owner s share must be specified and remains with the owner and subsequently to their estate. There is no rule in respect of the percentage share, nor the number of tenants in common. May be required by a third party, such as a lender institution holding a policy as collateral to a debt. The policy may have an unregistered assignment on it. If in case of death, the third party may register the assignment. The owner may be the trustee, business associate, a company or anyone who needs to protect themselves against the risk of financial loss on the death or disablement of the life insured. Business ownership A company as a legal person can enter into a contract as policy owner. Proceeds will be used for either revenue or capital purposes. Trustee ownership When completing an application or transferring a policy to a trust (which is not a super trust), the insurer will only accept the risk and issue the policy in the names of the trustees (unless it is to a super fund). There may be CGT implications when a trustee owns a life insurance policy. Income Tax Assessment Act 1997 (ITAA 1997) s118-300 provides protection to certain trustees including super trustees. 6
IOOF TechConnect Technical Insurance Guide Cutting the cost of insurance premiums by using super There are funding advantages a person can derive from holding their death and TPD cover within super compared to outside. This is usually displayed in a simplistic example as shown in the following case study Case study: Funding efficiencies Jack (aged 45) is married to Dianne (aged 41). Jack earns $100,000 per annum. Dianne is taking time out of the workforce to raise their young family. They have a mortgage. Their adviser assesses their goals and financial situation and recommends $1,000,000 in life insurance so that Dianne can pay off their debts and replace Jack s income if he dies. The premium for this insurance is $1,181 p.a. The adviser also explains it is more cost effective if he takes out his cover in super, this is because if he arranges salary sacrifice into his super he is able to use pre-tax dollars. Otherwise if Jack purchases his cover outside of super he will pay $1,181 per annum from his after tax dollars. After taking into account his 39 per cent marginal tax rate (including Medicare levy), the pretax cost would be $1,936 per annum. By insuring through super he has pre-tax savings of $755 per annum in the first year (or $461 per annum after tax). The following table illustrates how this saving arises. Outside super (after tax salary) Inside super (salary sacrifice) Funding the cover through super provides immediate year one tax efficiency however the client may wish to have one of a number of different outcomes. For example, they may wish to fund cover and increase super benefits through additional contributions whilst minimising the impact on cash flow. So the fund passing on the benefit of this deduction to the member by offsetting that assessable income may be only half the story. Consideration also needs to be given to the method of funding this cover within super. The member has two options to fund the cover: 1 Where they have accumulated investment benefits, they can elect to simply have the cost deducted from those benefits; or 2 They can make additional contributions to fund the cost of the cover. It is with the second option that a clever strategy can maximise the cash-flow and super benefits of having the cover held within super. Premium $1,181 $1,181 Plus tax and Medicare Levy at 39% Pre tax salary received or salary sacrificed $755 N/A $1,936 $1,181 Pre tax saving N/A $755 After tax saving N/A $461 7
To show the potential benefits of funding cover through super, we consider the following case study. Case Study: Funding efficiency considerations Amy is an employee with a salary package of $109,500 (including super guarantee). Currently she has no insurance cover, however her financial adviser has suggested taking death and TPD cover equivalent to a premium of $4,000 per annum. She has agreed, and her financial adviser investigates five scenarios for funding this cover as follows: 1 Insurance policy is owned by Amy who funds the premium out of her after-tax salary. 2 Insurance policy is owned within super with Amy funding the premium by making an additional equivalent personal contribution to super. For the purposes of this scenario, we assume that the contribution is made to the same fund to which her employer contributes. 3 Insurance policy is owned within super with the premium funded solely from Amy s accumulated benefits. 4 Insurance policy is owned within super with Amy funding the premium by salary sacrificing an additional amount of her pre-tax salary so that her employer contributions are increased by the amount of the premium. 5 Insurance policy is owned within super with the premium funded by an additional employer contribution equivalent to the amount of pre-tax salary dollars that would have been required to fund the premium in after tax salary dollars. Given a marginal tax rate of 39 per cent (including Medicare Levy), the additional employer contribution required is calculated as follows: Additional employer contribution = Cost of premium (1 MTR) = $4,000 0.61 = $6,557 It is worthwhile recognising here that the beneficial outcomes shown below for scenarios 4 and 5 are only relevant to death and TPD cover since an individual is eligible to claim a personal tax deduction for premiums related to income protection cover. The table below highlights Amy s net annual income (cash-flow), and net annual increase in super benefits (excluding investment earnings), under the five scenarios outlined above. Scenario 1 ($) Scenario 2 ($) Scenario 3 ($) Scenario 4 ($) Scenario 5 ($) Salary (take home) 100,000 100,000 100,000 96,000 93,443 Tax and Medicare levy 26,947 26,947 26,947 25,387 24,390 Income situation Income after tax 73,053 73,053 73,053 70,613 69,053 Premium 4,000 Personal contribution 4,000 Net income 69,053 69,053 73,053 70,613 69,053 Taxable super cont n 9,500 9,500 9,500 13,500 16,057 Premium cost 4,000 4,000 4,000 4,000 Super situation Net taxable contribution 9,500 5,500 5,500 9,500 12,057 Tax 1,425 825 825 1,425 1,809 Personal contribution 4,000 Net super increase 8,075 8,675 4,675 8,075 10,248 Total income & super increase 77,128 77,728 77,728 78,688 79,301 Annual benefit over scenario 1 600 600 1,560 2,173 The above table shows that, of the five scenarios, if the focus was to achieve the best outcome in terms of gross cash-flow and increase in super benefits, the best approach for Amy would be to salary sacrifice the amount of pretax salary that would have been required in after tax dollars to fund the premium personally (scenario five). 8
IOOF TechConnect Technical Insurance Guide Scenario two provides a marginally better result from a super benefit perspective due to the premium cost providing a tax deduction. However it is worth noting that if the personal contribution was made to a risk only super policy, no assessable income would exist for the premium deduction to be offset against. In this circumstance, Amy s outcome under Scenario two would be the same as scenario one. Where cash-flow is the predominant concern, we find that scenarios three and four provide a better outcome. Under scenario three, this is simply due to the premium being funded solely from accumulated benefits without making additional contributions. However, Amy s retirement benefits will be compromised. Under scenario four, the higher cash-flow results because only $4,000 of pretax salary is required to fund the premium in super whereas $6,557 of pretax salary would have been required to fund the $4,000 premium after deducting 39 per cent tax (including Medicare levy) had the insurance been held outside super. We could also take it one step further by considering a lower income earning spouse. The primary income earner could look at salary sacrificing further, and then splitting part of their contributions to their spouse s super to fund their insurance. Of course, the entire circumstances of the individual would need to be considered before deciding on the optimal approach from a super benefit and cash-flow perspective. For example: is the person eligible for a government co-contribution if they opt to fund the premium via a non-deductible personal contribution? what is the effect of a lower marginal tax rate? Funding options for insurance as discussed in this paper should be an important consideration in determining the ownership structure of a person s life insurance cover, in conjunction with other estate planning factors such as taxation of benefits and beneficiary option flexibility. 9
Term life insurance Life insurance non-super Life insurance is comparatively simple when it is established outside of super and the premium is paid by a client. The premium is not tax deductible and the proceeds from the policy are exempt for capital gains tax purposes. 1 The proceeds are not usually subject to capital gains tax unless the proceeds: are received by a person, other than the original beneficial owner of the life insurance policy are received by a person, who had acquired the policy for money or other consideration. Life insurance through super The super environment is a tax efficient vehicle to save for retirement. With that in mind, the inclusion of life insurance within super can overcome some client specific funding issues and provide strategic planning opportunities. From a super perspective, upon death the insurance proceeds are paid by the insurer to the trustees of the super fund. The proceeds from the life insurance policy should be included within the deceased s super account and added to the taxable component of the account. Death is a compulsory cashing event under the SIS Act. The trustee will then pay the proceeds of the life insurance policy, along with the deceased member s account balance, to a super dependant or the Legal personal representative of the deceased. The taxation treatment of a payment (a lump sum death benefit) will depend on whether the person is classified as a dependant for taxation purposes (a death benefits dependant). SMSFs and life insurance When formulating the fund s investment strategy, SMSF trustees are now required to consider whether they should hold insurance policies for the members. While there is no requirement that the fund obtains insurance cover, the need (or otherwise) must be actively considered. If the trustee determines insurance is required, and that it should be held within the SMSF, the decisions need to be documented to form part of the fund s investment strategy. This may be achieved via a separate minute of the trustee. Also, as part of the regular review of investment strategy, trustees will need to document the review of insurances as part of that strategy. The notation could be as simple as: The trustees have considered the insurance needs of members of the fund. They have determined that the insurances held by the members within the fund remain appropriate. Alternatively it could be: The trustees have considered the insurance needs of members of the fund. They have determined that it remains appropriate for the fund not to hold insurance policies for the members. However, if trustee s documentation of the assessment of insurance needs is too brief, they risk the potential for future claims to be made against them by disgruntled next of kin. Trustees may therefore wish to undertake and hold a more detailed analysis of their insurance needs in a separate document (which could be a statement of advice provided by a financial planner). A review of a fund s investment strategy to consider member s personal insurances may provide a timely prompt to ensure that other insurances are in order. If funds have property (such as an investment property), they should ensure that the property is adequately insured. This includes the need to hold public liability insurance for the property to ensure that the trustees are covered for any injuries that may occur to visitors to the premises. If the SMSF has purchased a collectable since 1 July 2011, the collectable is required to be insured in the name of the trustee. If clients already held collectables in the fund as at 30 June 2011, insurance will be required from 1 July 2016. Trustees need to be aware of their obligations and are likely to require assistance from financial advisers to assess their insurance needs. This can include assessing the benefits of holding various types of insurance within the SMSF versus outside of super. 10 1 Income Tax Assessment Act (ITAA) 1997 s 118.300
IOOF TechConnect Technical Insurance Guide SMSFs, insurance and borrowing Additional complexities arise where borrowings have been used to acquire a property. Where only spouses are involved, the simple solutions of paying death benefits as an income stream or holding insurance outside of super may be appropriate. In business partner arrangements, a cross-insurance arrangement may be used. Under this strategy the members take out an insurance policy on each other. The premiums are paid from each other s account and are not tax deductible to the fund. When one member dies the proceeds are received into the surviving member s account and the surviving member trades cash for the deceased member s share of the property. The deceased member s death benefit can be paid in cash and the surviving member retains property. It is essential that the SMSF trust deed allows this type of structure and does not simply require the proceeds of any policy of insurance held on behalf of a member to be credited to their accumulation account and paid as a death benefit to dependants. Issues may also arise in respect of the surviving member s ability to service the loan. IOOF SMSF Insurance IOOF SMSF Insurance, is straight forward life cover with the option of linked (Any Occupation or Home Duties) TPD. It is easy to apply for via a short personal statement for sums up to $1.5M. It is available to all SMSF members/trustees and is administered and underwritten for IOOF by Zurich. For clients with existing cover there is a transfer protocol to bring their covers from other insurers (up to $2M in total) to IOOF SMSF Insurance. Other features: Entry age to 64, cover expires age 70 Unlimited death cover and up to $3 million TPD cover It has found favour with accounting practices in their intermediary role of establishing and administering SMSFs thanks to its simplicity. For end user applicants who are over age 50, IOOF SMSF Insurance is particularly competitive when compared to retail insurance policies. A 50 year old male with $1 million Life / TPD cover would typically save around $1,000 per annum. Premium savings improve with age to the extent that a 60 year old with $1 million Life/TPD could potentially save up to $6,000 in annual premium when compared to retail cover. All the information you need including Key Features, access to quoting tools, PDS etc. are available at the following link: SMSFs and cross insurance As at March 2014 there were 506,285 SMSFs with 962,263 members of which 22.7 per cent were single member funds and 69.2 per cent had two members. According to the same ATO SMSF statistical report there are only 2,781 LRBA s in existence. However, many more SMSF trustees consider such an investment strategy and seek informed advice from their financial advisers. The challenge is how do we ensure a member s death or disability does not negatively impact an existing LRBA arrangement? Why does the traditional insurance in super structure (self-insurance) not work? The sole purpose test, empowers the trustee to provide insurance for the purpose of death, terminal illness, permanent incapacity or temporary incapacity benefits The fund may claim a tax deduction for premiums when insurance is attached to the members account for the purposes of providing benefits to a member or their beneficiaries. However in the event of a claim the proceeds must be credited to the members account. The proceeds cannot be used to retire fund debt to protect fund assets underpinning other fund members account balances. The debiting of premium costs must mirror the crediting of the insurance proceeds, hence we come to the cross insurance strategy. The first consideration is that the trust deed and investment strategy must enable a cross insurance strategy to be implemented. Importantly, the fund cannot claim a deduction for the premiums under s295-460 of ITAA 1997 because there is no connection between the premium payment and the proceeds providing a benefit for the life insured. How does cross insurance work? The SMSF trustee takes out a policy over a member s life and the premiums are debited from the other members accounts. In the event of a claim the other members accounts are credited with the insurance proceeds. The ATO has confirmed this does not constitute an allocation from reserves. The insurance premiums are not deductible. (ATO Taxation Ruling TR 2012/6 Example 9) How cross insurance works is best displayed in the following case study. http://www.ioof.com.au/adviser/platforms/insurance/ smsf_insurance Offer documents are available only in electronic format. 11
Case Study: How does cross insurance work? Jack (60) and Dianne (55) have a two member SMSF with the following assets: Jack and Dianne SMSF Assets Amount of investment ($) Property 1,500,000 Liquid assets 400,000 Total assets 1,900,000 LRBA loan debt (900,000) Net equity 1,000,000 Account balances Jack 700,000 Dianne 300,000 If Jack died the fund would have to pay a $700,000 death benefit to Dianne. However, the fund only has $400,000 in liquid assets meaning there is a $300,000 shortfall. Should Dianne die the $300,000 has to be paid to Jack. The $300,000 could be funded from liquid assets or by using a cross insurance strategy similar to that proposed for Jack. The trustee could take out an insurance policy for between $300,000 and $900,000 on the life of Jack and debit the premiums from Dianne s member account. Option one If $300,000 the insurance proceeds and the $400,000 would be sufficient to pay out the death benefit. Option two If $900,000 the insurance proceeds could totally retire the debt. Debiting Dianne s account for the premium means it is fair and reasonable to credit her account with the insurance proceeds Option one Jack and Dianne SMSF $300,000 Insurance Assets Amount Property $1,500,000 Liquid assets $700,000 Total assets $2,200,000 LRBA loan debt ($900,000) Option two Jack and Dianne SMSF $900,000 insurance Assets Amount Property $1,500,000 Liquid assets $1,300,000 Total assets $2,800,000 LRBA loan debt ($900,000) Net equity $1,900,000 Account balances Jack (deceased) $700,000 Dianne $1,200,000 The trustees have two choices: Pay Jack s death benefit of $700,000 out of liquid assets (and reduce the debt to $300,000) Retire the debt in full and pay a death benefit pension or a combination of death benefit lump sum and pension. Option 2. Jack and Dianne SMSF $900,000 Insurance Assets Death lump sum only ($) Death pension only ($) Property 1,500,000 1,500,000 Liquid assets 1,300,000 400,000 Total assets 2,800,000 1,900,000 LRBA loan debt (900,000) 0 Net equity 1,900,000 1,900,000 Account transactions Jack (deceased) 0 0 Dianne 1,200,000 1,200,000 Lump sum payment (700,000) 0 Death pension capital 700,000 SMSFs are flexible and the members/trustees have the ability to structure optimal solutions to suit their individual circumstances. Net equity $1,300,000 Account balances Jack (deceased) $700,000 Dianne $600,000 12
IOOF TechConnect Technical Insurance Guide Estate planning implications Deciding to hold life insurance within super means a client who is a member of the fund is unable to consider their super account as an estate asset that will be dealt with via their Will, unless a binding nomination directs payment to the deceased s Legal Personal Representative. The following main factors need to be considered: the correct beneficiary/dependant(s) of the deceased member will receive the proceeds the taxation implications whether a lump sum, an income stream or a combination of both is available and which is appropriate. A few different considerations need to be taken into account: Payment of a lump sum death benefit into the client s estate Clients need to decide whether or not their super account balance should be paid into their estate and dealt with via their Will. To ensure this a client needs to make certain the trustee of the super fund is legally bound to pay the lump sum death benefit into their estate by using a valid binding death benefit nomination. Consideration of the lump sum death benefit tax liability is important. In simple terms, the executor must determine whether the beneficiary who receives the lump sum death benefit payment is classified as a dependant for taxation purposes (a death benefits dependant) or not and if applicable, withhold the appropriate amount of tax. Important: Payment of lump sum death benefits is common for clients who wish to benefit their relatives (such as a brother or sister) or a charity. These beneficiaries do not qualify to receive a payment directly from the client s super fund because they fail to satisfy the definition of dependant for super purposes. The advantage of using the client s estate is that it can ensure that an equivalent amount is paid to the required beneficiary. Payment of a lump sum death benefit into a discretionary testamentary trust A discretionary testamentary trust is a trust that is created within a Will but does not take effect until death. While the assets of the testamentary trust may be controlled by the intended beneficiary, as trust assets they do not form part of the beneficiary s estate. A discretionary testamentary trust can provide tax effective income to the deceased s spouse and children. One of the main sources of funding for the discretionary testamentary trust is a client s super account (including life insurance), however this advice needs to be carefully constructed in conjunction with an estate planning specialist. Important: If the client wants to make certain the trustee of the super fund will be legally bound to pay the lump sum death benefit into the client s estate and in turn into a discretionary testamentary trust, a binding death benefit nomination should be used. Failing to ensure the trust deed for the discretionary testamentary trust has been correctly drafted can result in lump sum death benefit taxes applying even if the main beneficiaries of the trust are death benefits dependants for taxation purposes (such as a spouse or minor children). Providing a lump sum benefit to a dependant from the deceased client s super fund To receive a lump sum benefit from a super fund upon death, the beneficiary/dependant must be classified as a dependant for super purposes. To ensure the lump sum death benefit will be tax-free, the beneficiary/ dependant must be classified as a dependant for taxation purposes (a death benefits dependant) at the date of death of the member. Providing an ongoing income stream to a dependant (such as a spouse or child) To be eligible to receive a death benefit income stream from a super fund upon death, the beneficiary/dependant is not only a dependant for super purposes but also one of a limited number of death benefits dependants for taxation purposes (such as a spouse or child under 18, a child under 25 who is financially dependent or a disabled child). Note: Financially independent adult children are ineligible to receive death benefit income stream and a lump sum death benefit must be received. Important: There continue to be some super funds that will not pay a child pension upon the death of a member parent. Understanding which super funds have this restriction could provide an adviser with a reasonable basis for recommending against the use of that super fund in appropriate circumstances. 13
Types of nominations A member can make either a binding or non-binding nomination (only one can be selected). The most appropriate nomination will depend on the client s personal circumstances taking into account the following: taxation implications the type of benefit to be paid whether the estate is a better mechanism to distribute or retain the lump sum death benefit within a trust structure. Important: If your client nominates their legal personal representative, their super account will form part of their estate and be distributed in accordance with their Will or if intestate in accordance with the state laws in which they were domiciled. A client should seek advice from a solicitor specialising in estate planning. Non-binding nomination If trustee discretion exists, the trustee will make the final decision to determine which of the deceased member s dependants and/or legal personal representative will receive the deceased members benefit and the proportions payable to each. A nomination will be taken into account when the trustee determines who to pay the benefit to. The trustee of the fund will take into account circumstances that are relevant to making a decision. Binding nomination If your client has a valid binding nomination in effect at the date of their death, the trustee must pay the benefit to the dependant(s) or to the legal personal representative) that the client has nominated in the proportions that the client has set out in their nomination. A valid binding nomination remains in effect for three years from the date it was first signed, last amended or confirmed. The following conditions that must be met to ensure that a binding nomination is valid: the nomination must be in favour of one or more of your client s dependant(s) and/or estate. each nominated dependant must be an eligible dependant at the date of nomination and at the date of your client s death. the allocation of the benefit must be clearly set out. the total benefit must be allocated (the percentage nominated must add up to 100 per cent) otherwise the entire nomination will be invalid. the nomination must be signed and dated by your client in the presence of two witnesses both of whom are over 18 years of age and are not nominated to receive the benefit. the nomination must contain a declaration signed and dated by each witness stating that the notice was signed and dated by your clients in their presence. Super trust deed clauses A super fund is governed not only by legislation, but also by rules set out in the fund s trust deed. A trustee has the ability to apply their discretion in relation to payment of death benefits (assuming no valid binding death benefit nomination is in place), provided that this discretion is within the law and does not breach the trust deed of the super fund. In some instances the trust deed of a super fund may state that a death benefit must be paid as a lump sum or to the estate of the deceased member which could pose a problem if the spouse wanted to receive a death benefit income stream instead or if the estate may be subject to a legal challenge under the relevant state law. SMSFs and SAFs are able to use trust deed clauses in the manner of non-lapsing binding nominations. Binding nominations and powers of attorney For APRA regulated super funds, a member cannot delegate to their attorney via a general power of attorney the ability to create a new or alter an existing binding death benefit nomination. These constraints do not necessarily apply to self-managed super funds (SMSFs). Depending on the SMSF s trust deed, an attorney may be able to nominate a beneficiary or alter an existing nomination. Important: Advisers should be aware that clients who have lost legal capacity could be negatively impacted by changing super. A new binding death benefit nomination may not be permitted with the new super fund and this means the fund rules where there is no nomination will apply. 14
IOOF TechConnect Technical Insurance Guide Taxation of death benefits lump sum death benefits Super death benefits paid as a lump sum to death benefits dependants for taxation purposes are classified as non-assessable nonexempt income which is entirely tax-free. Death benefits dependant Tax-free component Taxable component Element taxed Element untaxed Dependant Non-assessable non-exempt income (100% tax-free) Non death benefits dependant Non-assessable non-exempt income (100% tax-free) 17%* 32%* * Inclusive of two per cent Medicare levy. For non-death benefits dependant, the taxable component (element taxed) will be taxed at 15 per cent plus the Medicare levy and the taxable component (element untaxed) will be taxed at 30 per cent plus the Medicare levy. A taxable component untaxed element occurs when the lump sum death benefit is paid to a non-death benefits dependant and the super fund has claimed a tax deduction for the cost of the insurance premiums as outlined in the case study of Alison. Important: The taxation treatment of lump sum death benefits from super is widely understood and taken into account when advising clients. However, advisers may be unaware of the true cost which can result in a client losing government assistance payments and paying more personal income tax. Impact of the lump sum death benefit being paid into the estate If the lump sum is paid to the estate, the tax treatment depends upon which beneficiaries will receive the payment from the estate. The taxation treatment is the same as if the payment is made directly from the deceased client s super fund to the beneficiary except the Medicare levy is not applied. Two main outcomes may occur: If the beneficiary is a death benefits dependant for taxation purposes (such as a spouse), the estate will not withhold tax from the lump sum death benefit (it will be tax-free). If the beneficiary is not a death benefits dependant for taxation purposes (such as a financially independent adult child like in the following case study) then the applicable tax should be withheld by the executor (as outlined previously but Medicare levy does not apply). 15
Case study: Lump sum death benefit tax Alison s mother passed away in December 2014 2 and her super account valued at $510,000 (including life insurance proceeds of $400,000) was recently paid to her as a lump sum death benefit from the trustee of her mother s super fund. Alison (age 26) is classified as a non-death benefits dependant for taxation purposes and this means tax will be payable. The components of the lump sum death benefit payable to Alison are outlined in the following table. The effective rate of tax payable on the lump sum death benefit is 21.02 per cent whilst the net payment will be $402,774. Though the table includes a Medicare levy of $10,200 this will not be withheld by the Executor. Components and taxation of lump sum death benefit Gross payment ($) Tax rate* (%) Tax withheld ($) Net payment ($) Taxable component taxed element 373,161 17 63,437 309,724 Taxable component untaxed element 136,839 32 43,788 93,051 Total 510,000 107,225 402,775 * Includes two per cent Medicare levy. Important: The same taxation treatment will apply if the lump sum death benefit is paid via her deceased mother s estate. The trustee of Alison s mother s super fund will not withhold any tax and the death benefit paid to the estate will be the gross amount of $510,000. The estate withholds $97,025 (excluding the Medicare levy) in tax on the payment made to Alison. How is the taxable component untaxed element calculated? An untaxed element generally arises in death benefits in two situations: where a taxed fund pays out a lump sum death benefit funded by insurance where deductions were claimed for insurance premiums from an untaxed fund, such as a public sector fund. To determine the taxed and untaxed element of a super death benefit for a client like Alison, including the life insurance proceeds, follow these steps: A. Amount of the lump sum death benefit (including any anti-detriment payment) will be $510,000 When a death benefit is paid as a lump sum to a death benefits dependant, the funds will remain tax-free, irrespective of the presence of the untaxed element. However, a non-death benefits dependant beneficiary will pay 30 per cent tax (plus Medicare levy) on any untaxed element and the untaxed element will be calculated on the entire lump sum death benefit held within the deceased member s super account. Important: When a death benefit dependant chooses to receive a death benefit income stream, the untaxed element will not be relevant as it relates only to lump sum death benefits payments. Could you compensate for the additional tax? Often the insurance cover is grossed up when a benefit is to be paid to a non-death benefits dependant. Ensuring a set amount will be paid to the dependant; this could mean a higher insurance premium. With the case study of Alison, the amount of life insurance would need to increase to $645,761 to provide a lump sum death of $510,000 as shown on the next page. B. The reduced death benefit using the formula below will be: Amount of benefit x days in service period (days in service period + days to age 65) C. Reduce the amount in step B by the tax free component. This will form the taxed element in the fund. D. Subtract the element taxed of the reduced death benefit from step C and the tax-free component from the taxable component in step A to determine the untaxed element. $373,161 $373,161 $136,839 16 2 Alison s mother (aged 56 at death and date of birth 23rd March 1958) passed away on 3 December 2014. Her service period date was 11 April 1992 and last retirement date at age 65 is 23 March 2023.
IOOF TechConnect Technical Insurance Guide The revised components of the case study are outlined in the following table. The effective tax rate remains at 21.02 per cent whilst the tax payable increases to $135,761. Components and taxation of lump sum death benefit Gross payment Tax rate Tax withheld Net payment Taxable component (taxed element) $472,553 17.0% $80,334 $392,219 Taxable component (untaxed element) $173,208 32.0% $55,427 $117,782 Total $645,761 $135,761 $510,000 Important: The gross up life insurance strategy needs to be regularly reviewed to ensure the net lump sum death benefit will continue to be achieved. An adviser will need to assume that a client will die on a set date each year (the review annual date), however assuming the client s super account balance remains constant, the amount of lump sum death benefit taxes will reduce and the net lump sum death benefit will increase. Anti-detriment payments An anti-detriment payment to an eligible beneficiary only occurs at the time a lump sum death benefit is paid. The additional payment is a refund of the fund tax paid on concessional contributions made during the member s lifetime. Where the calculation is by formula the lump sum payment amount used is reduced by any tax free amount and any insurance proceeds. Important: Not all super funds will pay an anti-detriment benefit. Further, whilst they may pay it in accumulation phase they may not pay it for commutations of pensions It is important that an adviser research the fund they intend to recommend. Understanding the intricacies of this area could make a substantial difference to a lump sum death payment. Avoiding unintended super lump sum death benefit tax a need for appropriate pre-death planning When a lump sum death benefit is paid on the death of a super member into an estate, the taxation treatment of the lump sum death benefit will depend upon who will receive the payment. If a non-dependant for tax purposes receives the payment (such as an adult financially independent child), the taxable component will be taxed at 15 per cent (plus Medicare levy). Where the lump sum death benefit includes life insurance proceeds they are added to the taxable component. The taxable component will consist of a taxed element and an untaxed element. If the beneficiary is a super dependent who is a tax dependent the taxable component is treated as non-assessable non-exempt income (tax free). If the beneficiary is not a tax dependent there will be a taxed element and an untaxed element Tip: Maximise the client s service period. The longer the service period of the client s super interest the smaller the untaxed element. When the super passes into a testamentary trust, the ATO will seek to determine whether the beneficiaries of the trust are dependants or non-dependants for tax purposes. If the beneficiaries of the testamentary trust include nondependants for tax purposes, lump sum death benefits tax will apply and potentially the higher tax rate on the taxable component untaxed element if life insurance is involved. An opportunity exists for a solicitor, who is an estate planning specialist, to draft the terms of the testamentary trust deed to avoid this issue. The deed could exclude beneficiaries that are non-dependants for tax purposes from being capital beneficiaries and limit them to being income beneficiaries. The terms for the deed could be complicated and costly. However, the lump sum death benefits tax would far outweigh the cost to do so. Important: To avoid this issue and maintain flexibility for the beneficiaries of the testamentary trust, the life insurance may need to be structured outside of super. The estate would be the intended beneficiary of the insurance policy. 17
Terminal illness benefit Most life insurance policies inside and outside super have a terminal illness benefit if a client is diagnosed as having a terminal medical condition. The life insurance can be pre-paid as a death benefit as a result of the terminal medical condition where the insured is diagnosed with an illness that is expected to result in their death within 12 months. Inside super the condition of release is known as a Terminal Medical Condition Accessing the terminal illness benefit In order to access the life insurance terminal illness benefit contained within the client s super account, two events must occur: Satisfy the insurance policies terminal illness benefit definitions requirements. Then the insurer releases and pays the proceeds to the trustee of the super fund to form part of the fund member s account Meet a condition of release a terminal medical condition otherwise another condition of release (such as retirement or permanent incapacity). Satisfying the condition of release terminal medical condition Taxation treatment lump sum benefit A super lump sum benefit paid to a client who has a terminal medical condition is tax free 3. From a taxation perspective, the definition of a terminal medical condition 4 is the same as the super definition shown above. Financial planning implications If a client decides to access their total super benefit using the terminal medical condition of release, this will come at the loss of an anti-detriment payment. Closure of the client s super account will cancel any remaining life insurance within the account (assuming a pre-death terminal illness benefit is available). This means the remaining dependants will not receive the life insurance upon the death of the client. If you client does not require access to their full balance, they might consider requesting a partial withdrawal under the terminal illness condition of release. The remaining funds can stay in super and be paid as a death benefit. This may provide the opportunity to take advantage of any available anti-detriment payments or additional insurance. A terminal medical condition exists in relation to a person at a particular time if the following circumstances exist: two registered medical practitioners have certified, jointly or separately, that the person suffers from an illness, or has incurred an injury, that is likely to result in the death of the person within a period (the certification period) that ends not more than 12 months after the date of the certification at least one of the registered medical practitioners is a specialist practicing in an area related to the illness or injury suffered by the person for each of the certificates, the certification period has not ended. Important: Advisers and clients considering an application under a terminal illness option should be mindful of the Centrelink implications of doing so. 18 3 ITAA 1997s.303.10 4 Income Tax Assessment Regulations 1997 Reg 303.10.01
IOOF TechConnect Technical Insurance Guide Total and permanent disablement insurance Total and permanent disablement insurance non-super TPD insurance premiums are not tax deductible and the proceeds from the policy will be exempt for capital gains tax purposes 5. This applies provided the payment is made to the insured person, their spouse, or a defined relative. Outside of super own occupation cover is available. Inside super only any occupation definitions are allowable though there are grandfathering provisions for pre 1 July 2014 cover in super Any occupation definition The any occupation definition is regarded as the definition of a disability super benefit and typically requires: That the member suffers from an injury or illness (whether physical or mental) and is unlikely to ever be gainfully employed in any occupation for which they are reasonably qualified by education, training or experience. Own occupation definition The own occupation definition is a more generous definition which generally requires: That the member suffers from an injury or illness (whether physical or mental) and is unlikely to ever be gainfully employed in their own occupation. Total and permanent disablement insurance through super TPD insurance can be offered to members of a super fund to provide benefits in the event that a member is totally and permanently disabled. TPD insurance satisfies the sole purpose test 6 as it provides benefits for retirement, however in this case they will no longer be able to fund their retirement themselves due to their inability to be gainfully employed. The premium can be deductible to the super fund and the proceeds from the policy will be exempt for capital gains tax purposes 7 since the client is a member of the super fund. A member may be entitled to a benefit payment under a grandfathered the own occupation definition policy, however they may still be capable of being engaged in other gainful employment for which they are reasonably qualified by education, experience or training. Accordingly, the benefit may credited to the members account but not meet a permanent incapacity condition of release. Furthermore the premium will not be fully deductible. Sub regulation 4.07D(2) of the Superannuation Industry (Supervision) Regulations 1994 (SISR) states that a trustee of a regulated super fund must not provide an insured benefit in relation to a member of the fund unless the insured event is consistent with a condition of release specified in items 102 (Death), 102A (Terminal medical condition), 103 (Permanent incapacity) or 109 (Temporary incapacity) of Schedule 1 to the SISR. Regulation 4.07D of the SISR applies from 1 July 2014. However, sub regulation 4.07D(2) of the SISR does not apply to the continued provision of an insured benefit to members who joined a fund before 1 July 2014 and were covered in respect of that insured benefit before 1 July 2014. Opportunity: TPD policies have different lengths of time in which an insured person can be considered for a claim. Generally, the wait time is either 90 days or 180 days. An adviser should know what the wait period is but also the insurance company s claims history. Accessing TPD insurance In order to access the TPD insurance contained within the client s super account, there are two requirements as follows: Satisfying the insurance policy definitions the client needs to satisfy the definition of the TPD insurance policy contract. Satisfying a super condition of release the trustee of the fund must be satisfied that a condition of release of permanent incapacity is met. Otherwise, the client must satisfy another condition of release such as retirement. Permanent incapacity, in relation to a member, means: Ill-health (whether physical or mental), where the trustee is reasonably satisfied that the member is unlikely, because of the ill-health, to engage in gainful employment for which the member is reasonably qualified by education, training or experience8. Important: Some super funds do not recognise the difference between the trustees decision to release accumulation benefits on the basis of permanent incapacity and the underlying insurer s decision to pay out under a TPD policy. Obviously, if the TPD policy has a 180 day waiting period the insured member may find themselves in financial difficulty in the meantime. 5 ITAA 1997 s118.37(1)(b) 6 Superannuation Industry Supervision Act (SIS) 1993 S.62 7 ITAA 1997 s118.37(1)(a) 8 SIS sub-regulation 6.01(2) 19
TPD insurance and not satisfying a condition or release A problem arises when the client satisfies the own occupation TPD policy terms, but does not satisfy a condition of release. This is outlined in the following case study. Case study: Conflicting definitions John (age 44) is a chiropractor who has recently lost both of his legs in a car accident. John cannot complete his employment as a chiropractor and this means his will satisfy the insurer s requirements of his own occupation TPD insurance contained within his super account. Based on the super definition of permanent incapacity John has the capacity to engage in gainful employment for which he is reasonably qualified by education, training or experience by becoming a university lecturer. John s super fund may not release the proceeds of the TPD insurance payment. The proceeds will be contained within his super account until he satisfies another condition of release such as: retirement at or after preservation age reaching age 65 severe financial hardship compassionate grounds, as determined by the Department of Human Services terminal medical condition death. Disability super benefit taxation treatment A disability benefit is only tax-free when the member has attained age 60 years. Clients will be subject to normal super benefit taxation treatment which varies dependent on the nature if the benefit taken and the age of the client at the time of disability. For a client that satisfies the definition of a disability super benefit, that is: they suffer from ill-health (whether physical or mental), and two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in a capacity for which they are reasonably qualified because of education, experience or training. The client needs to determine what type of super benefit will be received. There are three choices: lump sum disability benefit disability income stream benefit a combination of lump sum and disability income stream benefits. Lump sum disability benefit taxation treatment When a lump sum disability benefit is being paid or rolledover to another super fund an additional tax free amount is calculated and added to the tax-free component of the members account. The additional tax-free amount is worked out using the following formula. Additional tax-free amount for a lump sum disability benefit = Amount of benefit x [ Days to retirement (Days to retirement + Service days ) ] Where; Days to retirement = number of days from when the person stopped being capable of being gainfully employed and their last retirement date (usually age 65). Service days = number of days from the start of the eligible service period in the fund to the day the person stopped being capable of being gainfully employed. Financial planning implications When determining the impact of this calculation on the additional tax-free component, the following needs to be considered: The additional tax-free component is calculated each time the client receives a lump sum disability benefit. The calculation is limited to the amount of the lump sum disability benefit paid. The younger the client is, the larger the amount of the additional tax-free amount. A longer service period also results in a lower tax-free portion. For clients who have multiple super accounts, it can be more tax effective to place TPD insurance in a fund with a shorter service date. The additional tax-free amount does not apply to a disability income stream benefit. Note: The additional tax-free amount will not be automatically created when the insurance proceeds are credited to the super fund member account. The insurance proceeds are added to your clients taxable component. 20
IOOF TechConnect Technical Insurance Guide What is the taxation treatment of the components of a lump sum disability benefit? Withdrawals from super for clients over age 60 (from a taxed fund) are tax-free. For those aged under 60 the following table outlines how the components of a disability super benefit paid from a taxed super fund as a lump sum are taxed: Components Tax-free component Tax treatment No tax payable Tax rates shown above are maximum rates. The super fund trustee will withhold at the above maximum rates. Where a person would be subject to a lower rate of tax than the maximum specified, the lower rate applies. Any refund of tax will be refunded to the client from the ATO when their taxation return is completed for the financial year the lump sum disability benefit was received Taxable component If aged under 55, taxed at 22 per cent 9 If aged between the 55 and 59 years, the first $185,000 10 tax free and the balance is taxed at 17 per cent 11 Case study: Calculating the disability lump sum benefit Harrison (age 44) 12 was injured at work and he ceased his gainful employment on 16 May 2014 13. His super account balance of $425,000 includes a TPD policy of $350,000. Harrison s account contains $12,000 of non-concessional contributions (the tax-free component). Harrison decides to withdrawal $300,000 and the remaining funds are retained within his super account. The calculation of the additional tax-free amount and the components of the lump sum disability benefit are outlined below. Components and taxation of Harrison's disability lump sum benefit Component Gross payment ($) Tax rate* (%) Tax withheld ($) Net payment ($) Tax-free component 165,634 0 0 165,634 Taxable component 134,366 22.0 29,561 104,805 Total 300,000 29,561 270,439 * Includes Medicare levy. 9 Includes two per cent Medicare levy 10 As at 1 July 2014 and indexed annually 11 Includes the two per cent Medicare levy 12 Date of birth is 14 May 1970. 13 Eligible service period start date is 18 April 1995. 21
Case study: Calculating the disability lump sum benefit (continued) A. The tax-free proportions of the super account balance just before the benefit is paid: Disability income stream benefit taxation treatment Standard tax-free component $12,000 Total super account balance $425,000 Expressed as a tax-free percentage 2.82% Apply the tax-free percentage to calculate the tax-free component of the lump sum benefit as if it was a normal lump sum benefit: Amount of lump sum benefit x tax-free percentage $300,000 x 2.82% $8,460 B. The additional tax-free component of the disability lump sum benefit using the formula below will be: Instead of taking the lump sum, Harrison could take the benefit as a disability super pension which is assessable income for taxation purposes; however the taxable portion of the income payments will be subject to a 15 per cent tax offset. The additional tax-free component will NOT apply to the commencement of a disability income stream benefit. Most importantly, a disability income stream benefit can have effective tax-free threshold of $49,753 15 This assumes that the client does not have any other assessable income. In Harrison s case, the effective tax free threshold for his disability income stream benefit will increase to $51,197 as a result of the inclusion of a small tax free component within his account (2.82 per cent). Taxation for the 2014/15 financial year Disability income stream benefit $51,197 C. Calculate the total tax-free and taxable components of the disability super benefit as follows: The tax-free component is the sum of the amounts worked out under A and B $165,634 Taxation of the disability lump sum benefit The following table outlines the taxation treatment of Harrison s $300,000 lump sum disability benefit. The effective rate of tax on the benefit is 9.85 per cent. Less tax-free portion (calculation: $51,197 x 2.82%) $1,444 Assessable income $49,753 Gross tax* $7,717 Total tax including 2% Medicare levy $8,712 Disability income stream benefit tax offset (calculation: ( $51,197 $1,444) x 15%) $7,463 Low income tax offset $254 Total tax offsets $7,717 Net tax $0 Medicare levy payable $995 Income after tax $48,758 * 2014/15 taxation scales. 22 14 Normal retirement date is 14 May 2036. 15 Based on 2014/15 tax scales, excluding the Medicare levy of 2 per cent and including low income tax offset
IOOF TechConnect Technical Insurance Guide The deductibility of insurance premiums within super Life, total and permanent disablement (TPD) and income protection insurances can be provided by super funds without breaching the requirements of the sole purpose test for super funds under section 62 of the SIS Act. A deduction is allowable in respect of insurance premiums paid for the following: life insurance included in a super death benefit a disability super benefit that satisfies the requirements of the regulations an income protection insurance policy funding a temporary disability benefit in the form of a non-commutable income stream 16. Deductibility of insurance premiums for disability super benefits TPD premiums are deductible to the extent that they relate to the provision of a disability super benefit 17. A disability super benefit is defined in section 995-1(1) ITAA 1997 as: a benefit that is paid to a person because he or she suffers from ill-health (whether physical or mental) two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training. Post 1 July 2011, if an existing insurance policy does not meet the SIS definition, an actuary will need to apportion the premium into deductible and non-deductible components. 18 ATO tax ruling TR 2012/6 explains when a TPD premium will automatically be able to be claimed as a deduction and when an actuary s certificate will be required to determine the proportion of the premium that is deductible. From 1 July 2014 own occupation definition TPD cannot be purchased within a super fund. This does not prevent members who already hold own occupation policies from increasing the level of TPD cover they have. It does prevent members who hold life only policies from adding an own occupation TPD rider or a stand-alone TPD policy. It also prevents any occupation TPD cover being altered to an own occupation definition. Some insurers offer the option of a split policy where the Any occupation section is paid for from the balance of the super fund and the Own occupation portion is paid out of the member s own funds. This strategy is still permitted. The regulations limit the deductibility of premiums for existing TPD insurance for own occupation insurance. ITAR 1997 sub-regulation 295-465.01(1) sets out the deductible proportion of premiums for different types of TPD policies. However, should a fund wish, they can get an actuary to specify an alternative. The level of the deduction will depend upon the type of TPD insurance offered. Prescribed deductible percentages Insurance policy Specified proportion (%) TPD any occupation 100 TPD any occupation with one or more of the following inclusions: activities of daily living cognitive loss loss of limb domestic (home) duties 100 TPD own occupation 67 TPD own occupation with one or more of the following inclusions: activities of daily living cognitive loss loss of limb domestic (home) duties TPD own occupation bundled with death (life) cover TPD own occupation bundled with death (life) cover with one or more of the following inclusions: activities of daily living cognitive loss loss of limb domestic (home) duties 67 80 80 16 ITAA 1997 S.295-460 17 ITAA 1997 S.295-460 18 Tax Laws Amendment (2011 Measures No. 4) Act 2011 Schedule 3, Income Tax Assessment Regulations 1997 (ITAR 1997) 23
TPD insurance for the over 65s Generally, from the age of 65 or 70 activities of daily living TPD will apply. This means that policies that were own or any occupation will revert to an activities of daily living definition. This may be regarded as a good thing for many clients because the premium drops to approximately one third of the previous premium. Of course, it s appropriate to check that the insurer that your client is using actually does provide cover after age 65. TPD and aged care funding The reversion of TPD to an activities of daily living definition may enable a funding strategy for an aged care place. Advisers will find that the premium drops to approximately one third of the any occupation definition. If you are using IOOF s platform you could refer to our panel of insurers and their underwriting guides. Some retail insurers offer TPD up to the age of 75 on IOOF s super platform. However, it can continue until age 100 so long as premiums continue to be paid. An activities of daily living definition would be: bathing the ability to shower and bathe dressing the ability to put on and take off clothing toileting the ability to get on and off and use the toilet mobility the ability to get in and out of bed and a chair feeding the ability to get food from a plate into the mouth. The issue is how do you fund the premiums when the client is no longer eligible to contribute to a super fund? A solution is to leave a residual value in the accumulation division for the client and the premiums may be debited from it on a pseudo non-forfeiture basis. 24
IOOF TechConnect Technical Insurance Guide Income protection insurance Income protection insurance non-super The income protection policy premium is tax deductible where it can be proven that those premiums relate to the earning of assessable income. The proceeds of the policy are considered to be assessable income for taxation purposes because the proceeds are paid to fill the place of lost earnings. PAYG tax is not deducted from benefits paid from an income protection insurance policy paid outside super. The tax liability will be assessed at the time the insured s tax return is completed. The same taxation treatment applies to lump sums paid to settle all outstanding claims under an income protection policy as per Sommer v FC of T. Premiums paid by an employer (outside super) Where the premiums are being paid by an employer, with the client being the owner and life insured on the policy, the client cannot claim a tax deduction because it is the employer who will be entitled to claim the deduction for the cost of premiums. As the premiums are an otherwise deductible expense, there is no fringe benefits tax (FBT) payable on the payment of the premiums. There is also no capital gains tax (CGT) amount payable as it is not a capital item. In the event of a benefit being paid to the client, they will need to include the insurance proceeds as assessable income and pay tax on the benefit at their marginal tax rate. The employer will not have to pay any tax on the insurance benefit. Income protection insurance through super When an income protection policy is held in a super fund, the premium is deductible to the fund. The cost of the premium can be paid with pre-tax dollars via salary sacrifice, personal deductible contributions or debited from the members existing account balance. If premiums are funded by contributions they count towards the concessional contribution cap. In order to access the income protection insurance contained within the client s super account, there are two requirements: Satisfying the insurance policy definitions if the client satisfies the definitions of the income protection insurance policy. Satisfying a condition of release the trustee of the fund must be satisfied that a condition of release of temporary incapacity has been met. Temporary incapacity in relation to a client of a super fund who has temporarily ceased work due to physical or mental ill health that does not constitute permanent incapacity. The temporary incapacity benefits paid as a non-commutable income stream are considered to be assessable income for taxation purposes. No super pension tax offset applies nor is income tax free after attaining age 60. PAYG tax is deducted from income protection benefits paid from a policy that was owned within a super fund. Did you know? Where an income protection benefit is paid directly from an insurer no PAYG tax is deducted. However, if a benefit is paid from a super fund PAYG tax will be paid. Retention of benefits within the super fund Income benefits payable as a result of the insured being unable to work may not be retained within a super fund which owned the policy. Restriction on the level of pre-disability income/earning The SIS Act does not prevent the payment of a temporary disability benefit in the form of a non-commutable income stream above 75 per cent of a client s pre disability income. This means a super fund can pay a maximum of 100 per cent of the pre-disability income; however the income protection policy owned by the fund which funds the temporary disability benefit may limit the payment to 75 per cent of a client s pre disability income. Employment does not have to fully cease and benefit payments can continue where a member makes a partial return to work whilst incapacitated, provided that the member s remuneration plus the incapacity benefits do not exceed the member s remuneration at the time the member became ill. 19 19 SISR Schedule 1 (conditions of release), APRA Super Circular No IC2). 25
Agreed value versus indemnity value Indemnity value policies generally only cover the average of the last two or three years of the insured s income regardless if they are insured for more. A client with indemnity value income protection insurance within super, whose income has subsequently reduced in the financial year prior to a claim, may have problems at claim time. The trustee of the super fund may not pay out more than the client s earnings prior to temporary incapacity (also taking into account any earnings received from lighter duties). Agreed policies offer protection at an agreed rate at the time of application. For larger amounts of cover the amount usually requires some degree of substantiation which is described in each individual life company s underwriting guide. More often than not, industry super funds do not offer agreed style policies. Therefore, it is important to consider a wider range of policies where recommending income protection insurance inside super. Some people have an employment package which is made up of a base plus bonuses and may be highly variable. Self-employed people are also more likely to have variable income depending on demand for their services and the economy. For that reason, an agreed value policy may be in their best interests. It is important to understand with an agreed value policy inside super that the trustees cannot pay out more than what the insured was earning just before the time of claim. They cannot pay more than 100 per cent of pre-disability earnings (although they can pay between 75 per cent and 100 per cent of pre-disability earnings.) Therefore, if there is a surplus over and above their pre-disability earnings it may not be able to be paid to them. While any surplus amount from the insurance payments can be credited to your client s super account, this does not make the expected income available to them. Outcomes of benefit payments from a super fund may not be what your client envisaged. It is important to establish that: the super funds definition of pre-disability earnings is in alignment with the insurers the fund trustee is satisfied that its definition is in compliance with super law the super funds governing rules are not more severe than the law requires. Tip: Structure agreed value policies outside super as the additional income over and above what the insured s pre-disability earnings may not be able to be paid out by the super fund. Premier versus standard Premier policies offer benefit features which are not permissible in super. Examples of these would be: rehabilitation benefits nursing benefit accommodation benefit emergency travel benefits income payments to a family member to care for the insured for six months whilst the insured is confined to bed accidental injury benefits. Many retail insurers aligned with retail super funds allow members to split the benefit so that the standard portion of the policy is funded from the super balance with the premier component being funded by the insured themselves outside of super. 26
IOOF TechConnect Technical Insurance Guide Compromising on cost with income protection Case study: Do the math Don t let a client talk the monthly benefit amount down make sure their decisions are in their own best interests. This example illustrates how you can negotiate on price of premiums with your client without compromising too much on the benefits for a client. Andy (30 years old) is a real estate agent on $80,000 plus $120,000 of bonuses. He has a history of earning bonuses at this level. SG is paid on the full amount of $200,000 which brings his super guarantee to $19,000 per annum. His financial planner, Jane recommends that Andy takes income protection premier agreed $12,500pcm plus 100 per cent super contributions bringing the full recommended amount to $14,083 per calendar month. The premiums for this recommendation amount to $2,014.03 per annum. Andy thinks that this quote is too expensive and looks to compromise. He says he doesn t need this much cover. He says he can cope on $10,000 per calendar month and asks for a quote for this amount of cover. Naturally, Jane is more than happy to oblige but she s aware that there may be a better way of getting the same discount without losing as much of the benefit. The quote for this amount is $1,409.10 per annum. However, there is a better outcome for Andy. Jane lets Andy know that a better way to incorporate his desire for a discount with the need to protect himself. She says that if he takes a 90 day wait rather than a 30 day wait but retains the benefits amount of $14,083 per calendar month then he only loses up to $28,166 of benefits rather at $14,083 per month than up to $1,714,860 of additional benefits. This is because he is only losing two months of benefits rather than 35 years of benefits at $4,083 per calendar month. In taking this alternative approach Andy s premium would only be $1,333.19 per annum. Andy is thrilled because Jane has told him how to save money without compromising his benefit. When Jane pointed out to him how much he stood to lose by making his own choice he was most surprised. He could see the logic in Jane s argument and decides to take income protection premier agreed with a 90 day wait to age 65. This is a win-win for both Andy and Jane. Andy wins because he gets even more of a discount than he hoped for. It s a win for Jane because she gets Andy s business but she also shows Andy how she can value add to their relationship and secures a client for life. It would be negligent if Jane didn t let Andy know that his decision means he stands to lose up to $1,714,860 of benefits by making this choice. It would be negligent if Jane didn t know that Andy has a couple of other choices when looking to factor the premium into his budget. Concessional contributions to super whilst on a benefit Outside super Where income protection has been paid for outside super and is not coming from an employer source, a concessional contribution can be made up to the concessional contribution limit for which a personal deduction can be claimed. That is, provided that the 10 per cent maximum employment earnings test is met. This is explained in ATO TR2010/1 paragraphs 62,63 and It therefore follows that someone on income protection where their employment contract has since ceased need not comply with the self-employed test either. Inside super Where the income protection policy was owned by the super fund the payment of benefits will be paid from a super fund. The benefits will not be coming from an employer. So long as the insured is not engaged in gainful employment, and meets the 10 per cent maximum employment earnings test requirements a contribution may be made up to the concessional contribution limit and a personal deduction may be claimed. However, if a benefit is being paid whilst the member is still in the employ of the employer and will be returning to work once off claim then the ability to claim a deduction becomes more difficult. 27
Income protection and 100 per cent super contribution coverage These days many income protection policies offer the ability to be insured for 100 per cent of one s super contributions. The question then arises if a benefit is payable how is the super contribution classified? If a benefit is payable these benefits are paid into the super fund and are taxed at the concessional contribution tax rate. They are treated as concessional contributions made by a third party (as distinct from family and friends). Salary packaging and income protection Income protection is an item which can be salary packaged where an employer offers salary packaging. This is distinct to salary sacrifice. Many hospitals allow an employee to salary package up to $17,000 per annum gross (or $9,095 per annum net 20 ). Charities offer the option of packaging up to $30,000 per annum gross (or $16,050 per annum net 21 ). From 2014/15 these figures will be $17,667 ($9,363 per annum net) and $31,177 per annum ($16,524 per annum net) respectively as a result of the budget deficit levy. Income protection premiums can be packaged on top of these figures. The packaging provider will generally reimburse the insured for the premiums that the policy amounts to. This means that your clients won t have to wait until the end of the financial year to claim a tax deduction. They can pay their premiums in pre-tax dollars rather than after tax dollars. TPD and income protection within the same super fund An important concern may arise, where clients have taken out both income protection and total and permanent disability (TPD) insurance within their super fund. In some cases, depending on the policy wording of the insurance contract and the super platform used, where a client is receiving an income protection benefit via super and subsequently receives a successful TPD claim as well, as soon as the TPD claim is paid the income protection benefits may cease to be paid or is reduced accordingly. Event based cover versus occupation based cover Not surprisingly there are some occupations which aren t covered or are offered very limited coverage in terms of occupation based cover. For example, it s extremely difficult, if not impossible, to find income protection cover for airline pilots, police officers, prison officers, defence personnel, actors and musicians. Other occupations may only be offered a benefit for two (or if lucky, five years). Such occupations might include roof tilers, oil rig workers, fishermen, truck drivers, unqualified underground miners or professional divers. Naturally, such people may wish to protect 100 per cent of their income just like any other employed person. These restrictions have seen the growth of several solutions some of which we will mention here. General cover income protection General income protection is offered by a number of insurers in the Australian market. Such income protection policies are extremely restrictive and often limit the benefit amount (to say $5,000 per calendar month) which may not be close to 75 per cent of an insured s salary. General cover income protection with general cover IP definition provides a monthly benefit if the Insured Person becomes severely disabled because of sickness or injury, and is unable to perform the activities of daily living. In effect, it is activities of daily living cover paid as a monthly benefit. To be eligible for such cover an applicant must be working. The premiums for such cover are tax deductible. Please note: there is no such (adverse) offsetting feature for income protection and TPD insurance within the IOOF and TPS super funds. 28 20 $17,000/1.8692 = $9094.80 where 1.8692 is the gross up rate for items that do not include GST. The factor for items which do include GST is 2.0647. 21 $30,000/1.8692 = $16,049.65 where 1.8692 is the gross up rate for items that do not include GST.
IOOF TechConnect Technical Insurance Guide Gap cover For those applicants who are only offered a two or five year income protection benefit this still leaves them uninsured for the remainder of the time between now and their 65th birthday (less the two or five years). One common strategy is to capitalise the uninsured section of income in a trauma/tpd policy. This is not only sensible but also in the best interests of the client because they need to protect 100 per cent of their income. It can also be an appropriate strategy to capitalise the uninsured 25 per cent of their income that won t be covered by any income protection policy either. The strategy of capitalising income in the form of a trauma and/or TPD benefit can also be applied to those who are refused income protection on the basis of their occupation, lack of occupation or medical grounds as well. For formulas as to how to capitalise the benefit please refer to your individual dealership or insurance representative. There are numerous calculators available to advisers through these intermediaries. Income 100% of insured's salary Capitalise income in the form of trauma and TPD to cover the area of uninsured income 75% of insured's salary Income covered by normal income protection policy Two years of cover To age 65 29
Trauma insurance Trauma insurance non-super Trauma insurance is comparatively simple when it established outside of super, the premiums are paid by a client and the policy is also owned by the client. The premium is not tax deductible (ATO Interpretative Decision ATO ID 2002/371) and the proceeds from the policy will be exempt from for capital gains tax purposes 22. This applies provided the payment is made to the insured person or their spouse or a defined relative. A defined relative is given meaning in Income Tax Assessment Act 1997 section 995-1 as a the persons spouse, or b the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that person, or that persons spouse, or c the spouse of a person referred to in paragraph (b). Trauma insurance through super Trauma insurance via super was never available in APRA regulated funds, however there may be instances where trauma insurance was put in place via an SMSF prior to 1 July 2014. From 1 July 2014, a trustee of an SMSF is prohibited from providing such an insured benefit in relation to a member unless the member joined the fund before 1 July 2014, and was covered in respect of that insured benefit before 1 July 2014. It is the Commissioner s view that an SMSF trustee that continues to provide a trauma insurance benefit to a member who joined the fund before 1 July 2014, and was covered in respect of that insured benefit before 1 July 2014, can purchase a trauma insurance policy to support the provision of that benefit and still satisfy the sole purpose test in section 62 of the SISA provided the conditions set out in SMSFD 2010/1 are met. Trauma and neurological conditions Various neurological conditions such as Parkinson s disease, Motor Neurone disease, Multiple sclerosis and early onset Dementia, may not pay 100 per cent of the insured benefit immediately but stage the payments over various levels of decline of the insured. This is of benefit to the client because it ensures that the money is there when it is really needed rather than at the early stages of the disease where the risk is that it could be spent all at once. Even when diagnosed with some of these diseases an insured can live for a considerable amount of time. Income protection and trauma Generally, income protection can only cover an insured for up to 75 per cent or 80 per cent of their total remuneration package. This is to give the insured some incentive to want to return to work. However, the question must be asked, Does the client want to be the same off, better off or worse off? Few clients will say worse off, in which case they really need 100 per cent of their income covered but how? A legitimate strategy is to capitalise the remaining 25 per cent of income that is not insured into a trauma policy. This may be for any number of years and may include a discount factor. That is, if this lump sum were received and invested at 4 per cent (as an example) then it would be capable of producing this much income for this amount of time. The same approach is often used for calculating TPD needs in conjunction with a sum for clearing debts. Income protection, if payable, is taxed. Therefore, the actual benefit may be closer to 60 per cent (or less) of the total remuneration package once tax is taken into account making a top up policy with the use of trauma/tpd most important. It is imperative to ensure that the client doesn t mistakenly think that a benefit is likely to put them in the same position if it is quite unlikely to do so. The super fund will receive insurance proceeds upon a successful claim and unless the member meets a condition of release (such as permanent incapacity or retirement) no benefit can be paid to the member. Tax treatment of trauma benefits The ATO has indicated the trauma benefit is a capital amount and not considered assessable income to the fund. The ATO will treat the proceeds as being exempt in the event of illness or injury if they are received by the life insured or their defined relative. 30 22 Section 118.37(1)(b) of the ITAA 1997
IOOF TechConnect Technical Insurance Guide Expats, inpats and insurance The first point of reference should be your Underwriting Guide for the relevant insurer. Then if this still doesn t answer your question please call the insurer themselves. Case Study: Check the fine print John was born in and for most of his life worked in New Zealand (NZ). He obtained a special category visa to work in Australia in 2006. John worked for N2Z transport as a semi-trailer driver in Australia from 2006 to 2008. During that time N2Z paid super for John into their default fund. The default fund provided automatic acceptance insurance to all its members as a result of a group insurance policy. The fine print of the group insurance policy said that the cover was only to apply to permanent residents of Australia. Two months after John moved back to NZ (after which time he had rented a flat), he died at age forty. John s insurer now refuses to pay the $250,000 life policy to John s mother (the LPR) saying that John was not a permanent resident of Australia at the time of his death. A dispute arises and John s mother lodges a case with the Superannuation Complaints Tribunal. In this case the mother s lawyers argued that: The deceased was a blue collar worker unaccustomed to reading and understanding large complex documents such as an insurance policy document and shouldn t be held to have been aware of the exclusion. A specific request by the super trustee to the insurer to cover 950 members who had overseas addresses was made and granted in 2007. This should indicate that there was a lack of clarity around the definition of who was and wasn t a permanent resident of Australia. The definition of permanent resident wasn t clearly defined. In this real case D13-14\090 the outcome was in favour of the insured. However, it is better to check before rather than find out after the case that one isn t covered by a policy. What this example illustrates is the importance of checking the definitions of the policy: What classes of people does the policy apply to? If the insured is covered, are they covered if they go overseas? Does the insured need to inform the insurer if they are going overseas to continue their cover? If they don t need to inform the insurer for just a holiday, is there a time frame after which they do need to inform the insurer? Does the policy apply to people on longer stay visas? If an insured is intending to go overseas for a year sabbatical will they be covered? If the insured regularly travels overseas for work will these periods be covered? Is there any exclusions for regions where there is war or there are DFAT alerts or warnings on? What is covered by the exclusions of acts of war or terrorism? 31
Centrelink and insurance payments Centrelink generally views insurance payments as compensation if there is a component of economic loss. When an insurance policy is payable a number of different Centrelink entitlements may already be being paid or be payable in the future such as disability support pension. Exactly how the compensation affects social security payments depends on whether the compensation is paid as a lump sum or as a periodic payment. However, for some compensation recipients, the periodic compensation payment will still be assessed as ordinary unearned income where no economic loss occurs. Compensation assessed as ordinary unearned income is NOT employment income 23. Compensation/compensatory payments assessed as ordinary unearned income A compensation payment is assessed as ordinary unearned income and may include payments which are compensatory in nature but do not contain economic loss due to personal injury. Examples are 24 : disability insurance lump sum payment from a super fund where the calculation is totally based on the person's entitlement from the insurance from the super fund, death benefits, payments for a personal accident or insurance policy; an income replacement insurance policy; or salary continuance payments, when: the person has made contributions towards the policy, and the policy does not include an offset clause, or the policy contains an offset clause but it has not been invoked. The following table shows how payments that are compensatory in nature are assessed as ordinary unearned income for allowances/benefit and pensions: Compensation that is paid... as a lump sum (eg TPD, trauma), If a lump sum is received instead of periodical payments and the lump sum is calculated at a set weekly, fortnightly or monthly rate over a specific period, the payment is treated as if periodical payments were being made throughout the relevant period. Periodically (eg income protection whether paid for inside or outside super, TPI payments paid as income) Payments made from super Is assessed as ordinary unearned income for... allowances/benefit in the fortnight it is received, BUT ignored as income for pensions. allowances/benefit, AND pensions. A disability benefit paid from a super fund, whether or not there is an 'offset' clause, is NOT a compensation payment. This includes regular, ongoing payments made under a sickness and accident policy and/ or income protection policy when paid from a super fund, whether funded by the person, or another party (for example, their union or employer). 25 A series of regular and ongoing payments made from super funds are income streams for social security purposes. 32 23 SS Guide 1.1.E.102 24 SS Guide 4.13.1.20 Assessment of Compensatory type payments 25 SS Guide 4.9.1.30 Specific Provisions for Assessing Income Streams
IOOF TechConnect Technical Insurance Guide The initial treatment of a compensation lump sum does NOT affect the treatment of any on-going income generated by the lump sum. The initial treatment of this lump sum does not make this an exempt lump sum. The continuing assets and income tests treatment will be determined by how a person makes use of the funds. The funds may be used to obtain additional assets such as a car. For a purchase such as this the assets test would apply. Or, the funds may be invested with a financial institution. The funds have then become a financial asset, assessable as an asset and subject to the income test deeming rules. Compensation economic loss A compensation lump sum can preclude the compensation recipient from social security income support for periods in the past as well as into the future. Centrelink repayments In many instances it may take an insurance company some time to admit a claim for TPD or income protection. In the meantime the insured may have had to rely on disability support pension. Invariably, in these instances, the insured may be required to pay part or all of the disability support pension back to Centrelink. This guide is not intended to be a comprehensive guide as to how these repayments will be calculated. A more comprehensive guide it put out by the Department of Human Services themselves. This guide can be found at the following link: http://guides.dss.gov.au/guide-social-security-law Most periodic payments are assessed as a dollar for dollar deduction against the compensation recipient's Compensation Affected Payment (CAP), but in some circumstances can be treated as income. Note that this is different from ordinary treatment of income with respect to disability support pension which reduces at 50 cents per dollar over the income limit. The notification requirements for a person who receives a compensation payment, is the period of seven days after the day on which the person becomes aware that he or she has received, or is to receive, a compensation payment. 26 Important: Do not advise a client or spouse to cash TPD benefits out of super if they are under pension age. To do so may preclude their ability to get some Centrelink benefits and/or concessional treatment for Aged Care purposes. Check first. If necessary contact IOOF TechConnect for help. If a client does get a lump sum payment it is important that they be reminded not to repay a mortgage or make other large payments such as deductible debt without checking what the Centrelink outcome is first. 26 SS(Admin)Act section 72(3) 33
Business insurance Insurance is used as a solution for several different aspects of business succession planning. These include: Business Succession Planning (Buy-sell agreements) Business protection/debt reduction insurance Key person insurance Business expenses insurance Guarantor insurance Before considering discussions with clients regarding business succession planning it is essential to understand the purpose behind each type of cover and be able to articulate them clearly. This also helps in working out how to structure the cover and knowing where there will still be gaps. Business succession planning is indeed a wider discussion than just the insurance component. To have any success in this area it is necessary to appreciate those wider areas. Further, it is crucial to involve a solicitor who is specialised in this area to ensure that the intentions of the business owners cannot be subject to legal challenge. It is important to understand that whilst it may be possible to recommend all the various covers they may not be taken up for a number of reasons including cost and/or health of the people one proposes to protect. Purpose Buy-sell agreement To provide a person with sufficient funds to buy out another owner (or the owner s estate) in the event of death, total and permanent disablement or a traumatic event Business protection/debt reduction To pay off any debts associated with the business in the case that one of the owners dies, becomes totally and permanently disabled or suffers a traumatic event Key person (revenue) to provide cash flow to employ another person in place of a key person in the business Key person (capital) to provide a lump sum to replace the income/profit estimated to be lost in the event of a key person dying, suffering a traumatic event or becoming totally and permanently disabled Business expenses insurance to fund regular business expenses if a business principal is unable to work due to illness or injury. The orderly transfer of ownership typically requires two documents as detailed below: Business Owners Agreement: Such as partnership, shareholders or unit-holders Agreements dealing with issues including ownership details. It covers the rights of each business principal (principal) and outlines their obligations. Buy/sell agreement or bare/absolute entitlement trust. A buy/sell agreement is a legal agreement between two or more principals facilitating an equitable and orderly transfer of ownership. It covers exit trigger events such as death, total & permanent disability (TPD) or critical illness. This agreement, combined with funding put in place, ensures the successful transfer of a proprietor s interest. Areas that need to be addressed are: parties to the agreement events that would trigger the sale and purchase of business equity value of the business most appropriate funding solutions. There are three types of buy/sell agreements: mandatory agreements condition precedent agreements put call options. A bare / absolute entitlement trust occurs where a trustee owns life insurance policies on behalf of all the business owners. There may be some extra costs involved in establishing and administering a trust. The Australian Tax Office (ATO) must consider the trust beneficiary is absolutely entitled to the trust assets and the Trustee s only obligation is to transfer the trust property to the beneficiary in accordance with the beneficiary's direction. A bare trust is an example of an absolute entitlement trust. If this condition is not satisfied, capital gains tax may be payable on the proceeds. 34
IOOF TechConnect Technical Insurance Guide Key Person Insurance Key persons impact the profitability of a business. Revenue or capital that could be adversely affected if a business principal or a key employee became totally and permanently disabled, suffered a critical illness or died. Insurance proceeds are used to compensate for a reduction in revenue, the costs for funding a suitable replacement or to protect the capital value of the business. Identifying key persons If the loss of an employee would have an adverse financial impact on the business, then they are a candidate for key person insurance. Some examples are: founding business principal key sales people employees whose unique skill, reputation, prestige or connections attract valued customers, or finance/venture capital IT staff programmers and analysts project managers critical to meeting deadlines financial controllers key supplier including service people. Establishing the sum insured The sum insured is an estimate of the cost incurred in the absence of the key person. Subjectivity may be involved but arbitrary methods of calculation should not be used without considering whether the result is reasonable in the circumstances and acceptable to business principals and the underwriter. If the loss of a key person impacts on the balance sheet, the purpose of the insurance will be capital. Some examples are: covering guarantees repaying money borrowed from the key person protecting the goodwill and capital structure of the business insurance on the life of a key supplier for the purpose of providing funds to buy the supplier s business on the death of that person. Purpose of the key person policy Taxation Rulings IT 2434 and IT 155 provide guidance on who may be insured for revenue protection purposes. Premiums are generally deductible to the business, less commonly to sole traders. Key points are: Revenue purposes: Premiums tax deductible to the sole trader, partnership, company or trustee(s) of a trust and the proceeds are assessable income to the business Capital purposes: Premiums are not an allowable deduction, and the insurance proceeds are not assessable business income If insurance proceeds are seen to be for a revenue purpose, they may be assessable, even if no premium deductions were claimed and the documented purpose was a capital purpose Purpose may change from time to time or a decision could be made to use capital proceeds for a revenue purpose after they are received. This does not impact prior deductions If capital purpose insurance proceeds exceed the amount required, the excess is generally deemed revenue purpose and assessable income If deductions were claimed for revenue purpose premiums, but based on the available evidence the proceeds were intended for a capital purpose (at the time when the tax deduction was claimed), prior deductions may be denied and penalties may arise. A key person doesn t seem to exist where the loss of an owner/ manager of a one-person business, could result in the business being terminated. The ATO considers the proceeds would most likely be used for debt retirement, wind up costs or as a lump sum payment to the deceased s beneficiaries. There is an exception to this rule. If a family member decides to manage the business or if it is sold to a third party e.g. a competitor, there may be sufficient continuity to satisfy IT 2434. Record keeping Adequate records must be kept in the form of minutes of the meetings recording the purpose and the method used to determine the sum insured. A review of the purpose should be documented annually to minimise the possibility of an adverse ATO outcome, such as denying deductibility. 35
Guarantor insurance Many businesses have significant debt only manageable if existing revenue is maintained. Generally the guarantee given by the business principal is not extinguished until the debt has been repaid. Death, disablement or critical illness, will not release a principal or the estate from such obligations. It is recommended that the level of cover be equal to the total amount of debt to be repaid (not just a business principal s portion), ensuring the guarantor or their estate is not left with outstanding business debt. Ownership and tax treatment Generally there are two ownership options, either by the business entity or self-owned. Business-owned (and pays the premium) Premiums are not deductible Proceeds are paid to the business Proceeds are not assessable income Death cover not subject to CGT TPD and critical illness subject to CGT Self-owned (and pays the premium) Premiums are not deductible Proceeds are paid to the individual Proceeds are not assessable income Death cover not subject to CGT TPD and critical illness not subject to CGT Business expenses insurance Business expenses insurance is designed to pay regular expenses if a business principal is unable to work due to illness or injury. An indemnity policy, a claim which can only be paid if there is a genuine reduction in revenue due to the business principal s illness or injury. The following are the types of business expenses covered for a period, generally up to 12 months. Rent on business premises Regular interest installment payments on business mortgage or loan Electricity, gas, water, telephone bills Cleaning and laundry Business property levies, rates and taxes Non-income producing employee s salary and salary related costs Equipment or vehicle lease costs Net cost of a locum. A negotiated waiting period normally between 14 and 90 days applies. A shorter waiting period usually means a higher premium. Three things should be considered when calculating the amount of business expenses insurance: 1 How many business owners/partners are in the business? 2 How much revenue does each owner/partner generate for the business? 3 Does the business have any income producing employees? 36
This document is for financial adviser use only it is not to be distributed to clients. Issued by IOOF Investment Management Limited (IIML) ABN 53 006 695 021 AFSL 230524 as trustee of the IOOF Portfolio Service Superannuation Fund ABN 70 815 369 818 and Service Operator of the Investor Directed Portfolio Services. IIML is a company within the IOOF group of companies consisting of IOOF Holdings Limited ABN 49 100 103 722 and its related bodies corporate, and is not a registered Tax Agent. Examples contained in this communication are for illustrative purposes only and are based on the assumptions disclosed and the continuance of present laws and our interpretation of them. Whilst every effort has been made to ensure that this information is accurate, current and complete, neither IIML nor its related bodies corporate within the IOOF Group give any warranty of accuracy, reliability or completeness, nor accept any responsibility for any errors or omissions (including by reason of negligence) and shall not be liable for any loss or damage whether direct, indirect or consequential arising out of, or in connection with, any use of or reliance on, the information provided in this document. PLA-9578