There have been a number of changes to the way in which insurance can be held within a self-managed superannuation fund (SMSF). Broadly, these changes limit the types of policy that can be held by SMSF trustees, but there is also a broadening of the rules relating to terminal medical conditions.
Buy-sell agreements, insurance and SMSFs
The Commissioner of Taxation (Commissioner) has cast doubt on the use of SMSFs to provide insurance underpinning buy-sell agreements.
On 5 March 2015, the Commissioner published ATO Interpretative Decision 2015/10 (ATO ID). The Commissioner concluded that an SMSF trustee would contravene the sole purpose test and financial assistance provisions in the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act) by purchasing a life insurance policy over the life of a member of the SMSF where the purchase is a condition and consequence of a buy-sell agreement the member has entered into with his brother as a co-owner of their business.
More recently on 29 July 2015, the ATO published a case study on its website clarifying its view on whether an SMSF contravenes the SIS Act by purchasing a life insurance policy that covers the life of a member where the purchase is dependent on a buy-sell agreement (Case Study).
In both the ATO ID and the Case Study, the Commissioner analyses a specific set of circumstances and determines that the arrangement would contravene the sole purpose test and financial assistance provisions of the SIS Act. However, there are issues that must be considered before applying the Commissioner's views to rule out any form of involvement of an SMSF in the provision of insurance linked to a buy-sell agreement.
ATO materials are not "black letter law" or binding on any particular taxpayer. They are materials which can be relied on by taxpayers who have substantially similar circumstances to the facts described in the decision. The facts in the ATO ID are very specific and involve a buy-sell agreement, insurance policy, arrangements for contributions and payments of benefit that are interlinked as part of an overall arrangement. However, such steps are not commonly linked in the same way they are described in the ATO ID.
In both the ATO ID and the Case Study, contributions are made to the SMSF by the subject company under the terms of a buy-sell agreement that requires those contributions to be used to pay premiums on the relevant insurance policies. However, in many cases the buy-sell agreement would not mandate how the SMSF trustee deals with contributions received or stipulate the amount of contributions that must be made. For example, the premiums might be paid from the member's own contributions, or simply from the member's account. Each structure and set of facts would need to be considered on their own merits.
Issues with the view
The Commissioner's views in the ATO ID are broadly based on two main factors: (a) the calculation of any benefit under the insurance policy is based on the valuation of the share of the company and not on the future needs of the member's spouse; and (b) the substance of the benefit received under the insurance policy is compensation for the deceased's share of the business.
Presumably, if the benefit under the insurance policy was based on the future needs of the member's spouse and was not taken to be compensation for the deceased's share of the business, the sole purpose and financial assistance provisions would be met and the Commissioner would not view this arrangement as contravening the SIS Act. For example, a fund member might be concerned that, on their death, their spouse might be required to accept payment for the deceased member's share of a business in instalments over a lengthy period and left without sufficient resources to meet their needs. The fund member and their business partner might reach an agreement under which the fund member would receive remuneration or be entitled to drawings from the business sufficient to enable the member to make contributions that in turn would be used to pay insurance premiums. The level of cover purchased would be determined so as to provide a lump sum or pension adequate for the spouse's expected needs. As a separate matter not involving the SMSF, an agreement might be reached between the member and their business partner as to how payment, if any, would be made for the member's share of the business on their death.
It is evident that the Commissioner is concerned with buy-sell agreements that mandate the operation of the SMSF and cases such as that described in the ATO ID and the Case Study may indeed give rise to the contraventions he identifies. However, there may still be a place for appropriately drafted buy-sell agreements that contemplate the use of insurance within an SMSF, where care is taken to ensure that the terms do not trigger the Commissioner's concerns.
The ATO ID and Case Study represent a change of approach by the Commissioner and there are many buy-sell arrangements already in place that would include at least some of the relevant elements. The Commissioner clearly does not contemplate providing any form of grandfathering and states that arrangements that have already been entered into should be reviewed and, if appropriate, terminated. In our view, some of these arrangements, perhaps with amendments, could still be compliant and continue to be a useful business succession tool.
TPD (own occupation)
From 1 July 2014, reg 4.07D(2) of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SIS Reg) was amended to prevent SMSF trustees from providing an insured benefit, unless it is consistent with a condition of release.
Therefore, unless an insurance policy is consistent with death, terminal medical condition, terminal illness or permanent incapacity, that cover cannot be provided. Total and permanent disability (TPD) is not itself a condition of release, but has historically been associated with the "permanent incapacity" (PI) condition of release. PI is defined in SIS Reg 1.03C to mean ill health (physical or mental) which makes it unlikely that the member will engage in gainful employment for which they are reasonably qualified by education, training or experience.
Generally, TPD insurance policies are split into two categories -- TPD "own occupation" and TPD "any occupation". The difference between the two types of TPD insurance policies is the circumstances in which the insured is entitled to benefits. "Any occupation" is aligned with the definition in SIS Reg 1.03C, which requires the insured to be unable to be engaged in any occupation for which they are reasonably qualified by education, training or experience in order to receive a benefit. "Own occupation" only requires that the insured is no longer able to return to their previous occupation (generally resulting in higher premiums).
For many SMSF members, it is "own occupation" cover that is desirable. However, with the changes to SIS Reg 4.07D(2), TPD "own occupation policies" provide cover that is broader than the PI condition of release. While transitional rules allow "own occupation" policies that were entered into before 1 July 2014 to continue to be held, new TPD "own occupation" cover cannot be provided by SMSF trustees from 1 July 2014.
The amendment to SIS Reg 4.07D(2) also has application to trauma insurance policies. These policies pay a benefit where a person suffers a specific illness, such as cancer, heart attack, etc (regardless of whether the event leads to PI). However, much like TPD "own occupation" policies, trauma cannot be linked to a condition of release and therefore such cover cannot be provided by SMSF trustees after 1 July 2014.
That being said, the disconnect between a condition of release and a trauma event has always existed and advisors and brokers have been increasingly alert to this issue over recent years. Therefore it is unlikely that many SMSFs would hold these policies within an SMSF (even before the changes to SIS Reg 4.07D(2)).
Cross insurance in an SMSF
Another insurance arrangement that has been affected by SIS Reg 4.07D(2) has been the cross-insurance strategy. Quite often this strategy was used where an SMSF borrowed funds to acquire business premises which were then leased to a related business. Under this arrangement, members hold policies of insurance over each other's lives. Upon the death of one of the members, the other member receives the proceeds from the insurance policy within the SMSF and cash is available to pay out a death benefit without having to sell the business premises.
On 17 November 2014, the ATO published its view on a question and answer page as to whether this strategy was allowable after SIS Reg 4.07D(2) came into effect. The ATO stated that the regulations "do not permit cross-insurance policies on any new insurance products" from 1 July 2014.
Terminal medical condition
The Tax and Superannuation Laws Amendment (Terminal Medical Conditions) Regulation 2015 (Cth) took effect from 1 July 2015. The regulations amend the definition of the condition of release of terminal medical condition (TMC) across superannuation and income tax legislation.
Previously, for a member to access their superannuation benefit under TMC, two medical practitioners had to certify that the member had suffered a medical condition that was likely to result in their death within 12 months of certification. The Regulations have amended this definition to extend the life expectancy period to 24 months instead of 12 months.
Some insurance companies pay claims, in advance, under death insurance policies where a person is suffering TMC. However, it should be noted that the recent changes to the superannuation and income tax legislation do not mean that all life insurance providers will make the same concession (ie, extend the life expectancy period). Advisers should consider reviewing existing insurance policies to ensure that they are brought into line with this change.
Note: Originally published Retirement & Estate Planning Bulletin, September 2015, Volume 18, No 8