Are the premiums on your ‘key-man policy’ still deductible?

2011-02-03 00:00

EMPLOYERS often use insurance policies to protect themselves against the loss of profits arising from the loss of key employees. These plans, commonly referred to as key-man policies, typically involve a life or disability insurance contract for a key employee or director. The insured events usually include disability, severe illness, dread disease or death.

The employer may deduct the premiums paid on a key-man policy in terms of section 11(w) of the Income Tax Act, No 58 of 1962 (the Act) where:

•The policy belongs to the employer.

•The beneficiary is the employer.

The employer is then taxed on the proceeds of the key-man policy in terms of paragraph (m) of the definition of gross income in section 1 of the Act.

Although many key-man policies have legitimate uses, according to National Treasury, there are some that have been arranged to create a tax mismatch as the expected insurance proceeds are actually intended for the benefit of the key employee or director, and not the employer. These policies operate in the following manner:

•The employer obtains a deduction for the premiums paid.

•The insurance proceeds are included in the employer’s gross income upon the happening of the insured event.

•The employer pays the insurance proceeds to the key employee or director as part of his remuneration, thus obtaining a tax deduction.

•The amounts received in the hands of the employee are treated as a retrenchment or retirement benefit which is eligible for certain tax benefits, for example, the R30 000 tax exemption and the subjecting of the lump sum to the rating formula (effectively taxing the proceeds at average tax rates as opposed to marginal tax rates).

The net result is an upfront deduction for the employer and a delayed (and possibly reduced) inclusion for the employee.

In view of this, the entry requirements for deductible key-man policies have been revised in the Taxation Laws Amendment Bill, 2010, and apply to all premiums incurred during any year of assessment commencing on or after January 1, 2011. The revised entry requirements are as follows:

•The insured event for an employer is restricted to a key employee (or director) employment termination stemming solely from the employee’s (or director’s) death, disability or severe illness.

•Deductible premiums are limited to term policies that solely cover the insured against insured risks. Premiums on policies with investment elements, for example whole life, will not be deductible.

•The employer must be the sole owner and beneficiary of the policy throughout the year of assessment in which the premium is paid.

•No amount is deductible if the key-person insurance plan is part of a transaction, operation or scheme to make the benefits payable to an employee or director or their relatives.

Benefits payable implicitly include benefits payable by virtue of a cession of the policy or by virtue of an intended change of beneficiaries.

Therefore where the employer pays premiums on a key-man policy, a review of the policy is advisable to ensure that the entry requirements are met. Where the requirements are not met, the premiums will not qualify for a deduction under section 11(w) of the Act. In addition, the employee will be taxed at marginal rates on the lump sum received.

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