Tax implications of business protection

Emma Davies, market development manager of Legal & General, says the reason for the policy will play a big factor in deciding the tax bill.

It is wise to consider each case on its merits and to seek advice from their company’s inspector of taxes before completion of a policy, according to Dougy Grant, protection director of Aegon.

Generally Mr Grant says tax relief will be granted where the premiums meet the “wholly and exclusively for the purpose of the business” test. He says there is no direct legislation on the subject of the taxation of the premiums or proceeds of key person policies.

According to Mr Grant the principles governing tax relief on business protection premiums were set out in Parliament by the then chancellor, Sir John Anderson, in 1944 and are known as the Anderson rules.

A relevant life policy is defined in S393B(4) of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

This makes clear who is eligible to apply for cover and that cover can only be for life and terminal illness.

Mr Grant says the proceeds from a key person policy will be taxable if they are used for revenue purposes and won’t be taxable if they are used for a capital purpose.

Employers should always consult their local inspector of taxes to confirm how a policy will be treated for tax purposes, he adds, but tax relief is generally available providing:

1) The sole relationship is between employer/employee.

2) The cover is for loss of profits; and resulting from the loss of service of that employee, and

3) The insurance policy is annual or short term.

With key person cover, Ian Smart, head of product development and technical support for Bright Grey, says it is unlikely that the business will get tax relief on the premiums where the life assured is a significant owner of the business.

But Mr Smart says tax relief is possible if the life assured is an employee and the policy is for a short term (less than five years).

Plan proceeds paid to a limited company or limited liability partnership are likely to be taxed as a trading receipt, he adds

If the plan has been taken out by a partner on the life of a key employee and written in trust, Mr Smart says the plan proceeds will, generally be paid free of tax.

Who pays?

With business succession protection, Mr Grant says the business owners will generally pay the premiums from their post-tax income.

If the business pays the premiums, then Mr Grant says the premiums will usually be treated as drawings in the case of a partnership and they will form part of a shareholder director’s remuneration package where the business is a limited company.

He says there will not normally be an income tax or capital gains tax liability in the event of a claim.

A policy paying cash to a company will raise the value of the shares in that company, so on the death of a key person who is also a shareholder, Mr Grant points out the value of his or her estate would be increased and this needs to be considered in relation to the potential inheritance tax liability.

He says this might be a reason for holding the policy in trust and allowing the shareholders to introduce the funds into the company via their directors’ loan accounts.

Significant cash deposits within a company will affect the amount of business property relief (BPR) that the shares attract, Mr Grant notes.

If the shares aren’t bought and simply pass under the terms of a will to someone other than the wife, husband or registered civil partner of the person of the deceased, and business property relief is not fully available, Mr Grant says any inheritance tax liability may increase as a result.

Business property relief is protected due to the fact that a cross option agreement is used rather than a buy/sell agreement, Mr Grant says.

If a policy is held under a business trust and if the arrangement is wholly commercial, then Mr Grant says the policy should be outside the life assured’s estate in the event of their death.

Capital gains tax could arise following the sale of a partner’s or shareholding director’s share following the payment of a critical illness claim, he adds.

With ownership protection, Mr Smart says premiums paid by a limited company for plans written under a trust will usually be regarded as a trading expense, however, they will be taxed as income on the shareholder.

Premiums paid by a limited company under a company share buy back arrangement will not get relief but the shareholder will not be taxed, he adds. Premiums paid for partnership cover will not receive tax relief, he adds.

If a partner or shareholder pays the premiums, Mr Smart says this would be paid out of their pay after tax and would not attract tax relief. Generally, the proceeds of the plan would be paid free of tax, he adds.

With loan protection, Mr Smart says premiums would not attract tax relief and plan proceeds will generally be received free of tax as a capital receipt.

Mr Smart says advisers should also note a charge to income tax under the Pre-Owned Asset Tax legislation may arise where an own life plan is written under trust.

He says this is because the settlor of the trust is usually also included as a discretionary beneficiary of the trust. Accordingly, Mr Smart says where the plan pays out on critical illness or terminal illness and the funds continue to be held in trust, a charge to income tax could arise under POAT.

Where a plan is written under trust in a business protection arrangement, Mr Smart says advisers should be aware the trust will usually be a discretionary one and will fall within the relevant property regime.

Although unusual in a business protection arrangement, Mr Smart says in the event that the proceeds of the plan are left in the trust following the tenth anniversary of the creation of the trust, then any proceeds which exceed the nil rate band applying at the tenth anniversary, will be subject to inheritance tax at a maximum of 6 per cent.

In addition, Mr Smart says any capital distributed from the trust between tenth anniversaries will also be subject to an ‘exit’ charge which is calculated with reference to the periodic charge.