I’ve been told this particular ‘rule’ many times, and even read about it in some insurers’ guides. It’s often referred to as a rule of thumb. Apparently, the distance between the end of your thumb and the first joint is roughly an inch (you’re looking, aren’t you) and, for most of us, that’s not far out. But if you hired a builder who took measurements using his thumbs, you’d probably start searching for a replacement! So you should apply similar caution when giving advice to your business protection clients.
As you may have read in my previous blog, the tax treatment of premiums and any policy payout is for the company’s tax office to decide, at their discretion.
So let’s look at the available guidance on tax relief on premiums, much of which dates back to the Anderson guidelines, first quoted in 1944.
It is generally accepted that if the life assured is not a shareholder, but an employee, then the costs could be classed as wholly and exclusively for business purposes, thus qualifying as a trading expense. However, this will depend upon the purpose of the policy and the term and type of policy being used.
So here are some simple rules (no thumbs involved) that will help work out what is and isn’t possible:
- If the life assured owns more than 5% of the company’s shares, then the premiums do not qualify as a tax deductible expense in any event, regardless of the term of the policy or the risk it is designed to cover. (The gist is that if someone has a significant stake in the business, insuring its survival is as much to do with preserving their personal wealth as anything else.)
- If the policy is intended to be used to replace lost profits, the premiums may qualify as a trading expense, but only if the life assured is not affected by Rule 1 above.
- If the policy is being set up to cover a capital risk, such as a loan, the premiums don’t qualify as a tax deductible expense, regardless of whether the life assured is affected by the first rule above. There's a fourth rule too, though this one isn't quite as straightforward as the first three.
- The Anderson guidelines mention that, as well as the first three rules, the policy should be of a “short term” nature. However, they don’t define “short term”. Fortunately, HMRC has provided some recent guidance. Its Business Income Manual (BIM45525) states that in order to qualify as a trading expense “the insurance term should not extend beyond the period of the employee’s usefulness to the company”.
So if a key person is hired on a four year contract, writing a ten year term policy would clearly not reflect the likely length of their involvement with the role, and the premiums would be unlikely to attract any tax relief. Equally, if it is expected that a key employee, or a non-shareholding director, is likely to be in a key role for the next 20 years (think family businesses), there is no reason why the policy term shouldn’t reflect this. A renewable policy is usually seen as acceptable, whereas a convertible term or whole of life policy probably wouldn’t.
It’s worth noting that the same HMRC guidance states the policy should “cover only against the risk that one or more of the lives insured dies within the term of the policy, with no other benefits.” This raises a question mark over whether the inclusion of a critical illness (CI) element in the policy would remove any available tax relief.
The good news is that, during correspondence with the Chartered Institute of Taxation, HMRC confirmed it would apply broadly the same principles regarding the tax deductibility of premiums for CI policies as it does to life assurance policies. In terms of the treatment of the proceeds, there will always be a degree of uncertainty with a CI policy, as not all critical illnesses have the same effect on a company’s profits (think severe stroke versus mild heart attack). Ultimately, this will most likely be addressed at the point of a successful CI claim, and will be determined by HMRC on how the proceeds are actually used.
Remember that these rules apply only to business protection arrangements and not to relevant life policies.
Now that we’ve dealt with how the premiums might be treated for tax purposes, let’s look at how the policy proceeds might be viewed (subject to the discretion of HMRC) at the time a claim arises.
The proceeds of a policy which is designed to replace lost revenue/profits would normally be treated as a trading receipt, just like the revenue it seeks to replace. How much tax is due will depend upon the size of the company’s taxable profits in that trading period.
If, after adding in the policy proceeds, the business still shows a trading loss in the period, there won’t be any tax due as a result of the payment. However, if the payout is received at the end of the accounting period, the business won’t have had time to spend the proceeds. The receipt will then contribute to a higher trading profit, thus increasing the tax due for the period in question.
Where a policy is designed to be used to cover a loan or other capital risk – and assuming the proceeds are used to repay the loan – they should be treated as a capital receipt and shouldn’t affect the profit and loss account. Thus they won’t incur an immediate tax liability. Capital receipts are generally accounted for on the balance sheet rather than the profit and loss account so don’t normally generate an immediate tax liability. Any tax generally arises on the ultimate disposal of shares or business assets.
So what about that rule of thumb? (If you don’t claim tax relief on the premiums, you won’t be taxed on the sum assured). As we’ve seen, the treatment relies on the ultimate use of the policy proceeds. So, if it appears the policy premiums should be eligible for tax relief, it is important that the client’s tax advisers claim any relief that is due at the time it is available. They may not be able to claim it back later, or in the event that a claim arises. Waiving tax relief that is available today, in the hope of not being taxed tomorrow, is about as much use as employing your thumb to measure a set of curtains.
There’s a strong possibility that somebody is going to be disappointed with the result.
Paul McDowell is a business account manager at Zurich
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This content was last reviewed in December 2019