Keyperson cover for companies

NON-SHAREHOLDING EMPLOYEES

(i) Arranging the cover 

Where the keyperson is an employee the usual way to provide for keyperson cover would be for the company to effect the policy on a life of another basis. It is important to remember that the purpose of keyperson cover in such a case is to benefit the company not the employee. The employee is merely the life assured and has neither legal nor beneficial title to the policy benefits. 

(ii) Deductibility of premiums 

The deductibility of premiums for corporation tax purposes depends on the circumstances of each case. There is no specific legislation governing the tax treatment of premiums paid under keyperson policies, and the basic rules for determining eligibility for a tax deduction were explained by the then Chancellor of the Exchequer in 1944 in reply to a question raised in the House of Commons, as follows:- 

‘Treatment for taxation purposes would depend on the facts of the particular case and it rests with the assessing authorities and the Commissioners on appeal if necessary, to determine the liability by reference to these facts.  I am, however, advised that the general practice in dealing with insurances by employers on the lives of employees is to treat the premiums as admissible deductions, and any sums received under a policy as trading receipts, if 

1. the sole relationship is that of employer and employee, 

2. the insurance is intended to meet loss of profits resulting from the loss of services of the employee, and 

3. it is an annual or short-term insurance. 

Cases of premiums paid by companies to insure the lives of directors are dealt with on similar lines. I am advised that it may be taken as a general rule that if the premiums are not admissible deductions the policy moneys do not constitute taxable receipts. For technical reasons, however, it is not possible to give an assurance which could cover every type of case’. 

Current HMRC practice would seem to permit a deduction for premiums paid under policies effected by employers on the lives of employees for the employer's benefit, ie. non-trust policies, where the following conditions are satisfied:-  

1. The sole relationship is that of employer and employee. This would not be the case, for example, where a holding company insures the life of an employee of a subsidiary company.  

2. The policy is meant to meet the loss of profits arising from the loss of services of the employee (as opposed to a capital loss such as goodwill or the need to repay a loan). 

3. The policy is a short-term assurance. Long-term assurances may be allowed if they expire before the employee’s expected retirement date. This therefore excludes whole of life policies and endowments which would also fail the test under 2 because of the fact they are capable of acquiring a surrender value and so could be considered as part of the cost of raising capital. Therefore, the premiums cannot be said to have been expenses incurred "wholly and exclusively" for the purposes of the trade (section 54(1)(a) Corporation Tax Act 2009). Convertible term assurances would seem to fail the test under 2 above because they are capable of conversion to a permanent contract. Single premiums may be permitted for term assurance policies with terms of 5 years or less. 

4. The sum assured is reasonable. For example, the loss of profits should be related to the period within which the employee could be replaced or, alternatively, linked to a multiple of their earnings. 

HMRC will broadly apply the same principles with regard to the deductibility of premiums to critical/serious illness policies as they apply to life assurance policies. 

Where there is a single policy on the life of one employee it should be fairly easy to determine whether or not the premiums are likely to be deductible. 

For a group policy the same criteria apply as for a single life policy.  However, if one or more employees with major shareholdings are included within the group, (the premiums otherwise being allowable as a deduction), whilst there is no stated practice, a portion of the premiums is likely to be non-deductible. 

(iii) Taxation of the policy proceeds 

If the premiums have been allowed as a deduction, the proceeds referable to the deductible premiums will generally be taxed as a trading receipt. However, in this respect it is necessary to consider HMRC’s Business Income Manual at section 45525 where it states: 

“However, whether particular receipts are part of trading income is a separate matter of law to the deductibility of expenditure. No assurance can be given that any future receipt will be excluded from trading I income even though the premiums are not allowable (Simpson v John Reynolds & Co [1975] 49TC693 and McGowan v Brown & Cousins [1977] 52TC8).” 

Where premiums have not been allowed as a deduction [ie. they are treated as being for a capital purpose - and the nature of the “purpose” will be tested at the time the policy is effected, not at the time that the proceeds are actually used] the policy proceeds referable to the disallowed premiums will usually be treated as a receipt on capital account with the capital gain potentially subject to corporation tax. However, no tax charge should arise. This is because capital gains tax is only payable in respect of gains made under a life assurance policy where there has at some time been a disposal of the rights or any interest in the rights under the policy for actual consideration. 

For those seeking some certainty regarding the tax treatment of premiums paid (and assessability of the sum assured), confirmation of the deductibility or non-deductibility of the premiums can be sought from HMRC. If relief is denied on the premiums as having been paid for a capital purpose it is unlikely that the policy proceeds would then be taxed. However, in such circumstances, it would be prudent to go back to HMRC and seek confirmation in writing of the taxation of policy proceeds. 

It is important to remember that if, in any case, a premium satisfies the test for deductibility but tax relief is not claimed, this will not prevent the sum assured from being taxable. 

As well as considering the tax treatment of the policy proceeds it is necessary to determine whether any tax liability arises on any gains arising under the policy.  For corporately-owned policies the loan relationship rules are relevant but will only apply “to a policy of life insurance which has, or is capable of acquiring a surrender value”. It is unlikely that a keyperson policy will acquire a surrender value generally being term policies or serious illness/critical illness policies. Where a whole of life policy or endowment is owned by a company then a surrender value is likely to be acquired in which case the loan relationship rules will apply. In this connection it should be remembered that in calculating any profit under the policy any profit derived from mortality or morbidity is ignored. Further consideration of the loan relationship rules is beyond the scope of this article.

 

SHAREHOLDING DIRECTORS/EMPLOYEES 

(i) Arranging the cover 

For shareholder cases there are two possible ways of effecting the policy. 

• The shareholding director/employee can effect a policy on their own life subject to a business trust for the benefit of their co-shareholders for the time being in the company. This is sometimes referred to as the “personal route” of providing keyperson cover. This route is particularly appropriate where share purchase arrangements between shareholders are also to be put in place with life policies effected in a similar fashion. Here the cost of the keyperson cover would be on top of the cost of the share purchase cover. However, given that under a typical business trust the class of beneficiaries is restricted to those participating in the share purchase, this route will generally only be possible if all the shareholders take out equivalent policies. This means it is not possible if only one shareholder, for example, is a key person and the cover only required on his life. 

• The second method (the “corporate route”) of providing keyperson cover is for the company to effect the policy on the life of the director/employee. 

The tax implications will differ depending on which route is chosen.  

(ii) Deductibility of premium payments 

(a) The personal route 

As the director will be effecting a policy on their own life under trust, premiums will be paid out of their after-tax income. If premiums are met by the company then they will be treated as employment income of the director and subject to income tax and National Insurance contributions. 

(b) The corporate route 

Establishing whether the premiums paid by the company are likely to be deductible is more difficult than for a non-shareholding employee. 

As mentioned earlier, because there is no specific legislation that deals with the tax treatment of premiums or the taxation of the sum assured, reliance must be had on the original statement by Sir John Anderson in the House of Commons in 1944 and later general tax law provisions to determine deductibility and assessability.  From time to time HMRC has given further clarification on this. 

Business Income Manual (BIM) section 45525 states as follows:

“An employer may take out in his own favour a policy insuring against loss of profits resulting from the death, critical illness, sickness, accident or injury of an employee, director or other ‘key person’. The premiums on such a policy will be allowable if all the following conditions are met:

• The sole purpose of taking out the insurance is the trade purpose of meeting a loss of trading income that may result from loss of the services of the key person, and not a capital loss. 

• In the case of life insurance policies, they are term insurance, providing cover only against the risk that one or more of the lives insured dies within the term of the policy, with no other benefits. The insurance term should not extend beyond the period of the employee's usefulness to the company. 

The premiums on whole life or endowment policies, or critical illness or accident policies with an investment content - such that premiums contribute to a capital investment - are capital expenditure and will not be deductible, see Earl Howe v CIR [1919] 7TC289. 

From the above it can be concluded that if there is a duality of purpose on the premium payments, then there will be no tax relief.

To be deductible the premium payment must be paid wholly and exclusively for the purposes of the trade. As far as HMRC is concerned when considering whether expenditure satisfies the wholly and exclusively test, if there is some trade purpose, but this is not the sole purpose, this will amount to duality of purpose. Duality of purpose results in non-deductibility.

HMRC gives the following commentary on this in BIM section 45530:-

“Whether the sole purpose condition in BIM 45525 is met is a question of fact, to be determined by evidence of what the directors of the company concerned, or the proprietors of an unincorporated business, were seeking to achieve by taking out the insurance policy and paying the premiums”. 

This HMRC statement needs to be tempered by the decision in Greycon Ltd v Klaentschi in 2003 in which case the Special Commissioner made clear (among other things) that the time to test purpose was at the time the policy is effected.  In other words, there is no continuing test of purpose.

General guidance on the ‘wholly and exclusively’ test is given in BIM section 45530 as follows:

“Circumstances in which there may be non-trade purposes for taking out a ‘key person’ policy are:

• where the policy is in respect of directors who are major shareholders but not other employees, 

• if benefits under the policy exceed sick pay arrangements - or other employee benefits - typically offered to employees of equivalent status in similar concerns.

For example, where the key person is a director whose death would significantly affect the value of shares in the company, one of the purposes for taking out the policy may be a non-trade purpose of protecting the value of the director’s shares and therefore the value of their estate”.

This would then amount to, at best, duality of purpose and thus deny relief. It is important to remember that for deductibility the sole purpose must be a trading one.  So, for deductibility it is an “all or nothing” test. Where the life assured has a major shareholding the value of the shares (assuming they have a reasonable value) could be materially affected by that person’s death. So the keyperson insurance policy could be said to have a part capital purpose. 

As far as we are aware, HMRC has not commented on the meaning of “major” in this context. It seems likely that a shareholding of 5% or less would be treated as not being major for this purpose but the position in any particular case should therefore be confirmed by HMRC.  

Ultimately, it will be HMRC that will decide whether or not to allow the premiums as a deduction.  Where an employee is a shareholder it is imperative to obtain an advance indication as to how the premiums will be treated for tax purposes - in such a case it would be unwise to rely on premiums being deductible. Where the lives assured are substantial shareholding directors, it may be helpful to seek confirmation that the premiums are not deductible on the basis that they have been expended for a capital purpose.  The rationale for this approach would be that it would then be hard (having given the confirmation) for HMRC to seek to assess the receipt as revenue.  

(iii) Taxation of the policy proceeds 

(a) The personal route 

As the premiums will not be deductible there will be no tax on the policy proceeds. For a policy which provides life cover which is a non-qualifying policy the payment of benefits will give rise to a chargeable event. As the policies are individual policies held in trust, any chargeable event gain would be potentially liable to income tax with any tax falling on the settlor or the trustees as appropriate. In most cases, though, because a policy will not acquire a surrender value, no chargeable event gain will arise. 

(b) The corporate route

The position will be as set down in “(iii) Taxation of the policy proceeds” for non-shareholding employees above, depending on whether the premiums were deductible or not.

 

The next article in the series will be based on a comparison of the personal and corporate routes.