For those that do not otherwise have
access to the Weekly
Tax Bulletin, the article from earlier this month by fellow View Legal Director
Patrick Ellwood and me is extracted below.
Largely due
to the level of intergenerational wealth transfer, there has in recent years
been an increasing emphasis on all forms of succession planning and, in
particular, business succession planning.
In broad
terms, a buy-sell agreement is a contractual arrangement between the ultimate
owners (or ‘principals’) of a business. The agreement is structured so that if
certain events occur, such as the death or incapacity of a principal, the
continuing principals are given the option to purchase the interest of the
departing principal.
Most
commonly, insurance is obtained to help fund buy-sell arrangements.
Since the
withdrawal of the ATO's draft Buy Sell Discussion Paper in 2010 there has been
some uncertainty about many aspects of insurance funded buy-sell arrangements,
particularly those that utilise insurance trusts.
Recent
changes introduced as part of the Tax and Superannuation Laws Amendment
(2014 Measures No 7) Bill 2014 (now awaiting Royal Assent after having been
passed by Parliament without amendment) appear to have clarified the position (the
2015 Changes).
Trust
ownership
The trust
ownership approach generally involves the establishment of a special purpose
entity, often with an independent trustee appointed, to acquire the insurance
policies and then distribute proceeds, on the exit of a principal, in
accordance with the terms of the trust instrument.
If the
trading entity is itself a trust or owned via a trust (for example, a
discretionary trust owning shares in a trading company), then it may not be
necessary to establish a separate structure.
The core
benefit of an insurance trust is its ability to centralise the ownership of all
insurance policies and facilitate the efficient transition of an ownership
interest following a triggering event.
Historically,
from a tax perspective, the level of uncertainty regarding the tax treatment of
the insurance proceeds (compared with that of other ownership models such as
self-owned insurance) often undermined the commercial attractiveness of the
trust ownership approach.
Certainly
an insurance policy taken out by a trustee (who was also the beneficiary of the
policy) over one or more principals, was likely to see the proceeds paid
directly to the trustee and be exempt from CGT pursuant to s 118-300 of the
ITAA 1997.
However,
due to a lack of guidance from the ATO, many advisers believed there was a risk
CGT was triggered where a new principal joined the business and there was any
change to the trustee or insurance policy or on the subsequent distribution of
the insurance proceeds to the beneficiary.
The
concerns were largely driven by the ongoing uncertainty around the concept of
’absolute entitlement’, discussed later in this article.
2010 ATO
ruling
The ATO
released Product Ruling PR 2010/18 in relation to the CGT consequences for the
beneficiary of what is generally seen as a ’standard’ insurance trust deed.
In many
respects, the ruling reflects what most specialists in this area have advised
for many years, namely, that a properly crafted insurance trust deed should
provide appropriate protection for the principals of a business without any
significant tax detriment, notwithstanding there might be other commercial
issues to consider regarding the structure.
Unfortunately,
the positive aspects of the ruling were largely undermined by the fact that the
outcomes are based on the stated assumption that the insurance trust deed will
in fact create ’absolute entitlement’ for each beneficiary in the relevant
insurance policy.
As has been
widely documented, the expressed views of the ATO concerning absolute
entitlement are somewhat contentious and the ATO continues to refer to a draft
ruling that has never been finalised – despite being issued in 2004 (ie Draft
TR 2004/D25).
In this
regard, a significant concern was that the Product Ruling confirmed that, in
order to ensure absolute entitlement, the relevant beneficiary must be able to
call for the asset at any time. This largely undermined one of the main
commercial reasons why advisers historically recommended insurance trusts,
being that the trustee will be able to control the payment of any insurance
proceeds received.
A further
practical issue, given the way in which many providers traditionally structured
trust arrangements, was that the Product Ruling only related to insurance trust
deeds where the company acting as trustee was an entity owned and controlled by
the principals involved in the business entity and the relevant insurer was not
a party to the arrangements.
ATO
minutes
Minutes
released from a National Tax Liaison Group meeting in December 2010 (item 9)
provided further insight into the apparent ATO views in relation to insurance
trust deeds.
In summary
the minutes stated:
- the status of the taxation ruling on absolute entitlement (Draft TR 2004/D25) is unclear;
- the ATO considers the finalisation of Draft TR 2004/D25 as intricately linked to how it will deal with bare trusts, which again remains an unresolved issue;
- the ATO believes that the Product Ruling released in relation to one provider's insurance trust arrangement is based entirely on the assumption that absolute entitlement was created. This assumption might be an unwise one to make, given the ATO's apparent attitude in this area; and
- while the ATO flags that it will further consider providing appropriate guidance, it specifically confirmed that the ATO Buy Sell Discussion Paper is not current.
Ultimately,
given the complexities in this area and the uncertainty created by the ATO Buy
Sell Discussion Paper, Draft TR 2004/D25, the Product Ruling and the above
minutes, many advisers defaulted to recommending the obtaining of a private
ruling on any proposed trust arrangement documenting an insurance funded
buy-sell agreement from the ATO before implementing the approach.
Needing to
seek a private ruling on what was otherwise a relatively benign arrangement was
for many business owners sufficient reason to either use a different ownership
approach or, more commonly, simply decide against implementing a business
succession plan.
The 2015
changes
Amongst
other amendments, the 2015 changes have adjusted the way insurance payments are
taxed in certain circumstances.
In
particular, the 2015 changes amend the ITAA 1997 to:
- remove the requirement that, in order to access the exemption under s 118-300, the insurance proceeds are received by the original ’beneficial’ owner of the life insurance policy. The amendment removes the reference to ’beneficial’ to clarify that a trustee is eligible for the exemption, where they hold the beneficial interest in the policy for a beneficiary;
- extend the exemption for compensation for injury/illness (ie total and permanent disablement and trauma insurance proceeds) in s 118-37 to apply where the proceeds are received by the trustee of a trust or superannuation fund (subject to certain policy ownership prohibitions for superannuation funds), if the injured/ill person is a beneficiary of the trust; and
- insert a CGT exemption where a trustee makes a payment to a beneficiary (or their legal personal representative) in respect of life, TPD or trauma insurance proceeds. This change also ensures that where the relevant trust is a unit trust, CGT event E4 does not apply.
The 2015
changes make it likely that trust and superannuation fund ownership of life,
total and permanent disablement or trauma insurance policies will be more
attractive, given the new clarity regarding the tax treatment of the insurance
proceeds.
Importantly,
the changes also operate to reflect the intended administrative position of the
ATO in this area, and therefore apply from 1 July 2005 and taxpayers adversely
impacted who would otherwise be out of time are granted an extension to amend
their returns.