Tax implications on Keyman Insurance payouts and Share Buy and Sell policies 

 Many clients are unaware of the tax implications regarding Keyman Insurance payouts and the accounting treatment of monthly premiums is vital. Indeed, the tax rules relating to the treatment of premiums paid out and the proceeds received are often overlooked. 

Although the memorandum of incorporation (MOI) or the shareholders’ agreement of the company may contain provisions on what should happen to the shares on a disability of a particular shareholder, they often do not take into account, the practical aspects involved. It’s important to note that, in terms of the Companies Act, 71 of 2008, no other agreement may supersede the shareholders’ agreement or MOI, so the company will need to ensure that if it is a buy and sell agreement they want to enter into, such agreement is properly aligned with the MOI and shareholders’ agreement. 

Deductibility of insurance premiums paid by the company 

Section 11(w) of the Income Tax, Act 58 of 1962, amended (“the Act”)(ITA), allows for a company to claim insurance premiums paid on the life of a director or in the case of a taxpayer, over the life of an employee, so long as the policy is what is referred to as a “conforming policy”. To claim the premiums paid on the policy in question the policy must contain a number of conditions and particularly: 

 A prohibition on the substitution of the life assured. 

 The premiums must be actually paid. 

 The policy must be owned by the company, or taxpayer, as the case may be. 

 The policy shall provide for a death benefit which shall not be less than an amount arrived at by multiplying the death benefit period of the policy by the lowest premium factor relevant to the particular policy year and any preceding policy year. 

 The policy issued must comply with the regulations issued by the Minister of Finance under paragraph (dd)(C) of the proviso to section 11(w) of the Act. 

Typically, a policy that conforms to the provisions of section 11(w) of the Act specifically provides that the policy complies with the regulations issued by the Minister. 

Furthermore, it is important to ensure that the specific policy contains all the conditions required in section 11(w) of the Act and the regulations issued by the Minister. It is only the premiums paid on a conforming policy that can be deducted for income tax urposes. 

Where, for example, a life insurance policy has been contracted such that the life assured may be substituted or premiums are payable at irregular intervals, or the minimum death benefit is not in conformity with the regulations issued by the Minister, the taxpayer cannot claim the premiums paid under section 11(w) of the Act. 

Those companies that are claiming insurance premiums on key personnel should ensure that the policies conform to the provisions of section 11(w) of the Act. The insurance company should issue a certificate to the policyholder confirming that the policy complies with the statutory provisions thereby confirming that the premiums are indeed deductible for tax purposes. If the policy does not conform to the rules set out in section 11(w) of the Act, the premiums will not be deductible for tax purposes. 

Nature of proceeds received 

If the policyholder receives a benefit under the policy because of the death, disability or illness of the insured, it is necessary to determine the nature of those proceeds for income tax and capital gains tax. 

In the event that the premiums were deductible under section 11(w) of the Act, any proceeds received from such a policy are specifically regarded as falling into “gross income” by virtue of paragraph (m) of the definition thereof contained in section 1 of the Act. 

In principle therefore, where the premiums paid on a conforming policy are deductible for tax purposes, any proceeds received under such a policy on maturity thereof or disposal thereof, will be regarded as “gross income” liable to normal tax. 

Where the premiums were not deductible, it is submitted that the proceeds received will constitute a receipt of a capital nature and thus not liable to income tax. 

It is necessary to consider whether such proceeds constitute proceeds as envisaged in the rules regulating capital gains tax contained in the Eighth Schedule of the Act. Where the company is the first owner of the policy and receives the proceeds on the maturity thereof, such proceeds will be excluded from capital gains tax in accordance with paragraph 55 of the Eighth Schedule of the Act. 

Where the policy proceeds are received by a company from a non-conforming policy, no tax will be payable on the proceeds received. If, however, the company wishes to distribute those proceeds to the company’s shareholders, dividend tax will become payable thereon. 

If a company owning insurance policies wishes to award those policies themselves to the company’s shareholders, that award is also subject to dividend tax. 

Capital Gains Tax (CGT): 

In terms of paragraph 55 of the 8th Schedule to the ITA, the proceeds of key-man policies are exempt from CGT in the following instances: 

 where the person is the original beneficial owner of the policy; 

 where the person, whose life is insured, is or was an employee or director and any premiums paid by the person’s employer were deducted in terms of section 11(w) of the ITA; 

 where the policy is a risk policy with no cash or surrender value; 

 where the policy’s proceeds are exempt from income tax under section 10(1) of the ITA. 

Tax implications for Buy and Sell of shares 

Refer to your policy and determine the tax status whereby it clearly stipulates if premiums are ‘non-tax deductible’, therefore I presume that the policy does not meet the requirements of section 11(w). In other words, the premiums were not deductible as an expense but rather offset against directors’ loan accounts. If so, then the proceeds of this policy is of a capital nature and is exempt for taxation in terms of section 10(1)(gG), however, in the case of an income protection policy and annuities paid in terms of the policy the proceeds would be taxable and included in gross income. 

If risk policies are used to fund the buy and sell agreement, the proceeds are exempted from CGT in terms of paragraphs 55(1)(a), (c) and (e) of the 8th Schedule to the ITA. 

Inconclusion 

Considering the above, depending whether section 11(w) was applied or not, it appears that the keyman policy payout is subject to taxation and the buy and sell policy is of a capital nature therefore exempt from taxation.