David Shirlow explains how the rules around total and permanent disablement (TPD) will change from July 1.

From July 1 this year, many super funds, large and small, face a change in the extent to which they can claim a tax deduction for premiums paid for total and permanent disablement (“TPD”) policies. This is when transitional deduction rules negotiated with the industry come to an end.

This change will typically flow through to member accounts and raise issues for clients about the appeal of having some types of TPD cover within super. For some quite common types of TPD cover, a significant part of the premiums will not be deductible, and in many cases there will be a need to get actuarial verification of the deductible part of the premium. Some large funds also face administrative accounting hurdles in dealing with the partial deductibility of premiums.

This change is not unexpected: the industry has had at least four years’ notice of the law which will operate from July 1. However, a recent draft ATO ruling on how the law will be administered has really brought home some of the more difficult actuarial and administrative aspects of the change, and focussed minds on what needs to be done by super funds and their members in respect of certain types of TPD policies.

On the positive side, the deduction rules line up with the super law benefit payment rules, which seems entirely logical. The change can be viewed as an opportunity for insurers and super funds to align their TPD cover and benefit provisions with the boundaries provided by those rules.

‘This change will typically flow through to member accounts and raise issues for clients’

It makes sense for TPD super product design to be driven by these boundaries rather than historical market pressures which have produced features which breach them (and are quite often quirky in any case).

Some insurers have anticipated the changes and designed products which enable clients to optimise the tax efficiency of their TPD arrangements.

Having said that, there are probably some tweaks which could be made to the law to enable the deductible component of premiums to be identified more easily; and some tolerance in allowing a full deduction for policies which technically would have an extremely small part of the premium classed as non-deductible would lead to more efficient outcomes.

The new rules

Essentially, the relevant provisions of tax legislation (sections 295 to 460 and section 465 of the Income Tax Assessment Act 1997) provide that a TPD policy premium will be tax-deductible for a superannuation fund to the extent that it is in respect of a contingent liability of the fund to provide a “disability superannuation benefit”.

Broadly, this is a tax law term which has a similar basis to the term “permanent incapacity”. The latter term is used in the Superannuation Industry (Supervision) Act (SIS) to prescribe one of the circumstances in which benefits can be released from a fund. So if a policy provides a benefit in a broader range of circumstances than that, the premium will be only partially deductible. In order to be deductible, the part of the premium which would provide benefits in the defined circumstances must either be specified in the policy or in an actuary’s certificate obtained by the fund trustee.

Why the change?

Actually, this is the way the ATO considers the law worked even before the 2007 reform which led to a “re-write” of the super fund tax deduction provisions. The rewrite made it patently clear that, once the reforms became effective, premium deductions would be aligned with the SIS standards as discussed above. However, a widespread view across the industry was that this was actually more restrictive than the pre-reform law and was therefore at odds with the tax accounting of many super funds.

The Government resolved this by consulting with industry and legislating transitional rules which provided a full deduction for many typical types of TPD policies held by super funds. The transition expires at the end of this financial year.

How the law applies from July

In December last year, the ATO published a new draft ruling (TR 2010/D9) which outlines the ATO’s proposed approach to the law which will apply from July 1, 2011.

Own Occupation TPD issues and solutions

The draft ruling confirms that, from that date, premiums for “own occupation” style TPD insurance held by super funds will only be partially tax deductible whereas they have been fully deductible in the past.

Some product providers have taken an innovative approach in response to this, essentially redesigning traditional own occupation TPD insurance so that the cover is split into two linked policies. Part of the cover (similar to what is commonly referred to as “any occupation” cover) is held inside super and the balance is held outside of super. The aim of this approach is to ensure full deductibility of premium expenses for that part of the cover held by a super fund.

The ATO have issued a final ruling confirming this effect for Macquarie Life’s Super Optimiser, which was the first product designed with this “dual policy” approach.

For many clients interested in own occupation TPD cover the appeal of this approach is that it produces an optimal tax outcome on the premiums. An additional appeal – and, for many, the main appeal – is that it ensures any insured benefit payable will be able to be immediately accessed by the insured client (assuming the governing rules of the relevant super fund allow benefits to be paid whenever SIS permits). This is because policy benefits under the cover held by the super fund are payable only in circumstances in which the fund trustee will be permitted to release the benefit to the client immediately under the SIS rules.

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