Jennifer Brookhouse explains why TPD premiums may become less effective inside super

A common strategy to reduce the effective cost of
total and permanent disability (TPD) insurance premiums is to hold the policy
inside superannuation.

However, this strategy may become less effective from
July 1, 2011. This gives advisers a year to provide new advice to affected
clients and, in some cases, move the insurance out of superannuation. If
legislation is not passed to ensure this change applies only from 2011, the
reduced deduction could be backdated to July 1, 2004.

Reducing the cost of premiums

Superannuation is commonly used to allow a
client to cost effectively pay for life insurance premiums. The cost of
premiums is reduced through a combination of salary sacrifice (or personal tax
deduction for contributions) and the ability for the trustee to claim a tax
deduction for the premiums to offset the contributions tax. This is shown in
the diagram below.

If the trustee passes on the value of the tax deduction
directly to the client, tax is not deducted from the contribution.

The new interpretation of legislation

Changes to legislation wording on July 1, 2007
highlighted a problem with the full deductibility of TPD premiums. This issue
has been in dispute for the past two years. The Australian Taxation Office
(ATO) is sticking to its position that the new wording did not change the
rules, and its current interpretation – that TPD premiums are not always fully
deductible – should have applied since July 1, 2004.

Temporary relief is
proposed to allow the industry time to make adjustments and to avoid
backdating. If legislation is passed, TPD premiums will remain fully deductible
until July 1, 2011, but from that date the circumstances around the policy need
to be examined to determine how much of the premium is deductible. The current
interpretation is that the TPD premiums will be deductible only to “the extent the
policies have the necessary connection to a liability of the fund to provide
disability superannuation benefits to their members and not other types of
insurance for which premiums are collected from their members”.

In simple
terms, this means that if the TPD policy definition matches the Superannuation Industry
Supervision (SIS) permanent incapacity release definition, the full premium is
likely to be deductible. However, the premium for policies with other
definitions, such as “own occupation”, may only be partially deductible or
potentially not deductible at all.

The changes are proposed to apply from July 1,
2011, but this may have immediate implications for advice strategies to
determine whether policies should:

• be selected with disability definitions
that are likely to maintain the full deductibility, or
• be moved outside
superannuation by July 1, 2011.

Adviser action – impact on advice

Legislation to defer the new interpretation to
July 1, 2011 has not been passed, so advisers should keep abreast of the
developments to assess the final outcome.

Unless the ATO concedes to any
further changes, advisers will need to consider the following steps.

1. If TPD
is recommended inside superannuation, review the policy definitions to
determine which policy is most suitable for the client and consider the
taxation implications.

2. If the TPD premium is not fully deductible, the
benefits of holding the policy inside superannuation compared to a
non-superannuation TPD policy may reduce. For some clients, the advantages
inside superannuation may no longer offer sufficient value and they may wish to
transfer to a non-superannuation policy.

3. Clients with TPD insurance inside a
self- managed super fund (SMSF) will need to determine whether the premiums are
tax deductible.This may require an actuarial calculation.

4. Statements of
advice (SOAs) recommending clients take TPD inside superannuation should now
include a warning about the potential change from July 1, 2011 and the need to
review circumstances closer to that date.

5. Review all clients with TPD inside
superannuation (especially with policy definitions other than “any occupation”)
before July 1, 2011 to notify them of the changes and make any required
adjustments to their strategy.

6. If legislation is not passed to start the
limited deductibility from July 1, 2011 (and remove the backdating from July 1,
2004) trustees of SMSFs will need to review previous tax returns and determine
if they need to be lodged again to reduce the amount of the deduction. The trustees
will need to work with their tax advisers.

Transferring insurance policies

While an insurance policy that is owned by a member
or a related party cannot be transferred into a superannuation fund, there is
no restriction on transferring policies out of a superannuation fund.

Therefore,
if it is no longer appropriate to hold a policy inside superannuation, the TPD
policy can be transferred to an ordinary non-superannuation policy, unless
restrictions are imposed by the life company. Before taking any action you
should speak with the insurer to understand requirements and any limitations.