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.
This is not always the case with traditional own occupation TPD cover. Where traditional own occupation cover is held by a super fund and a policy benefit is paid to the fund trustee, there is a risk that the benefit will not be able to be released immediately because the nature of the disability would not meet super law conditions for release of benefits. This is potentially a significant practical problem, particularly for those under the age of 55, since they will typically need to meet the “permanent incapacity” condition of release to receive the benefit.
So, alongside these benefit release issues, the July 1 tax changes provide an additional reason for trustees and members to rethink their TPD cover strategies, particularly if they are interested in own occupation cover. The availability of a dual policy arrangement should be considered in that process.
Issues with other TPD policies:
“Own occupation” policies are not the only types of TPD policies held by super fund trustees which will lose their full deductibility status from July 1. The ATO’s ruling provides a number of examples in which the circumstances of disability insured under the policy are broader than permanent disability – in other words, the policy potentially provides some benefits to the insured fund which can’t be paid on to a member as disability superannuation benefits. These include policies which have “loss of limbs” or “activities of daily living” definitions, and even some “any occupation” definitions.
‘The availability of a dual policy arrangement should be considered in that process’
Some of these are quite common and the difference between the policy definition and the statutory definition is relatively minor. Unfortunately, in these cases it may be impractical to get the percentage of the premium which is deductible certified by an actuary or specified in the policy in time. Also, in the case of large funds, it may be difficult to adjust systems to cope with the accounting involved with something less than 100 per cent deductibility.
So some parts of the industry are exploring interpretative and legislative solutions with the ATO and others.
The way forward for TPD
We await the outcome of negotiations and the final ATO general ruling on TPD deductibility for super funds. It could well be that in some cases there will be a frantic scramble to put measures in place to deal will partial deductibility of insurance in the 2011-12 year. However, for many clients, it will remain tax efficient to have permanent incapacity TPD cover, which is immediately releasable if held within super rather than outside it. For these clients and funds generally, the July change may be a catalyst to review their arrangements and optimise the accessibility and deductibility of TPD insurance.
David Shirlow is an executive director of Macquarie Adviser Services.
