Nicholas Ali explains the importance of insurance when entering a Limited Recourse Borrowing Arrangement.
We receive many queries regarding self-managed super funds (SMSFs) in receipt of insurance proceeds, particularly where an SMSF has entered into a Limited Recourse Borrowing Arrangement (LRBA).
Insurance can provide the liquidity requirements when a benefit needs to be paid, but there is much conjecture as to how insurance proceeds are treated for contribution cap purposes.
Indeed, the question was put to the NTLG Superannuation Technical Sub-Group meeting in June 2012 – “Will proceeds from a life insurance policy held by a SMSF for liquidity purposes result in the creation of a fund reserve?”
Firstly from TR 2010/1 – Superannuation Contributions, the life or TPD insurance proceeds are considered income of the fund (but not assessable):
“138. An insurance company that pays an amount to a superannuation provider on the occurrence of an insured event under the terms of an insurance policy does so under the terms of the insurance contract. The proceeds of the policy will be treated as income, profit or gain from the use of the fund’s existing capital and not as a superannuation contribution.”
Fair and reasonable allocation
The trustees must determine the investment return in a way that is fair and reasonable between all members of the fund and the various kinds of benefits of each member of the fund.
From APRA Circular IC1 Minimum Benefits Standards:
“Fair and reasonable investment return
Regulations 5.01B, 5.03(2) and Division 6.1
49. In determining the investment return a trustee should ensure universal fairness between the interests of all members and not adopt a course which advantages the interests of any particular member or class of members. For example, if the trustee knows that a member is retiring from the fund shortly before the fund receives substantial income on an investment, and the investment was maintained by the fund while the person was a member, the trustee should take this into account.
50. It is not necessarily appropriate for a trustee to determine a uniform investment return for all members of the fund for it to be considered as fair and reasonable.
For example, where members choose particular investment strategies, it is fair and reasonable to determine investment return in relation to member’s benefits taking into account the returns obtained from the assets backing the particular investment strategies members have chosen.”
So what is fair and reasonable?
This may be determined on a proportional basis considering the members’ benefit balances.
This could even amount to splitting the net investment returns evenly between the members.
Deductibility of Insurance Proceeds
Where it is evident that life or TPD insurance proceeds are to be placed in the Income Account and then allocated to the members, living and dead, this would suggest that part of the insurance premium would not be deductible – this would relate to the amount of proceeds that have been diverted to the surviving members and not used to pay a death or disability benefit.
Evidence could be in the way of a written agreement or minute.
If it is not apparent how the life or TPD insurance proceeds are going to be treated on the happening of an insurable event, then it could be possible that the entire premium is deductible as the trustee still has a contingent liability to pay a benefit at the time the insurance premium is paid – see TR 2012/6:
“Effect of superannuation fund trust deed
41. The possibility and likelihood of a member electing not to receive a benefit that is otherwise payable under the terms of the trust deed will not in itself deny deductibility of that insurance premium. The likelihood of a member electing not to receive a benefit, where the permanent incapacity condition of release has been met and the payment if made would satisfy the ‘disability superannuation benefit’ definition requirements, does not affect whether the trustee has a contingent liability to provide the ‘disability superannuation benefit’ at the time the insurance premium is paid.”
The ability to retain the lumpy asset will depend on how much is allocated to the deceased or disabled member based on the fair and reasonable test and the existing cash levels.
The accounting method probably provides more flexibility than allocating to a reserve given the restrictions on redrawing from the reserve – the reserve issue was discussed at the NTLG but ATO response was fairly non-descript.
The following is a definitive answer on borrowing for an LRBA and the deductibility of the insurance premium – see TR 2012/6:
“Example 9: no deduction for premium for additional death and TPD insurance where no connection to a current or contingent liability of a fund to provide a ‘disability superannuation benefit’.
122. The same fund as in Example 8 (at paragraphs 109 to 121 of this Ruling) enters into a limited recourse borrowing arrangement.
123. At the encouragement of the lender, the fund takes out additional death and TPD insurance with an insurance company connected to the lender, to cover its liabilities in relation to the repayment of this debt, should contributions to the fund cease, or be significantly reduced, in the event of a member’s death or disablement. A single premium is paid for this additional insurance cover. It is intended that this cover be reduced each year in line with the reduction in the debt, such that, if an insured event occurs, no excess of proceeds over remaining debt would be received by the trustee in any year.
124. The fund’s trust deed is silent on how insurance proceeds can be dealt with, but it is the trustee’s intention that, in the event of the member’s death or permanent disablement, the proceeds from the original insurance policy will be used to pay to the member, or in respect of the member, a benefit referred to in section 295-460. The proceeds from the additional insurance policy will be used to repay the fund’s debt in relation to the limited recourse borrowing arrangement.
125. As there is no connection between the occurrence of an insured event under the additional policy and the fund’s current or contingent liability to pay a death or disability benefit to a member, the premium paid for the additional insurance policy is not deductible under subsection 295-465(1).”
To summarise, an insurance policy is merely an investment of a superannuation fund, just like public company shares and any other investment of the fund.
The proceeds of the policy will be treated as income, profit or gain from the use of the fund’s existing capital and not as a superannuation contribution.
There is nothing to prevent the fund’s deed from giving the trustee discretion to credit none or part of the policy proceeds to the deceased or disabled member.
Any amount not credited to the member’s account may be used for purposes of the fund, including eliminating LRBA debt.
The amounts allocated do not go via a reserve account and do not come within the rules which treat allocations from reserves as a concessional contribution. Any amount that is distributed to member’s accounts, however, must be on a fair and reasonable basis.
Nicholas Ali is the technical services specialist at Super Concepts.
By Nicholas Ali