Traditionally, SMSF trustees have effected insurance for members under a self-insurance model. This involves the SMSF trustee to take out, say, death insurance on a particular member. In the event of a claim, the insurance proceeds are allocated to the relevant member’s account in the fund. The proceeds can then be paid to the member if a valid cashing requirement has been satisfied or, on their death, to their dependants or legal personal representative.
However, there is another method growing in popularity that SMSF trustees can use to manage their insurance risks and cash-flow positions, especially when the SMSF has undertaken a limited recourse borrowing arrangement (LRBA). This method is called cross-insurance.
Under the cross-insurance model, the SMSF trustee, on behalf of member one, takes out an insurance policy over, for instance, the life of member two. Assuming members one and two are business partners sharing the same SMSF that owns the business real property for their business, then cross-insurance can offer certain advantages over self-insurance.
Cross-insurance
Why is it needed?
With the rise of LRBAs to acquire properties, many SMSFs find themselves in a position where the majority of fund assets are tied up in property. Basically, in the event of the death of one of the members, a benefit is generally payable, but there are often few, or in some cases no, liquid assets to pay these liabilities.
For example, consider John and Anne who purchase a property in their SMSF. Their balance sheet would look something like Table 1.
In the event of the death of John (or Anne), the SMSF trustee would need to be able to generate $300,000 (or $200,000 in Anne’s case) to meet their payment obligations to the deceased’s estate. However, as is quite evident from their balance sheet, there is clearly a disparity between the amount of cash available in the SMSF and the obligation that could arise.
Consequently, as in many funds, the SMSF trustee may need to sell the property if an unfortunate event such as death occurs, unless there is adequate and appropriate insurance in place, irrespective of whether there are negative capital gains tax (CGT) and stamp duty consequences or just simply poor market conditions for the sale of the property. Moreover, if the property was acquired for long-term investment purposes, especially if it is business real premises used in a related business, considerable other disadvantages can arise.
Why does self-insurance not work in this situation?
Many people ask why self-insurance doesn’t work in this context. The difficulty that arises with self-insurance is that as the SMSF trustee owns a policy with respect to each member – the insurance proceeds must be credited to that member’s account. For example, if John was to insure himself for $500,000, upon his death, the insurance proceeds would add to his equity, creating a fund liability of $800,000 that is owed to his estate. Accordingly, instead of $300,000 needing to be distributed by the SMSF trustee to his estate or dependants with $50,000 of cash holdings, the SMSF trustee will need to distribute $800,000 with $550,000 of cash holdings. As is clearly evident, the SMSF will still face cash-flow problems. That is, there will not be enough cash within the fund to pay out that death benefit without forcing the sale of the property.
How does cross-insurance solve this problem?
A cross-insurance policy involves the SMSF trustee taking out a policy over a member’s life, whereby premiums are debited from another member’s account. Accordingly, in the event of an insured event arising, the other member’s account is credited with the proceeds from the insurance.
In the example above, assume the SMSF trustee on behalf of Anne takes out a $500,000 insurance policy over John’s life and the insurance premiums attributed to that policy are debited from Anne’s account. Once John subsequently passes away, the balance sheet would, immediately after the proceeds are allocated, look something like Table 2.
And potentially, once a payment is made to the estate of John or to his dependants, it may look like Table 3.
In this situation, the SMSF trustee has reduced the loan by $200,000 and is still able to satisfy the $300,000 death benefit payment in respect of John. For completeness we also note Anne would probably receive some, if not all, of the distribution of John’s estate.
However, there are some other additional considerations that must be taken into account before entering into cross-insurance policy.
Issues to consider with cross-insurance
Do the governing rules of the SMSF permit a cross-insurance policy?
Before considering a cross-insurance policy, due regard should be given to the governing rules of the SMSF. If the governing rules stipulate any proceeds of insurance must be allocated to a deceased member’s account, then this type of arrangement cannot be used. However, in this situation, an appropriately worded update of the SMSF’s governing rules could be implemented.
Given cross-insurance has only recently gained popularity in an SMSF context, it is prudent to ensure the updated governing rules contain an express power dealing with this situation. Alternatively, if there is flexibility or discretion for an SMSF trustee to deal with those insurance proceeds, then an overarching deed of variation is entered into to provide certainty on how the premiums and proceeds are to be dealt with.
The Australian Taxation Office (ATO), in the National Tax Liaison Group (NTLG) superannuation technical sub-committee minutes of December 2012, confirmed, among other things, that where the governing rules of the fund allow for a policy of cross-insurance, and provide the mechanics for this policy to operate, then this approach is broadly allowable. Further, the ATO confirmed the insurance proceeds could be allocated to a surviving member’s account and this allocation would not constitute an allocation from a reserve, thus allaying any fears relating to contribution caps.
Is cross-insurance allowable under superannuation law?
As you will appreciate, this area of law is still relatively underdeveloped. Accordingly, there is nothing within the Superannuation Industry (Supervision) (SIS) Act 1993 and SIS Regulations 1994 that would preclude such a cross-insurance policy.
Interestingly, the ATO has also confirmed this position in its NTLG sub-committee minutes of June 2012, providing that: “Where the trustee has determined the insurance premiums for a particular policy are to be deducted from a specific member’s account (or entitlement), it would appear consistent with [the SIS Regulations] that the insurance proceeds received under the insurance policy should be allocated to that member’s account (or entitlement).”
How much insurance should be taken out on each member?
As with many questions, the answer really is, it depends.
The purpose of the cross-insurance policy in this example is to ensure the SMSF has enough capital to pay a benefit in the event of the death of a member without having to sell the business real premises. Therefore, the value of such a policy should consider the liability that would be owed to a member in the event of death and the amount of cash holdings that would be available to pay the benefit. This is more commonly referred to as the net equity position of the relevant member in the fund.
However, one compromise is to well over insure, and just use cross-insurance to retain the property, with any excess balance going towards self-insurance (that is, adding to the deceased member’s benefit).
How do we deal with excess insurance proceeds?
We suggest a special type of buy-sell agreement is entered into by the SMSF trustee and its members in the form of a specially tailored buy-sell deed of variation. This deed would stipulate, among other things, where the excess insurance proceeds are to be allocated, such as to the deceased member’s account, or whether they are to be retained in the SMSF for the surviving member(s). However, we note the ATO generally assumes the proceeds would be allocated to the same account that pays the insurance premium. Thus, unless the cross-insurance deed provides otherwise, any excess would usually end up with the member whose account pays the premium (that is, the surviving member).
A well drafted cross-insurance deed can ensure the SMSF trustee is clear as to whom, and how, insurance proceeds are to be allocated, and therefore reduce the potential for others to challenge these allocations.
Are the cross-insurance premiums deductible and what about CGT?
Unfortunately they are not.
Under section 295-465(1) of the Income Tax Assessment Act 1997 (ITAA), a deduction is only available broadly where the premium paid is for a policy that may provide an insured benefit to a member. While cross-insurance policies indirectly provide cash to pay benefits to other members, in the form of insurance proceeds, they are not directly associated with the payment of a benefit to the member who suffers the insured event.
Consideration should also be given to the CGT consequences of any receipt of cross-insurance proceeds. The provisions of the ITAA are proposed to be amended to more expressly cover the receipt by a trustee of insurance proceeds on behalf of an individual. In particular, the current provision for providing a CGT exemption for disability insurance, namely section 118-37 of the ITAA, does not expressly cover a trustee holding insurance, but the commissioner’s practice has been to accept this in ATO Tax Determination 14, where the proceeds are in respect of the particular member’s disability or that of a close relative. This would naturally not cover a business partner.
Does this meet the sole purpose test and is it consistent with the member’s investment strategy?
There has been conjecture as to whether a cross-insurance policy would satisfy the sole purpose test. That is to say, is the purpose of the insurance cover solely to provide retirement benefits for the member, or upon death, to provide benefits to the member’s dependants or legal personal representatives? If the cross-insurance policy is entered into concurrently with a cross-insurance deed, as suggested above, that stipulates the proceeds are to be used to provide ready cash flow to satisfy the deceased member’s benefit and to reduce the fund liabilities, this still is consistent with the sole purpose test.
The trustee of an SMSF must also formulate an investment strategy that considers insurance (pursuant to section 52B(2)(f) of the SIS Act and regulation 4.09(2) of the SIS Regulations). In particular, where cross-insurance policies are to be implemented, we suggest these policies are regularly reviewed together with the level of cover each year.
Will this arrangement still be available after 30 June 2014?
From 1 July 2014, regulation 4.07D(2) of the SIS Regulations, will read as follows: “A trustee of a regulated superannuation fund must not provide an insured benefit in relation to a member of the fund unless the insured event is consistent with a condition of release specified in item 102, 102A, 103 or 109 of Schedule 1.”
Further, regulation 4.07C of the regulations provides that “insured benefit for a member, means a right, other than an anti-detriment payment, for the member’s benefits to be increased on the realisation of a risk”.
We now apply regulation 4.07D(2) to the cross-insurance model for John and Anne:
The first condition: The trustee of the SMSF would be providing an ‘insured benefit’ (that is, John has insured risks in relation to Anne’s life and vice versa).
The second condition: The insured event is consistent with a condition of release in item 102 (death).
On a strict reading of the legislation, the second condition is not expressly linked to the first condition. Therefore, the cross-insurance model is not prohibited from being provided after 30 June 2014. However, this is on the condition the insurance is for an insured event that is consistent with one of the prescribed conditions of release.
However, we recognise there is an alternative construction to the above (that is, the second condition is linked to the first). This is not what the regulation requires and, in our view, would be reading too much into the text of the regulation.
Thus, we favour the first view as being reflective of the law.
We note as there is some uncertainty arising from having two differing views, we are seeking to obtain some guidance from the regulatory authorities on what their views are.
What if the insurance proceeds are insufficient?
For completeness, we note if the insurance proceeds are insufficient to pay out a member’s balance, then the members can always roll in proportional superannuation or contribute to the SMSF. This will create the cash flow required to pay out the deceased member’s account, without needing to sell the property.
As usual, these injections of capital should be subject to the relevant contribution caps.
Implemented correctly, cross-insurance can ensure an SMSF that owns business real premises, which are leased to a related party, are effectively protected in the event of the death of one of the members.
