Key to the tax door
Tax implications of key person insurance
Companies may sometimes take out a policy (key person insurance) insuring them against loss of profits resulting from the death, critical illness, sickness, accident or injury of an employee, director or other ‘key person’. This could be a life policy taken out on a main director/shareholder to cover repayment of borrowings in the event of that person’s death.
HMRC’s Business Income Manual (BIM) 45525 states that premiums on Key Person Insurance (KPI) will be tax deductible if all the following conditions are met:
- Sole purpose of taking out the insurance is the trade purpose of meeting a loss of trading income that may result from loss of the services of the key person, and not a capital loss.
- In case of life insurance policies, they are term insurance, providing cover only against the risk that one or more of the lives insured dies within the term of the policy, with no other benefits. The insurance term should not extend beyond the period of the employee’s usefulness to the company.
Premiums on endowment assurance and other policies with an investment element are regarded as capital expenditure. Even where a lender insists on KPI as a condition of providing finance, HMRC do not consider these costs as allowable as incidental costs of finance.
As with other forms of expenditure, for such insurance premiums to be allowable for tax purposes they must be incurred ‘wholly and exclusively’ for the purposes of the trade. Circumstances in which there may be a non-trade purpose, according to HMRC BIM45530, are:
- Where the policy is in respect of directors who are major shareholders, but not other employees
- If benefits under the policy exceed sick pay arrangements, or other employee benefits, typically offered to employees of equivalent status in similar concerns
For example, where the key person is a director whose death would significantly affect the value of the shares in the company, one of the purposes for taking out the policy may be a non-trade purpose of protecting the value of the director’s shares and therefore the value of their estate.
Taxing insurance receipts
It is important to note that where premiums are deductible then it follows that any receipts under that policy are taxable income in the hands of the company. Conversely, where premiums are not relievable for tax, then any subsequent receipts are not taxed as trading income. However, HMRC BIM45525 gives no assurance that any future receipts will be excluded from trading income even though the premiums are not allowable.
In the Special Commissioners case of Greycon Ltd v Klaenstschi (2003), even though the company had not claimed tax relief for the premiums, nevertheless HMRC sought to tax a policy receipt. Greycon Ltd took out six life assurance policies on one of its directors who later died of cancer. Following the death, the company received £586,000 which HMRC argued was subject to corporation tax. The Special Commissioner however disagreed and allowed the company’s appeal as the policies had been taken out at the request of one of the shareholder’s as a condition for the shareholder agreeing to guarantee the company’s bank overdraft. As such, there was a ‘capital purpose’ in the company taking out the policies and the insurance proceeds were held not to be trading income.
Where a company takes the decision that premiums are not deductible and therefore any receipts are not taxable, then it is advisable to record that decision by way of a board minute. This will set out that the company’s purpose for taking out the policy is to protect the share value, goodwill or facilitate a purchase of own shares and therefore any future insurance receipts will be capital rather than revenue, ie not trading income.