Is there a key person in the business? Would the business owner himself or another person whose role is so important that if he is either disabled or dead, the business’s profitability would suffer significantly?
If there is such a key person or “keyman” in his business, then one solution to compensate for any possible losses to the business is to put in place “keyman” insurance. This is regarded by many business organizations today as part of their business succession strategies. If the business owner himself is the “keyman” of his business, the business organisation should therefore insure itself against the loss of his services.
Under the tax regime, premiums for keyman policies are allowed a deduction on the basis that the keyman policy is purchased to compensate the company for loss of profits arising from death or disability of its key employee whose services are invaluable to the company.
Deductions are allowed when stringent conditions are met. This requires proof of the insured as keyman and for the sums insured that reflect the correct proportion of the annual profits of the company, directly attributable to the key position on whose life the policy is taken.
The managing director of a company is not necessarily a “keyman” merely by virtue of his position. As a general rule, it will be necessary for the company claiming the deduction to show that the key person who is insured has special qualifications which have been effective in generating the company’s business. Hence without the services of that person, the business will be substantially affected.
Special qualifications in this context need not necessarily be limited to his academic and professional qualifications. It can include other abilities such as the person’s business acumen or simply his business connections that are pivotal in bringing in profits for the company.
IRAS Deductibility of “Keyman” Insurance Premiums
IRAS provides guidelines in relation to the deductibility of premiums which a company pays to insure their keyman (see IRAS e-Tax Guide “Deductibility of “Keyman” Insurance Premiums”, published on 29 Jun 2012). In general, to understand the rationale when IRAS would allow the deductibility of premiums, the principles behind the income tax law need to be understood:
Section 14 of the Income Tax Act allows deduction only for expenses that are wholly and exclusively incurred in the production of income.
Section 15 of the Income Tax Act provides, among other things, that expenses that are capital in nature are not allowed a deduction.
Accordingly, when the company purchases keyman insurance and is the beneficiary of the policy, the premiums incurred would not ordinarily be deductible because the expense is not incurred in the production of income but rather to acquire a capital asset (the insurance policy).
The allowance of deductions of premiums paid by the company for keyman insurance is therefore the exception to the above rules. IRAS stipulates that there are five conditions that must all be met in order for the deductibility of premiums paid on a keyman insurance policy.
Where premiums paid for a “keyman” insurance policy qualify for deduction under section 14(1) of the Income Tax Act, insurance recovery under the policy would constitute a trading or income receipt subject to tax.
Notwithstanding the tax element involved in keyman insurance policies, proceeds from such policies are sometimes distributed by the company ex-gratia to the family of the deceased keyman. But note the condition that the insurance policy must remain the property of the company for deduction of premiums (see condition 3 in table above).
The following is an extract from PreceptsGroup Succession and Trust in Wealth Management, 4 th Edition. To read about the five conditions mentioned above, you can refer to the book for more details.
The book can be purchased here.
