Is a Life Insurance Benefit Classed as Capital Gains Tax?
Life insurance is designed to offer much-needed peace of mind and provide essential financial protection for your loved ones when you are no longer around to provide for them.
However, it’s important to consider the tax implications when you take out a life insurance policy. While you’ll need to consider whether there are any situations where the premiums you pay will be tax deductible, it’s also vital to examine whether you’ll have to pay Capital Gains Tax (CGT) on any benefits that are paid.
- What is Capital Gains Tax Treatment of Life Insurance Policies
- What Does Original Beneficial Owner Mean?
- What Does Consideration Mean?
- What is the Capital Gains Tax Treatment of Other Life Insurances?
- Is Life Insurance Taxable as Capital Gains?
- Recent Changes in the Handling of Capital Gains Tax and Life Insurance
- Capital Gains Tax Exemptions
- When it comes to CGT, life insurance policies are treated as CGT assets by the Australian Taxation Office. In other words, the payment of proceeds from an insurance policy will constitute the disposal of a CGT asset in the eyes of the ATO.
Exemptions to be aware of
However, under the Tax Assessment Act 1997, there are a couple of exemptions where people will not have to pay CGT on the disposal of a term life insurance policy.
- Original beneficiaries. If a term life insurance policy pays out a benefit on the death or diagnosis of a terminal illness of the insured, no CGT will be payable if the benefit was paid to the original beneficial owner of the policy.
- The beneficiary did not make any payments towards the policy. The proceeds can be exempt from CGT when paid to someone who was not the original beneficial owner of the policy, as long as they did not pay any fees or give any other consideration to purchasing the life insurance cover.
- Legal representatives of the beneficiaries. Legal representatives of the beneficiary of the trust are also exempt if they receive the benefit.
However, you will need to pay CGT if the proceeds from the term life insurance policy are paid to someone who is not the original beneficial owner, and if that someone paid money or gave some other form of consideration to acquire the rights to the policy.
What this all means is that CGT is generally not an issue for personal insurance policies because the insured is also typically the owner of the policy, but it’s something that will need to be considered in many business insurance situations.
What Does Original Beneficial Owner Mean?
Original beneficial owner is a term you’ll come across plenty of times when researching the CGT treatment of life insurance. For an accurate definition, you need to head to Tax Determination TD 94/31, where the Commissioner of Taxation stated:
… the original beneficial owner is the first person who, at the time the policy is effected, holds the rights or interest, and possesses all the normal incidents of beneficial ownership, for example, who is entitled to the benefits of the policy proceeds and has the power of management and control over the policy, as well as the power to transfer, grant as security, surrender or otherwise dispose of the policy.
In layman’s terms, the original beneficial owner is therefore the person who is the first to possess or take control of the benefits offered by the policy. In cases where two or more people jointly affect a life insurance policy, each person can be considered an original beneficial owner. In an insurance trust, the trustee of the trust is considered to be the policy’s legal owner.
It’s also important to determine what the term ‘consideration’ means in order to determine whether or not you are exempt from paying CGT. As mentioned above, if a life insurance policy is transferred to a new owner for no consideration, no CGT is payable. However, consideration is quite a broad term with a wide range of meanings.
It can refer to an agreement to do something in return for something else, or a payment of funds in exchange for an item or a certain right. Other possible definitions include an exchange of property, the act of giving or receiving benefits in exchange for the term life insurance proceeds, or exchanging life policies.
In a nutshell, in order to be exempt from CGT you must not have received or given any items, services, benefits or money in exchange for the life insurance policy payout.
In addition to term life insurance, CGT can also have an impact on TPD, trauma and terminal illness insurance policies. The exemptions that apply to term life insurance policies do not apply to TPD and trauma policies. If you’ve got bundled life cover, this can be little confusing come tax time as your insurance policy proceeds will be taxed differently depending on whether they were paid upon the life insured’s death or upon the life insured meeting the policy’s definition of TPD or a trauma condition.
However, CGT exemptions do apply to TPD and trauma insurance payouts. If your claim was related to a disability related either to your occupation or personal events, no CGT will be payable. There are specific guidelines for this exemption which can be found in full in section 118-37 ITAA97. This exemption covers physical injuries and a range of diseases and illnesses. In addition, the exemption only applies if the person who is entitled to the payout from the policy is the injured person, their spouse or their relative (child, sibling, parent, grandparent, aunt, uncle, niece or nephew).
Is Life Insurance Taxable as Capital Gains?
The Australian Taxation Office classifies life insurance policies as CGT assets. This is because life insurance policies include a chose-in-action, which is a contractual promise to either do or pay something. In this case, it refers to the fact that an insurance provider makes a contractual promise to pay a benefit in the case of the death of the life insured. When the benefit is paid, the contract is processed, meaning that a CGT asset has now been disposed. As a result, CGT may now be payable on the life insurance proceeds.
However, as mentioned above, there are a range of circumstances where you may be exempt from paying CGT, so it makes good financial sense to enlist the services of your accountant if you need any assistance.
The 2012-13 Federal Budget contained some important changes that affect how CGT applies to life insurance policies. The changes relate to people who receive life insurance payments from policies held under trust structures, with an increased number of people now able to claim exemptions from CGT.
In cases where a taxpayer receives certain insurance proceeds through a trust, any CGT consequences will now be disregarded. In effect, this means that taxpayers who receive proceeds through a trust will now have the same CGT outcome as taxpayers who receive proceeds directly. It also means that insurance policies owned by superannuation funds will continue to be CGT exempt.
In terms of non-death insurance benefits, the CGT exemption where you receive proceeds for any illness or injury you or your relative suffers personally has now been extended to include the trustee of a taxpayer. If the trustee of a family trust owns a trauma or TPD policy, any insurance benefits paid to a suitable family member would be exempt from any CGT.
However, if the trustee of a fixed or unit trust owns a trauma or TPD policy, whether or not an exemption applies depends on the beneficiary who receives the proceeds. For more detailed information on the changes to CGT and life insurance, speak to your accountant for advice tailored to your needs.
There are a range of situations and circumstances where you can be exempt from paying any CGT on the proceeds of a life insurance policy. These include:
- Where the original beneficial owner of the policy receives the life insurance proceeds.
- Where the benefit recipient acquired their interest in the policy for no consideration.
Other exemptions may apply depending on your personal situation and the type of cover you take out. For example, if you receive life insurance proceeds through a trust you will also be exempt from having to pay any CGT.
The issue of CGT as it affects life insurance is a complex and confusing one. However, it’s important to ensure that you understand all the ins and outs of this topic to ensure that you can stay well on top of your financial situation. If you need any help understanding how CGT applies to your life insurance proceeds, your accountant can offer all the help you need.