Key Person Insurance – The ‘Ins’ And ‘Outs’

Businesses take out key person insurance (‘KPI’) for a variety of reasons and it is common commercial practice, so one might think that the tax treatment would follow a well-trodden path. This article explores why that may, or may not, be so.

The fact is that there are no hard and fast rules as to whether premiums paid for KPI are allowable for tax purposes or whether, in the event that the policy benefits are received, they are taxable or not.

The only test that is relevant as far as tax legislation is concerned is the ‘wholly and exclusively’ test (at ITTOIA 2005, s 34 for sole traders and partnerships, and CTA 2009, s 54 for companies). Obviously, there is a massive body of case law on the wholly and exclusively test, but very little which directly concerns KPI, and what case law exists is inconclusive. What we are left with therefore is largely a matter of accepted practice in line with HMRC guidance, which in turn is based upon the so-called ‘Anderson rules’.

The Anderson rules refer to a House of Commons reply by the then Chancellor of the Exchequer, Sir John Anderson, in 1944:

‘… the general practice in dealing with insurances by employers on the lives of employees is to treat the premiums as admissible deductions, and any sums received under a policy as trading receipts, if:

(i) the sole relationship is that of employer and employee;

(ii) the insurance is intended to meet loss of profit resulting from the loss of services of the employee; and

(iii) it is an annual or short term insurance.

Cases of premiums paid by companies to insure the lives of directors are dealt with on similar lines.’

HMRC guidance in the Business Income manual at BIM45525 states:

‘The premiums on such a [key person] policy will be allowable if all the following conditions are met:

• The 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. Guidance on possible non-trade purposes is at BIM45530.
• In the 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.’

The guidance goes on to note that premiums on endowment assurance and other policies with an investment element are not allowable as being capital expenditure. Sometimes a lender will insist on KPI as a condition of providing finance; however, HMRC do not consider such costs are allowable as incidental costs of raising finance under ITTOIA 2005, s 58 (‘incidental costs of obtaining finance’) or under CTA 2009, s 307 (for the purposes of the ‘loan relationship’ rules).

Importantly, it is stated that:

‘Where both conditions outlined above are satisfied, the premiums will be deductible, and sums received under such a policy will be income of the employer’s trade.

As a general rule, where a policy does not comply with both of the above conditions:

• the premiums cannot be deducted, and
• receipts under that policy are not taxed as trading income.’

The parliamentary question that led to the Anderson rules followed the decision in Williams’s Executors v CIR [1945] 26 TC 23, though in fact that case has nothing to do with KPI and is therefore of little relevance. Samuel Dracup & Sons Ltd v Dakin [1957] 37 TC 377 concerned whether payments under endowment assurance policies for the benefit of two directors were allowable for corporation tax purposes. The commissioners did not find any benefit to the company’s trade, and that the directors had taken out the policies to benefit themselves. The payments were therefore not allowable.

The much more recent case of Beauty Consultants Ltd v Inspector of Taxes [2002] SpC 321 concerned (among other things) relief for premiums on a policy for £200,000 on the lives of two directors (referred to anonymously as ‘Jack and Jill’), who together owned 55% of the shares in the company.

It was contended that the intention in taking out the policy was to pay a year’s salary and benefits to a professional manager if Jack and Jill died. The Special Commissioner agreed that this would benefit the company, but would also benefit Jack and Jill, as it protected the value of their shares. There was therefore a ‘dual purpose’ (and so the wholly and exclusively test was not met), which meant that the premiums were not allowable.

HMRC’s guidance at BIM45525 states:

‘No assurance can be given that any future receipt will be excluded from trading income even though the premiums are not allowable (Simpson v John Reynolds & Co (Insurances) Ltd [1975] 49 TC 693 and McGowan v Brown & Cousins [1977] 52 TC 8).’

However, if the two conditions for allowance are not met and the premiums are therefore disallowed, as a general rule the policy benefits should not be taxable.

In Greycon Ltd v Klaenstschi [2003] SpC 372, however, HMRC sought to tax a policy receipt despite the fact that relief for the premiums had not been claimed. The company took out six life assurance policies on one of its directors. The director was diagnosed with cancer and died. The company received £586,000 under the insurance policy, which HMRC assessed to corporation tax. The Special Commissioner allowed the company’s appeal against the assessment, finding that the policies had been taken out at the request of one of the shareholders as a condition for the shareholder agreeing to guarantee the company’s bank overdraft. On the evidence, the policies had been ‘taken out as a requirement of…entering into the agreement to provide funds’. The company therefore ‘had a capital purpose’ in taking out the policies and ‘the policy moneys therefore were not part of the trading profits’.

Firstly, in line with the Anderson rules, the position where the employee (including a director) is not a shareholder and the stated conditions are met, the premiums on KPI should be allowable for tax purposes and any policy benefits would be taxable.

Where the employee or director is a shareholder, as a general rule the premiums will not be allowable and any policy benefits should not be taxable.

HMRC’s guidance at BIM45530 states:

‘Circumstances in which there may be non-trade purposes for taking out a ‘key person’ policy 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 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.’

The HMRC guidance does not offer any further clarification of what is meant by ‘major shareholder’. The shareholders in Beauty Consultants would certainly seem to be in that category, but as a general rule of thumb if an employee is a director and has a 5% or more shareholding in the company the policy will not qualify for tax relief.

In Greycon, the taxpayer was assisted by detailed documentation supporting their position that the purpose of the policy was supporting a capital asset (the overdraft guarantee being conditional on the policy). This is perhaps particularly important where the view is taken that the policy premiums are not allowable and where, obviously, it is hoped that any receipt would similarly be non-taxable.

For example, a board minute recording that the company’s object in taking out the policy is to protect the share value, the goodwill or to enable a purchase of own shares, and that therefore no claim would be made for tax relief for the premiums, may assist to establish the capital nature of the purpose in the event that policy benefits are received.