Employees earning remuneration are generally prohibited from claiming tax deductions for any expenditure other than those items listed in section 23(m) of the Income Tax Act (58 of 1962). This is in contrast to persons carrying on a trade independently of an employer.
One of the few deductions still available to employees is for premiums paid on income protection insurance policies. Currently, such premiums are deductible if (a) the policy covers the person against loss of income as a result of illness, injury, disability or unemployment, and (b) the amounts payable in terms of the policy constitute or will constitute income. The general principle has been that the premiums will be deductible if the proceeds are taxable – for example, if the policy pays a salary replacement annuity to the policyholder in the event that he/she is no longer able to earn a living. The deduction available for these premiums is, however, an exception to the general rule that personal expenditure is non-deductible, on the basis that these premiums incurred may, in fact, produce taxable income (and therefore passes the section 11(a) general deduction test).
The deduction is also an exception to the general prohibition on tax relief for personal insurance – for example, life insurance, again on the basis that life insurance proceeds are typically a non-taxable capital lump sum. This exception carries through into the way the premiums are treated for fringe benefits tax purposes: where such premiums are paid by employers on these policies to cover employees, the premiums are not a taxable fringe benefit, as opposed to employer-paid group life insurance, which is taxable (but again, the proceeds of employer-fund group life policies, where the premiums are taxed as fringe benefits, are specifically exempt from tax).
Tax authorities and policymakers dislike and avoid exceptions almost as much as they dislike allowing tax relief for personal expenditure. As a result, the Taxation Laws Amendment Bill published on 24 October 2013 has deleted this deduction from section 23(m)(iii) and, for good measure, confirms a prohibition on the deduction of any insurance premiums where the policy “covers that person against death, disablement, severe illness or unemployment” (section 23(r)). The exception to the fringe benefit rules at para. 12C(2) of the Seventh Schedule has also been deleted, meaning that employer-paid premiums to such policies will be taxable in employees’ hands, as is the case for group life premiums.
Of some consolation is the insertion of a new exemption at section 10(1)(gI), for any amount received or accrued to a policyholder in respect of a policy of insurance relating to their death, disablement, severe illness or unemployment. This exemption will cover proceeds of such policies, whether in the form of income (annuities) or capital (lump sums). The same exemption extends to employer-funded policies, in terms of section 10(1)(gG). Furthermore, the exemption is not limited to policies taken out after the effective date of the amendment (1 March 2015), but will apply to all proceeds from any policy. That is to say, there is no clawback provision which seeks to disallow the exemption for the portion of proceeds relating to premiums paid for which a tax deduction was allowed under the old rules (or for which no fringe benefits tax was paid, in the case of employer-funded premiums). Consequently, individuals who have existing policies (or existing employer-funded cover), and who suffer a setback resulting in a claim and proceeds after 1 March 2015, will not pay tax on those proceeds, notwithstanding that they will have benefited from a tax deduction or tax-free benefit on the premiums in prior years.
While the proposed regime is quite clean, simple and consistent, it has the potential to discourage individuals from taking out this type of cover, and similarly discourage employers from offering it as a benefit (indeed, if it is offered as a benefit, the take-up by employees will no doubt be reduced). Policymakers have pointed out that the proceeds are now tax-exempt, which should reduce the amount to be insured to achieve the same coverage. This should, in turn, reduce premiums and encourage insurance. There is, however, the potential that people will value a tax deduction today more than the potential of tax-free proceeds in the future, and so are likely to cancel or avoid such insurance. This, in turn, creates the potential of more uninsured people, in a society with 25 percent unemployment and where the state does not provide a substantial safety net in terms of welfare or health services.
In addition, insurance companies have already complained to National Treasury (to no avail, it seems) that individuals currently receiving benefits will be less likely to return to work if they receive tax-free payments, and that the insurance books are currently based on a certain return-to-work rate which will need to be revised (and which may impact premiums). No doubt, the insurers will also suffer if policies are cancelled once the deduction is abolished.
A few examples are displayed below to assist in clarifying these changes:
- An individual purchases a policy costing R2000 per month, which provides a partial salary-replacement annuity should he be injured and unable to work.
- The individual earns over R638 600 per annum and pays tax at the top rate of 40%. He therefore receives tax relief of R2000*40%*12 = R9600 pa for the premiums.
- This tax benefit will be nil from 1 March 2015.
- An employer takes out a policy which covers all its employees, so that if they are injured after hours and unable to work, they will receive a limited annuity.
- The policy costs R1 000 000 pa and covers 100 employees. The fringe benefit is therefore approx R833 per month. However this is a nil value fringe benefit so the employees pay no tax on it.
- From 1 March 2015, the employees will pay tax on this benefit. For a highest-rate taxpayer, the additional tax will be R333 per month.
It should be noted that the premiums may change once the tax rules change given that the proceeds of the policies will become tax-free.
This article was first published on www.kpmg.co.za