Private ruling: Life insurance proceeds
Published: April 2014
Ruling period: 1 July 2013 to 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Is the lessor assessable on the life insurance proceeds as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or capital gain under Part 3-1 of the ITAA 1997? | A1: No - to the extent that it does not represent receipt of the lease payments on the remaining equipment | Q2: Are the life insurance proceeds applied to pay out the balance of the lease payments on the remaining equipment owed by the lessee assessable income to the lessor under section 6-5 of the ITAA 1997? | A2: Yes | Q3: Will the surplus (the difference between the life insurance proceeds and the lease payments including the residual values) paid by the lessor to the estate of C be deductible to the lessor under section 8-1 or Division 30 of the ITAA 1997? | A3: No | Q4: Will the surplus of the life insurance proceeds paid to the estate be treated as a deemed dividend under Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936)? | A4: No

Relevant facts and circumstances: The lessor owned a subsidiary company X. The lessor sold Company X to Company Y a couple of years ago. The current shareholder of Company Y is B. B used to hold the shares in Company Y together with her/his spouse C until his/her recent death. Company Y in turn owns a subsidiary company Z, which was also controlled by B and C. The lessor owns equipment that was previously leased to Company X. The lessor continues to own the equipment. However, it ceased leasing the equipment to Company X and instead, they were leased to Company Z ('the lessee'). Each of the equipment was subject to a different lease agreement on similar terms. As each lease ended, the lessee would buy the equipment at their residual values. C arranged a life insurance policy on his/her life at about the same time as the leases were entered into. This was to ensure that if C died, there would be sufficient money available to pay out the remaining leases of the lessee. This is not a 'key man' policy as the lessor did not pay the premiums. C paid for the life insurance premiums. The lessor was the sole policy owner and beneficiary. C died recently. The lessor has received the life insurance proceeds. The final payout to terminate all remaining leases is less than the amount of life insurance proceeds received by the lessor. The lessor has decided to pay the surplus to the estate of C (the difference between the life insurance proceeds and the lump sum required to pay out the remaining leases). After the remaining leases are paid out, the lessor will transfer the ownership of the equipment to the lessee. The applicant states that: • the lessor is not related or associated with the lessee, Company Y or B and C. • There is no relationship between the late C's family and the directors and shareholders of the lessor. • No member of either family was a director or shareholder of each other's companies. • The life insurance policy on the C resulted from a commercial transaction to secure lease payments owing by the lessee to the lessor. • All transactions were carried out on a commercial, arm's length basis.

Relevant legislative provisions: Section 6-5 of the ITAA 1997 | Section 6-10 of the ITAA 1997 | Section 8-1 of the ITAA 1997 | Section 15-30 of the ITAA 1997 | Section 118-300 of the ITAA 1997 | Section 318 of the ITAA 1936 | Division 7A of the ITAA 1936

Reasons for decision: Detailed Reasoning - Detailed reasoning: Section 6-5 provides that the assessable income of a resident taxpayer includes the ordinary income derived directly or indirectly from all sources. Ordinary income includes income from rendering personal services, income from property and income from carrying on a business. For taxpayers who carry on a business, an amount will generally be income in any of the following situations: • the gain arises from a transaction which is made in the ordinary course of business; • the gain arises from a transaction which is outside the ordinary course of business but is nevertheless closely connected to the business; • the gain arises from a transaction which is not in the ordinary course of business and is not closely connected to the business, but the taxpayer made the gain from a profit-making undertaking or scheme, that is, the transaction was entered into for a profit-making purpose. As the lessor is a company it cannot have receipts of a personal services nature. The amount received under the life insurance policy was not derived by the lessor from property, nor was it made to compensate the lessor for loss of income or for any profit-making purposes. It was received as the sole beneficiary pursuant to the death of the insured person. The receipt was outside the ordinary course of the lessor's business. The receipt of the proceeds is also not attributable to a key man insurance policy. Taxation Ruling IT 155: Key man insurance - assessability of proceeds and deductibility of premiums considers the tax consequences of proceeds from insurance policies including life insurance policies. It states that the term "keyman" insurance is used in the industry to denote insurance on the life of a director, partner, employer or other "key" person associated with the taxpayer in business. The life insurance policy taken out by C did not fall into this category. He/she was never a director, partner, employer or key person associated with the lessor's business. The policy was directed towards a purpose of ensuring there was sufficient money to pay out the leases on the remaining equipment in the event of C's death. It was not designed to protect a revenue asset or to replace income and therefore was not of a revenue nature. The question of whether life insurance proceeds are of an income or capital nature has also been the subject of judicial deliberation over the years. In Marac Life Assurance Ltd v. Commissioner of Taxation [1986] 1 NZLR 694 ('Marac case'), the Court of Appeal concluded that it was common ground that traditionally proceeds of life insurance policies had been treated as capital. The decision in the Marac case was applied by the Federal Court in NM Superannuation Pty. Ltd. v. Young & Anor (1993) 41 FCR 182; (1993) 7 ANZ Insurance Cases 61-163. In conclusion, the life insurance proceeds are not income according to ordinary concepts under section 6-5. Under section 6-10 an amount that is not ordinary income could be included in assessable income under another provision as statutory income. Payments made under a life insurance policy may come under section 15-30 if it is in the nature of compensation, that is, insurance or indemnity for the loss of assessable income. In this case, the proceeds represent payment of a benefit contingent on the death of the insured person. They are not paid to fill the place of lost income. Therefore, section 15-30 does not apply. When a life insurance policy is paid out as a lump sum, this involves a surrender or termination of the holder's rights under the policy. As a consequence, the capital receipt could give rise to a capital gains tax ('CGT') event. However, section 118-300 specifically exempts any capital gain (or capital loss) arising on the payment of life insurance proceeds as a lump sum if the conditions in subsection 118-300(1) are satisfied. Items 3 and 4 of the table in section 118-300 respectively exclude the proceeds of a life insurance policy from CGT if the recipient is the original beneficial owner of the policy or has not paid any consideration for the rights under the policy. The term "original beneficial owner" of any of the rights, or any interest in any of the rights, under a policy of life assurance is defined in Taxation Determination TD 94/31 Income tax: capital gains: what is meant by the term "original beneficial owner" as used in subsection 160ZZI(3) of the Income Tax Assessment Act 1936 (the Act)? to mean the first person who: • at the time the policy is effected, holds such rights, or any interest in such rights, and • possesses all the normal incidents of beneficial ownership (for example, 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).' The lessor is the owner and beneficiary of the life insurance policy. It did not pay any consideration to acquire the rights under the policy, nor did it pay for the premiums. In any case, in the context of 'beneficial ownership' a premium paid under a policy of life assurance does not constitute an "amount of money or other consideration" paid to acquire rights, or an interest in any rights, under such a policy: Taxation Determination TD 94/34: Income tax: capital gains: can a premium constitute "an amount of money or other consideration" paid to acquire rights, or an interest in any rights, under a policy of life assurance for the purpose of subsection 160ZZI(3) of the Income Tax Assessment Act 1936? Accordingly, the lessor is the original beneficial owner under items 3 and 4 of subsection 118-300(1) and the proceeds are not assessable for CGT purposes. The life insurance proceeds would, therefore, ordinarily not be assessable income under either section 8-1 or Part 3-1. However, the proceeds in fact comprise two components: the amount required to pay out the remaining leases under the arrangement and the surplus which is the difference between the life insurance proceeds and the lease termination payment. As explained in Question 2 below, the lump sum to pay out the remaining leases is received in respect of the loss of future income and is therefore assessable under section 6-5. | Detailed Reasoning - Conclusion: The lessor is assessable on the amount required to pay out the remaining leases under section 6-5. The surplus is not assessable under either section 6-5 or Part 3-1. | Summary: The life insurance proceeds applied to pay out the balance of the remaining leases owed by the lessee are assessable income to the lessor under section 6-5 | Detailed Reasoning - Detailed reasoning: As outlined in Question 1 there are three situations in which an amount will generally be regarded as ordinary assessable income in the hand of a taxpayer who carries on a business if the money is received: • in the ordinary course of carrying on a business; or • as an ordinary incident of business activity even though it was unusual or extraordinary compared to the usual transactions of the business; or • as a profit or gain from an isolated business operation or commercial transaction. Other characteristics of income that have evolved from case law include receipts that: • are earned • are expected • are relied upon, and • have an element of periodicity, recurrence or regularity. Under the terms of the lease agreements, the lessor is entitled to receive regular rentals on each of the equipment for a specified period. As each lease ends, the equipment would be sold to the lessee at their residual value. The lease payments are assessable income to the lessor under section 6-5 as they are derived in the ordinary course of carrying on a business as a lessor and also exhibit the four characteristics of income referred to above. The lump sum amount applied to pay out the balance of the remaining leases brings forward the future lease payments which would have been received by the lessor over the remaining terms of the leases. The agreements, on the other hand, constitute CGT assets as they confer on the lessor the contractual right to receive the monthly payments under the respective lease. It could be argued that the early termination of the leases brings to the end of a CGT asset and the amount received is therefore capital as it is paid in consideration of the surrender of the contractual rights under the agreements. The issue is whether the life insurance proceeds applied to pay out the remaining leases is income or capital. A number of considerations and propositions emerged from case law in determining whether an item is income according to ordinary concepts concern the capital/revenue distinction. In all cases, the initial and vital step is to establish the character of the item in the hands of the recipient: McLaurin v. FCT (1961) 104 CLR 381; Scott v. FCT (1966) 117 CLR 514; the Federal Coke Company Pty Ltd v. FCT (1977) 7 ATR 519 (Federal Coke). The Full High Court in GP International Pipecoaters Pty Ltd v. FC of T 90 ATC 4413 (GP International) identified the following factors as relevant in determining if a receipt is of an income or capital nature: • the character of receipts may be revealed most clearly by their periodicity, regularity or recurrence; • the character of a right or thing disposed of in exchange for the receipt may be determinative; • the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business may reveal the character of the receipt. Payments to replace income were considered to be income in Keily v. Federal Commissioner of Taxation (1983) 14 ATR 156: 83 ATC 4248. In Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82, it was held that an amount paid to compensate for loss generally acquired the character of that for which it was substituted. The issue of whether the commutation of an entitlement to periodic payments to a lump sum affects the assessability of the receipt was also raised in Coward v. Federal Commissioner of Taxation 99 ATC 2166; (1999) 41 ATR 1138 ('Coward case'). It was found that payments made to replace income took on the character of the payment they replaced and that the method of payment did not alter the character of the payment. This view is consistent with the approach taken by the Commissioner outlined in Taxation Determination TD 93/ 3 Income tax: is a payment, being a partial commutation of weekly compensation payments, assessable income? and confirmed in Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? It is ruled that periodic payments paid as compensation for loss of income or salary is assessable income and a lump sum payment, which is a commutation of such payments, retains its character as income. The lump sum is in effect an advance of future payments. Consequently, it continues to be assessable under subsection 25(1) of the ITAA 1936 (the equivalent of section 6-5). It is recognised that the Coward case and TD 93/3 were determined in the context of individual taxpayers receiving compensation payments. Nevertheless, we consider that the same principle also applies to business entities in receipt of lump sum payment in lieu of future periodic payments. One important consideration in determining whether an item is revenue or capital is the character of the "right" or "thing" (as referred to in GP International) or "advantage" (the term used in Sun Newspapers Ltd v. FCT (1938) 61 CLR 337) disposed of in exchange for the receipt. The Federal Coke case reiterates the principle established in Sun Newspapers that a receipt is ordinary income if it is derived from disposing of a right or advantage as part of the process by which the profit-earning structure or organisation operates to obtain regular returns. Conversely, if the right or advantage disposed of is part of the profit-earning structure, the receipt is capital in nature. The rights embedded in the lease agreements entitle the lessor to receive regular rental returns. They are part of the process by which the profit-yielding structure of the lessor operates to receive income. They do not form part of the profit-yielding structure itself and therefore are not capital. On the basis of case law, it is considered that the lump sum received on the termination of the remaining leases is assessable income to the lessor under section 6-5. The amount is in effect a commutation of the monthly lease payments which the lessor would have continued to receive should the lease run its course. The fact that the monthly payments are replaced by one single amount does not change the revenue character of the receipt. The substance and commercial reality of the termination is that it is a full and final settlement of the contractual rights and obligations between the lessor and the lessee. Therefore, the lump sum amount retains the character of the lease payments it has replaced. That is, it is ordinary income under section 6-5 as the lump sum amount is received in respect of the loss of future income and not in respect of the loss of a CGT asset. | Detailed Reasoning - Question 3: Summary The surplus to be paid by the lessor to the estate of the late C will not be deductible to the lessor under section 8-1 or Division 30 Detailed reasoning | Detailed Reasoning - Section 8-1: Section 8-1 allows a general deduction for losses or outgoings incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. To be deductible under section 8-1, two essential conditions must therefore be satisfied: • the taxpayer must have incurred the expense, and • the expenditure must not be of a capital, private or domestic nature. Being the sole beneficiary, the lessor is entitled to the whole amount of the proceeds from C's life insurance policy. There is no obligation for the lessor to refund the excess and it is not a requirement under the lease agreements for this course of action. The payment is therefore not necessarily incurred in carrying on a business for the purpose of gaining assessable income. It is an expense of a private nature. Accordingly, it does not satisfy the nexus test and is not deductible under section 8-1. | Detailed Reasoning - Gifts: Division 30 deals with deductions for certain gifts and contributions which includes money. Taxation Ruling TR 2005/ 13 Income tax: tax deductible gifts - what is a gift? sets out the principles relevant to the factual determination of whether a particular transfer of money or property is a gift for the purposes of the gift deduction provisions in Division 30. It explains that as the term 'gift' is not defined, it has its ordinary meaning and the courts have described a gift as having the following characteristics and features: 1. there is a transfer of the beneficial interest in property; 2. the transfer is made voluntarily; 3. the transfer arises by way of benefaction; and 4. no material benefit or advantage is received by the giver by way of return. It is considered that the transfer of the surplus from the lessor to the estate constitutes a gift as it exhibits the following requisite characteristics: 1. The transfer of the insurance surplus involves the transfer of a beneficial ownership from the lessor to the estate and once it is effected, the estate will have immediate and unconditional right of control and full title to the money. 2. The transfer is made voluntarily by the lessor. It is not the result of a prior contractual or statutory obligation. It is not a loan. 3. An essential attribute of a gift is that benefit is intended and conferred on the recipient. The motive of the lessor appears to be altruistic, in view of its expressed concerns over the difficulties encountered by the estate following the death of C and its claim that it does not want to benefit from the event. It is reasonable to accept that the transfer proceeds from the detached and disinterested generosity of the lessor. 4. There is no evidence to indicate that the lessor will receive any material benefit or advantage from the transfer and the estate will not provide any consideration in return. In conclusion, the surplus payment to the estate is a gift. As the estate is not a gift recipient covered by the table in Subdivision 30-A or listed in Subdivision 30-B, the transfer is not deductible to the lessor for the purposes of Division 30. | Detailed Reasoning - Question 4: The legislative references in this question are to the ITAA 1936 | Summary: The surplus of the life insurance proceeds paid to the estate will not be treated as a deemed dividend under Division 7A | Detailed Reasoning - Detailed reasoning: Under Division 7A, amounts paid, lent or forgiven by a private company to certain associated entities are treated as dividends unless they come within specified exclusions. Specifically, Division 7A applies where the recipient of the payment (section 109C), loan (section 109D) or forgiven debt (section 109F) is: • a shareholder; • an associate of a shareholder; or • a former shareholder or former associate, where a reasonable person would conclude that the amount is paid, lent or forgiven because of that former status. An "associate" has the meaning given in section 318, which covers a broad range of entities that are associates of natural persons, companies, partnerships and trustees. Under paragraph 109C(3), the phrase 'a payment to an entity' means: (a) a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and (b) a credit of an amount to the extent that it is: (i) to the entity; or (ii) on behalf of the entity; or (iii) for the benefit of the entity; and (c) a transfer of property to the entity. Whilst the surplus is likely to be a 'payment' in accordance with subsection 109C(3), it does not satisfy subsection 109C(1) as the recipient would not meet the definition of "associate" (of the shareholder) in section 318. The late C was not and had never been a shareholder or director of the lessor or its associates. There is no relationship between his/her family and the directors and shareholders of the lessor and no member of either family was a director or shareholder of each other's companies. The applicant maintains that all transactions between C and the lessor and their related parties were carried out on a purely commercial, arm's length basis. Based on the information provided by the applicant, it is considered that the surplus to be paid to the estate will not be a deemed dividend under Division 7A.

Reasons for decision: All legislative references in these questions are to the ITAA 1997 unless otherwise stated | The life insurance proceeds are not assessable to the lessor under either section 6-5 or Part 3-1 to the extent that it does not represent receipt of the lease payments on the remaining equipment.