05 - Contingent Liability Plans

Question 1

What are the five contingent liability plans worth considering?

Answer 1

The life of a director or employee can be insured to supply capital in the following situations:

• To secure an overdraft
• To cover a personal guarantee
• To cover a shareholder’s loan account
• To cover a mortgage bond
• To provide a sinking fund or cash reserve

Question 2

Are premiums tax deductible for the policies purchased as contingent liability plans?

Answer 2

In none of the cases above will the premiums be tax deductible, as:

• It cannot be deductible under sec. 11(w)(i);
• All four requirements must be met under sec 11(w)(ii) and it cannot, as the policies under these plans are NOT TO COVER AGAINST LOSS to the business.

Question 3

Securing an overdraft

Answer 3

Situation

• Death of director could impair company’s credit rating and facilities;
• A policy on the life of such director can secure the loan capital and redeem the overdraft upon death;

Premiums
The premium will not be tax deductible as:
- It is not a fringe benefit in the hands of the director (sec 11(w)(i));
- It does not cover the company against loss (sec. 11(w)(ii).

Proceeds

• The proceeds of the policy will be included in the company’s gross income under par. (m) of the definition of “gross income” in sec. 1
• but be exempt from tax under sec. 10(1)(gH)

Estate Duty Implications
- Deemed property in the estate of the insured life.

Question 4

Covering a personal guarantee

Answer 4

Situation

• It will often be necessary for a director/shareholder to sign a personal surety for the bank debt or overdraft of a company.
• If the guarantor / surety dies, the bank may want to call up the loan
• Banks usually bind sureties as “co-principal debtors”, therefore if the company does not pay, the bank may claim the debt against the estate.
• To give the director peace of mind, a policy on his/her life could cover the amount of the loan

Premiums
- The premiums will, for the same reasons as above, not be tax deductible

Proceeds

• proceeds will be included in gross income (par. (m))
• but exempt from tax under sec. 10(1)(gH)

Estate Duty Implications
- Deemed property in the estate of the insured life.

Question 5

Cover shareholder’s loan account

Answer 5

Situation

• Upon death of a shareholder, his/her credit loan account (i.e. money the company owes him/her) becomes a claim in favour of the deceased estate.
• Executor has duty to collect all claims in favour • This can be covered in two ways:
• • The loan account amount can be included in the buy-and- sell insurance, which will have the effect that the remaining shareholders will take over the account;
• • A policy on the life of a director.

Premiums
The latter policy’s premiums will not be tax deductible

Proceeds

• Proceeds will be included in gross income (par (m))
• but exempt from tax under sec. 10(1)(gH)

Estate Duty Implications
- Deemed property in the estate of the insured life.

Question 6

Cover a mortgage bond

Answer 6

Situation

• Although there will be no immediate claim against the company for the redemption of a mortgage in the event of the death of a director, the company may wish to have the cash available to do so.
• Policy on director’s life.

Premiums
- The premiums will not be deductible under sec. 11(w)(ii), again because it is not insurance against loss.

Proceeds

• The proceeds will be included in gross income (par. (m))
• but be exempt under sec. 10(1)(gH)

Estate Duty Implications
- Deemed property in the estate of the insured life.

Question 7

Sinking fund or cash reserve

Answer 7

Situation

• A sinking fund is a policy similar to a pure endowment (i.e. without life cover) with the difference that there is no insured life.
• The policy therefore does not come to an end upon the death of any director / shareholder / employee of the company.
• It is useful as a way to accumulate a cash reserve for a business.

Premiums
- The premiums on a sinking fund cannot qualify for deduction under sec 11(w).

Proceeds
- The proceeds will be tax free as it is of a capital nature and is not included in the definition of gross income in sec. 1 of the ITA.

Estate Duty Implications
- As there is no insured life, there will be no estate duty implications.

Question 8

What are the mechanics of a Preferred Compensation plan?

Answer 8

Mechanics of the plan

• Employer selects employees it wants to retain;
• Employer offers these employees a salary increase, tied to the conditions of the plan;
• The amount of the increase must include the premium on an endowment policy, plus the income tax caused by an increase in that amount;

The employer and employee enter into an agreement that: 

• • An endowment policy will be taken out by the employee on his/her own life;
• • The policy will be ceded on a security session to the employer as security for compliance with the terms of the agreement;
• • If the employee remains in the employ of the employer for the term of the policy (e.g. 5 years) or dies, the security session is cancelled and the employee has full ownership of the policy restored.

Question 9

What are the tax implications of a preferred compensation plan?

Answer 9

For the employer
- As the salary increase becomes part of its payroll, the
amount will be deductible under sec. 11(a);
- As the employer does not receive the proceeds, there will not be any inclusion for proceeds in the gross income of the employer.

For the employee

• The salary increase is fully taxable, and the premiums are paid with the remainder after tax
• The proceeds are tax free in the hands of the employee
• As the employee is the original beneficial owner of the policy, any capital gain will be disregarded under par 55(1) of the 8th Schedule
• The policy will be included as “deemed property” under sec. 3(3)(a) of the Estate Duty Act, as there is no exclusion available

Question 10

What is a security cession?

Answer 10

A security cession may be said to resemble the pledge of goods.

The policyholder, for example, borrows money from a bank.
As security for the repayment of the loan the policyholder, instead of leaving pledged goods in the hands of the bank until the debt has been fully repaid (failing which the goods can be sold and the proceeds used to meet the debt),
cedes his right to the payment of the policy benefit to the bank.

The PRIMARY INTENTION of the cedent and the cessionary is not that the cessionary will claim the proceeds from the insurer when the time comes to do so but that he would hold the ceded right for the time being.

The loan debt thus becomes a secured debt.

If the debt is repaid the ceded right reverts to the cedent. It is only if the secured debt remains unpaid that the cessionary will be entitled to realise the proceeds of the policy.

• In that sense the purpose of a security cession is to ensure the eventual payment of the secured debt.
• Any surplus is then to be paid to the cedent.
• In the meantime the cedent retains, unlike in the case of an outright cession, what is termed a reversionary interest which is itself worthy of protection and capable of further cession.

Question 11

Who is the true creditor of the policy from the insurers perspective when a policy has been ceded?

Answer 11

Nevertheless the cessionary is, as far as the insurer is concerned, its true creditor for the time being to whom all contractual duties have to be fulfilled, such as the giving of notices.

Question 12

Can an insurer use a policy it issued as security for lending money to its own policyholder?

Answer 12

An insurer lending money to its own policyholder is entitled to take cession of the policy issued by itself as security for the repayment of the loan.

Question 13

What is the state of affairs on a ceded policy prior to the repayment of the debt?

Answer 13

Prior to the repayment of the debt secured by the cession, matters are in limbo.

• The policyholder (cedant), while remaining the owner of the policy document, cannot claim on it.
• But neither can the cessionary realise his security.
• By the same token the insurer will be at risk if it wrongly makes payment to either the cedent or the cessionary once it has been notified of the security cession.

Question 14

Under which conditions can a cessionary apply for the surrender of a policy?

Answer 14

The cessionary is only entitled to apply for the surrender of the policy in the absence of consent from the policyholder if the policyholder as cedant were in arrears with the repayment of the secured debt.

Question 15

How is the security function maintained on a ceded policy and how does the interest revert to a cedant?

Answer 15

The continued payment of the premiums is of course vital to the maintenance of the security for if payments are not made and the policy lapses or is surrendered the value of the security is destroyed or reduced.

Once the secured debt is repaid the security cession has fulfilled its function and the right to the proceeds of the policy reverts to the policyholder.

It is an issue whether this takes place automatically or whether there should be a formal recession of the right.

Question 16

On reversion of interest, does the policyholder become a new cessionary?

Answer 16

No.

Upon repayment of the secured debt the policyholder was, after all, entitled as of right, to the reversion of the ceded rights. His position could therefore not be equated to that of a subsequent cessionary.

The view of the office was that the policy provision meant that the rights of the beneficiary were suspended during the currency of the initial cession; the implication being that upon payment of the debt for which the cession was given, the rights of the beneficiary revived in full.

Question 17

What are the responsibilities of the insurer in the case of a ceded policy?

Answer 17

An insurer is entitled to insist on proof that the secured debt had been repaid before making payment of the proceeds of the policy.

When an insurer is aware of a security cession it should take particular care that it does not make payment to the wrong party, for example:

• to the security cessionary if the debt has in the meantime been repaid
• or to the policyholder if it has not been duly repaid.

Steps to be followed:

(1) The policyholder needs to provide reliable proof as cedant, that the secured debt had in fact been redeemed;
(2) The insurer is entitled to insist on adequate proof of that fact from the policyholder as cedent and that the mere statement to that effect was not enough;
(3) Once such proof is furnished it would then be for the insurer, and not for the cedent, to obtain confirmation from the bank as cessionary that it no longer retained an interest in the policy

Question 18

How will the security be realised?

Answer 18

When the debtor is in default with the repayment of the secured debt the security may be realised (cashed in) by the security cessionary.

Realisation can take the form of:

(1) a claim for payment from the insurer on the maturity or surrender of the policy; or
(2) the taking of judgment against the debtor and the sale in execution of the policy; or
(3) the on-cession of the policy for a price.

*A sale in execution is a public auction held by a Sheriff of the Court. This means a court order has been obtained by the bank to attach and sell the policy to recover the money that has not been repaid on the policy.

• In each of these instances the security cessionary would be obliged to account to the cedent for any surplus on the proceeds.
• If there is no surplus the debtor remains liable for the shortfall.

Question 19

What is a sale in execution?

Answer 19

A sale in execution is a public auction held by a Sheriff of the Court.

This means a court order has been obtained by the bank to attach and sell the policy to recover the money that has not been repaid on the policy.

Question 20

Can the cessionary realise the security without first obtaining either consent of the cedant or a judgement from the court?

Answer 20

• It is an issue whether the security cessionary is entitled to realise the security without first obtaining either the consent of the cedent or a judgment from the court.
• It is suggested that he may do so as long as the right of the cedent is not compromised, for example, by selling the policy for a sum covering the debt but far below a realistic value of the policy.

Where the right to the proceeds is not yet ripe for enforcement (for example, because the policy has not reached maturity or does not permit of immediate surrender)
and the security cessionary is unwilling or unable to find a purchaser for the policy out of hand,
his right of recourse is to obtain judgment on the unpaid secured debt, to sell the ceded rights under the policy in execution, apply the proceeds in satisfaction or reduction of the secured debt and account to the cedent for any surplus.

But where the policy is ripe for enforcement (for example, because the policy has reached maturity or allows immediate surrender) the better view is that the security cessionary is entitled to claim the proceeds in terms of the obligationary agreement, without first having to take judgment on the secured debt.