Income protection insurance is NOT always tax deductible!

Jeffrey Scott, Head of Product at ClearView

Many clients and advisers are focused on minimising tax at this time of year.

For clients who are thinking about protecting their assets and income, an easy and common way to obtain a tax deduction is to purchase an income protection policy.

The ATO has been approving deductions for premiums paid on income protection policies for over 35 years.

However, the ATO has recently started scrutinising the deductibility of income protection premiums.  It is asking some taxpayers to substantiate the entire deduction they have claimed for the income protection premiums paid.

Unless the taxpayer can substantiate the amount of premium relevant to the tax deduction, the tax deduction will be denied.

The ATO doesn't seem to have a problem with basic income protection policies that replace a percentage of the taxpayer's income, normally around 75%, in the event of injury, disease, or illness.

What the ATO appears to have an issue with are the ancillary benefits that are attached to income protection policies.  Some taxpayers are claiming tax deductions for the ancillary benefits which are treated as capital payments and are not taxable. These include ancillary benefits that:

• Provide a lump sum payment in the event of Total and Permanent Disablement (TPD);
• Provide a lump sum payment in the event of specific injuries such as broken bones; or
• Provide a lump sum payment in the event of traumatic events such as cancer, heart attack, stroke or paralysis. 

Other ancillary benefits that are treated as income payments will still have that proportion of the premium tax deductible.

ATO guidance

For income protection policies that provide lump sum TPD benefits, the ATO has provided guidance that normally 10 per cent of the income protection premiums would not be tax deductible.

For income protection policies that provide lump sum trauma benefits, the ATO has provided guidance that normally 5 per cent of the income protection premium would not be tax deductible.

These benefits are often calculated as a multiple of the monthly income protection benefit (for example, six times the monthly benefit) and paid as a lump sum when the life insured suffers critical illnesses such as cancer, heart attack, stroke or paralysis. The ATO has determined that since these benefits would be paid regardless of whether or not the life insured was absent from work, the benefit does not replace lost income but rather is a capital payment.

For income protection policies that provide lump sum specified injury benefits, the ATO has provided guidance that normally 5 per cent of the income protection premium would not be tax deductible.  These benefits are often calculated as a multiple of the monthly income protection benefit (depending upon the severity of the injury) and paid as a lump sum when the life insured breaks particular bones such as leg, arm, foot or hand. The ATO's rationale behind this ruling is that since these benefits would be paid regardless of whether or not the life insured was absent from work, the benefit does not replace lost income but rather is a capital payment.

Why is the ATO focusing on ancillary benefits?

According to APRA, the total amount of income protection premiums held outside superannuation totalled $3.6 billion as at 31 December 2017.   Assuming that up to 10 per cent of these premiums are attributable to ancillary benefits that provide capital payments (as opposed to income payments), the ATO could potentially be missing out on up to $180 million in taxation revenue each year ($3.6 billion x 10% x 47% top marginal tax rate with Medicare Levy). 

The table below provides an indication of the tax deductibility of the respective components of income protection premiums, based upon previous ATO rulings.

Deductibility of income protection premiums

TYPE OF COVER	ANCILLARY BENEFITS	TAX DEDUCTIBILITY
Income Protection	None	100%
Income Protection	Lump Sum TPD	Approx. 90%
Income Protection	Extras Cover (Critical Illness and Specified Injuries)	Approx. 95%
Income Protection	Lump Sum TPD + Extra Cover (Critical Illness and Specified Injuries)	Approx. 85.5%

Inside superannuation

Where taxpayers have chosen to hold their income protection policies within superannuation, there is no specific deductions for the income protection premiums as these premiums are deductible to the trustee of the superannuation fund, not the member of the fund.  For the 2017-2018 financial year, taxpayers (members) of superannuation funds can claim tax deductions of up to $25,000 made to superannuation funds as concessional contributions. Members need to be aware that they must submit a valid notice of intent to claim a tax deduction to the superannuation fund and they must receive a valid confirmation from the superannuation fund before they submit their tax return to the ATO.  These concessional contributions may then be used to pay for income protection premiums within the super fund.
 
Where income protection policies are split between inside and outside superannuation (super linked), and the premium outside super contains either TPD Lump Sum Benefits, Specified Injury Benefits, and/or Critical Illness Benefits, it is likely that only a small proportion (if any) of the premium will be tax deductible.

Claiming a tax deduction on income protection premiums is common practice but it's important to understand which ancillary benefits are eligible for tax deductions.  If in doubt, contact your life insurance company.