Life Insurance Policy Bonus: serious financial difficulties - assessability

For the purposes of paragraph 26AH(7)(c) of the Income Tax Assessment Act 1936 (ITAA 1936), was a life insurance policy surrendered by the taxpayer in circumstances arising out of serious financial difficulties?

Yes. For the purposes of paragraph 26AH(7)(c) of the ITAA 1936, a life insurance policy was surrendered by the taxpayer in circumstances arising out of serious financial difficulties.

The taxpayer purchased an investment linked life insurance policy which they surrendered in its tenth year.

The surrender proceeds were used to finance required domestic renovations and extensions for a disabled family member.

The taxpayer is a worker in an industry facing an uncertain future. They were unable to obtain a loan due to both the uncertainty associated with their job and the near certainty that they would be unable to gain alternative employment in the event of retrenchment. Apart from the life insurance policy, they had no other assets of value to assist in financing the renovations. Their partner was also retrenched at the same time.

In addition to their everyday expenses of living, the taxpayer was also incurring additional ongoing expenses for the medical condition of the disabled family member. The effects of such expenditure and the unavailability of loan funds meant that cashing in the insurance policy was their only available source of finance. The decision to cash in the life insurance policy was made as a last resort.

The taxpayer applied for relief under paragraph 26AH(7)(c) of the ITAA 1936 from the inclusion of the insurance bonus in their assessable income on the grounds of serious financial difficulties.

All legislative references are to the ITAA 1936 unless otherwise indicated.

Under subsection 26AH(9), the increase in a life insurance policy's unit value is deemed to be a bonus for the purposes of subsection 26AH(6) which includes bonuses from life insurance policies in assessable income.. If a policy is forfeited, surrendered or otherwise terminated in its tenth year, under paragraph 26AH(6)(c) one third of the policy bonus is included as assessable income.

Subsection 26AH(7) excludes from assessable income any amount received by a taxpayer in a year of income under an eligible policy where the amount was received by the taxpayer by reason of the forfeiture, surrender or other termination of the whole or part of the policy in circumstances arising out of serious financial difficulties of the taxpayer except where the policy was effected, purchased or taken on assignment with a view to it being forfeited surrendered or otherwise terminated.

The phrase 'serious financial difficulties' is not defined in the ITAA 1936 or the Income Tax Assessment Act 1997 (ITAA 1997) so the words are given an everyday meaning. From the various definitions in The Macquarie Dictionary , 1997, 3rd edn, The Macquarie Library Pty Ltd, NSW 'serious' means weighty or important (definition 5), or giving cause for apprehension; critical (definition 6); 'financial': relating to monetary receipts and expenditures; relating to money matters; pecuniary (definition 1); and 'difficulty': (often plural) an embarrassing situation, especially of financial affairs (definition 2).

The phrase and others similar (for example, 'serious financial hardship') have been used in the context of other income tax laws, income tax rulings and court cases. Hardship (definition 1) is defined in The Macquarie Dictionary , 1997, as '...a condition that bears hard upon one; severe toil, trial, oppression, or need.'

The difference between the terms 'serious financial hardship' and 'serious financial difficulties' is one of degree. The effects of hardship are likely to be more severe and longer lasting than those of difficulties, whereas 'serious financial difficulties' may involve a long term loss of liquidity, although not to the extent that denies permanent access to the necessities of life.

Some guidance on factors which may be taken into account in considering whether circumstances of serious financial hardship exist can be found in ATO policies which discuss serious financial hardship in relation to tax relief and payment deferral. These policies are discussed below.

Taxation Ruling IT 2440 (withdrawn with effect from 28 April 2010) discussed the criteria addressed by the Relief Board when a taxpayer applied for release from payment of a tax liability under subsection 265(1) of the ITAA 1936 on the grounds of serious hardship. Paragraph 6 of IT 2440 states: ...the term serious hardship has connotations of unduly burdensome consequences, the magnitude of which would be likely to lead to persons being deprived of necessities according to normal community standards. Thus, serious hardship would be seen to exist where payment of a tax liability would result in the taxpayer being left without the means to achieve reasonable acquisitions of food, clothing, medical supplies, accommodation, education for children and other basic requirements.

Law Administration Practice Statement PS LA 2011/17: Debt relief (PS LA 2011/17), provides guidance on debt relief situations including the commissioner's power to grant individual taxpayers release from their obligation to pay certain tax-related liabilities and the Commissioner's delegation not to pursue recovery of tax debts.

Applications for release are made under subsection 340-5(3) of the Taxation Administration Act 1953 (TAA), on the grounds of serious hardship. Paragraphs 37 and 38 of PS LA 2011/17 state: 37. The term 'serious hardship' is not defined at law and must be given its ordinary meaning. The ATO determines whether serious hardship exists by applying several tests which are designed to ascertain whether payment of the tax would produce unduly burdensome consequences for the person such that they would be deprived of necessities according to normal community standards. 38. Thus, serious hardship would be seen to exist where payment of a tax liability would result in the person being left without the means to achieve reasonable acquisitions of food, clothing, medical supplies, accommodation, education for children and other basic requirements. On the other hand, elements of hardship may be regarded as marginal or minor - rather than serious - if the consequences of payment of tax are seen, for example, as limitation of social activities or entertainment, or loss of access to goods or services of a more luxurious nature or standard.

Taxation Ruling IT 2569 (withdrawn with effect from 16 April 2008) discussed extensions of time to pay. It stressed that the guidelines are flexible and the Commissioner dealt with each particular case on its merits. Paragraph 11 of IT 2569 states: ... it is a pre-requisite in considering any extension application that the taxpayer establish to the satisfaction of the approving officer that insufficient funds are available to fully discharge the debt or that payment would cause financial hardship and that all avenues for obtaining the necessary funds have been exhausted.

Taxation Ruling IT 2569 also discusses taxpayers subject to source deduction, those with disputed assessments and those paying quarterly provisional tax. The guidelines for acceptance of a request for extension of time to pay are clearly directed at taxpayers suffering short term liquidity problems through circumstances beyond their control.

Law Administration Practice Statement PS LA 2011/14: General debt collection powers and principles (PS LA 2011/14), deals with the Commissioner's power to defer the time for payment a tax-related liability, and the circumstances in which the Commissioner may exercise that power.

Paragraph 12 states: Where tax debtors face genuine difficulty in meeting payment dates but have capacity to pay, we may allow them to pay their tax debts - and any additional charges for late payment, including the general interest charge (GIC) - by instalments over a reasonable period of time ... [emphasis added]

Paragraph 13 states: If payment of an income tax or fringe benefits tax debt will cause serious hardship, an individual tax debtor can apply for a release from that debt - refer to Law Administration Practice Statement PS LA 2011/17 Debt relief. [discussed supra ]

Paragraph 15 states: Tax officers must follow the principles and guidelines outlined in this practice statement when exercising the Commissioner's powers under sections 255-10, 255-15 or 255-20 of Schedule 1 to the TAA. It is noted however that it is not possible to set out all the circumstances in which the powers may or may not be exercised. Each case has to be considered on its merits and on the basis of all the relevant facts . Tax officers must however ensure that the pre-conditions prescribed for the exercise of the power are met and staff must take care not to consider irrelevant factors and must exercise their own judgment in arriving at an appropriate decision. The decision should be made in good faith and without bias. [emphasis added]

PS LA 2011/14 also discusses factors to be taken into account when individually considering a payment deferral.

Paragraph 31 states: Without limiting the Commissioner's discretion in relation to any particular case, the time for payment will generally not be deferred unless the debtor can demonstrate that: (i) payment cannot be (or has not been) made by the original due date because of circumstances beyond their control ,

Paragraph 32 states: It is not possible to anticipate every circumstance which may prevent payment by the payment time and which is also beyond the control of a debtor or the debtor's representative ... . However, it can generally be expected that a deferral will be granted where the debtor can show the inability to pay on time can be directly linked to: (i) natural disasters (flood, fire, drought, earthquake and the like) (ii) other disasters that may have, or have had, a significant impact on a debtor or region

Before relief can be granted under paragraph 26AH(7)(c), it must be established that at the time the policy was taken out, there was no intention to terminate the policy within 10 years. There is no evidence that the series of events culminating in the surrender of this policy existed any earlier than the year of its surrender.

The criteria used in IT 2440, IT 2569, PS LA 2011/14 and PS LA 2011/17 to address 'serious financial hardship' are directed towards establishing a taxpayer's present and anticipated financial positions. Similarly, in applying the provisions of paragraph 26AH(7)(c), it is necessary to examine the taxpayer's financial position at the time they decided to surrender the policy because the money was required when they had to pay a builder for the work undertaken.

At the time work commenced on the renovations and extension, they were facing a potential loss of income with their job under threat. The retrenchment of their partner also meant that the family was faced with no regular source of income. Financing the extensions and renovations by cashing in the insurance policy would lead to a permanent loss of future liquidity as the taxpayer would no longer have access to the funds expended. The taxpayer was in serious financial difficulties in the everyday sense of that phrase.

Tax Office policy in relation to other relief provisions is that incidents beyond the control of taxpayers, such as natural disasters, deserve consideration when the Commissioner assesses serious financial hardship. It is reasonable to extend similar consideration to this taxpayer on the grounds of serious financial difficulties given their particular personal circumstances.