The issues are complex—plan carefully, and seek professional advice
BY: PIET NEL
IT IS common for business owners to take out a policy for the purpose of enabling a person to acquire a deceased person’s share in a business.
The share in the business can relate to the whole or part of the deceased’s interest in a partnership or the deceased’s share or like interest in a company. As far as the interest in a company is concerned, it includes any claim by the deceased against that company, such as in respect of a loan.
According to Kobus Barnard, in his article Buy and sell—pactum successorium or not, these arrangements are based on two parts, i.e.
Co-owners enter into a buy and sell agreement to force the sale at a predetermined or determinable value at occurrence of a certain event (death and / or disability); and
Provides liquid capital through a policy to fund the forced sale.”
The policy will be a long-term insurance policy on the life of each owner to fund the obligation to purchase, created in the agreement.
Tax practitioners are often requested to give an opinion with regard to:
the normal tax consequences, particularly the ones arising on the date of death and thereafter, of these policies; as well as the estate duty consequences of:
a) the proceeds received under a life policy and a buy and sell agreement; and
b) the value of the shares held in a company, and interests in close corporation by the deceased.
The focus of this article is on the estate duty consequences.
For purposes of this article, we will take as an example an agreement that relates to businesses that consists of two companies. The parties to the agreement are business owner one (referred to hereafter as the ‘deceased’) and business owner two (referred to as the ‘survivor’).
At the time of the deceased’s death, they were the holders of shares in the two companies (the businesses). In terms of the agreement:
the interest of the deceased in the businesses must be sold to the other party to the agreement;
the ‘sale date’ is the first business day immediately following the date of death of a party to the agreement; and
the purchase price of the deceased’s interest, or the ‘seller’s interest’, in terms of the agreement, is the greater of (a) the net proceeds of the policies, after providing for the payment of any taxes or duties attributed to the policies; or (b) the value determined under and pursuant to the provisions set out in another clause of the agreement.
The value of the seller’s interest, according to the terms of (and for purposes of) the agreement, is to be determined as at the ‘sale date’ by reference to the most recent statement of valuation, as drawn up and signed by all the parties.
Let’s assume for purposes of the article that the most recent statement of valuation is the one attached to the agreement, and that the death benefit under the two policies is R8 million and R2.4 million respectively—the total value being R10.4 million. In terms of the agreement the buyer must, on receipt of the policy proceeds, pay the full amount to the executor in reduction or settlement of the purchase price.
The policy, referred to in the agreement, is a long-term insurance policy as defined in the Long-term Insurance Act. There will of course be two policies. The policyholder of the first policy is the survivor, and the life insured under this policy will be that of the deceased. In terms of the agreement, the ‘buying parties’ (the survivor) have affected policies on the life of each of the ‘selling parties’ (the deceased).
THE PREMIUMS PAYABLE IN RESPECT OF THE POLICY
The agreement states that the premium payable in respect of each respective policy included in the agreement must be “borne and paid by the policyholders proportionate to their shareholding in the business”. The parties had an equal interest in the businesses—50% each.
The premiums were paid by the businesses but were then debited to each individual’s loan account in each of the businesses. According to Meyerowitz, a “premium will have been paid or borne by the deceased where it has been paid either by him directly, or indirectly by someone else on his behalf out of funds provided by the deceased or in respect of which he has incurred a liability to pay someone the amount expended on the premium…” In this instance, the premiums on the policy on the life of the deceased were debited to the loan account of the survivor.
ESTATE DUTY CONSEQUENCES: THE POLICY
In terms of section 3(3) of the Estate Duty Act, “so much of any amount due and recoverable under any policy of insurance which is a ‘domestic policy’, upon the life of the deceased” is property “which is deemed to be property of the deceased”.
A ‘domestic policy’ means “any life policy as defined in Section 1 of the Long-term Insurance Act 1998, issued anywhere upon an application made or presented to a representative of an insurer (or to any person on behalf of such a representative) at any place in the Republic …”
In the Long-term Insurance Act 1998, unless the context otherwise indicates, ‘life policy’ means “a contract in terms of which a person, in return for a premium, undertakes to provide policy benefits upon, and exclusively as a result of, a life event … and includes a reinsurance policy in respect of such a contract …”
Based on the facts, and from the information provided, the policy is in fact a ‘domestic policy’. In terms of the proviso to Section 3(3) of the Estate Duty Act, a ‘domestic policy’ must not be included as property in the deceased, if SARS is satisfied that:
the policy was taken out or acquired by a person who on the date of death of the deceased … held any share or like interest in a company in which the deceased on that date held any share or like interest …
the policy was taken out … for the purpose of enabling that person to acquire … the deceased’s share or like interest in that company and any claim by the deceased against that company, and
that no premium on the policy was paid or borne by the deceased…
From the terms of the agreement, it is clear that the two policies were taken out by the survivor. The purpose of taking out these policies was to enable the survivor, on the death of the deceased, to acquire the deceased’s shares in the two companies. The premiums on these policies were paid or borne by the survivor—in other words, they were not paid or borne by the deceased.
The full amount due and recoverable under these policies of insurance upon the life of the deceased is therefore not property which is deemed to be property of the deceased at date of the death of the deceased. Because it is not included in the ‘total value of all property’ in the estate, it will not be included in the net value (or the dutiable amount) of the deceased’s estate. No estate duty will therefore be payable in respect of the proceeds of this domestic policy.
Apart from the two policies, the shares in the two companies are property in the estate of the deceased at the time of death. The next issue is what value must be used for estate duty purposes.
VALUATION OF THE SHARES IN A PRIVATE COMPANY AND MEMBER’S INTEREST IN CLOSE CORPORATIONS
At the time of death of the deceased, he was a party to a buy and sell agreement, and after his death an amount of R10.4 million was paid out, in terms of the two life policies, by the insurer to the survivor.
As was agreed in the buy and sell agreement, the survivor paid the amount received to the executor of the deceased. This was done to acquire the shares in the two companies held by the deceased at the date of his death.
In terms of the buy-and-sell agreement, the purchase price of the deceased’s interest, or the ‘seller’s interest’, in terms of the agreement, is the greater of:
the net proceeds of the policies, after providing for the payment of any taxes or duties attributed to the policies; or
the value determined under and pursuant to the provisions set out in a clause of the agreement.
The aggregate value of the shares in the two companies held by the deceased at the date of his death is less than the amount that was paid out, in terms of the life policy. Let us assume that the values of the two companies was R6 million and R2 million respectively.
Estate Duty consequences: The value of the companies
In terms of Section 5(1) of the Estate Duty Act, the value of any property for the purposes of the inclusion thereof in the estate of any person in terms of Section 3 … as at the date of death of that person must be determined, in the case of shares in any company not quoted on any stock exchange, in terms of Paragraph (f)bis of Section 5(1).
For the purposes of section 5(1)(f)bis, the term ‘shares’ includes any members’ interests … or right to purchase members’ interests … and the term ‘company’ includes any company or close corporation incorporated in the Republic or elsewhere.
It is specifically stated that the price realised by a sale, as envisaged in Section 5(1)(a), must not be used as the valuation of the properties in question. It was stated in the 1993 Explanatory Memorandum to the Taxation Laws Amendment Bill that “Section 5(1)(f)bis of the Estate Duty Act 1955 serves as a guideline for determining the value of shares held by a deceased person in a company not listed on a stock exchange.”
Value (or valuation):
In terms of Section 5(1)(f)bis, the value of shares in any company not quoted on any stock exchange shall be the value of such shares in the hands of the deceased at the date of his death, subject to the following provisions, namely:
no regard shall be had to any provision in the memorandum and articles of association, founding statement, association agreement or rules of the company, as the case may be, restricting the transferability of shares therein, but it shall be assumed that such shares were freely transferable;
no regard shall be had to any provision in the memorandum and articles of association, founding statement, association agreement, or rules of the company, as the case may be, whereby or whereunder the value of the shares of the deceased or any other member is to be determined; and
no regard shall be had to any provision or arrangement resulting in any variation in the rights attaching to any shares through or on account of the death of the deceased.
In this instance, the amount received by the executor from the survivor, in terms of the agreement, exceeds the value of the deceased’s interest in the two companies.
However, it doesn’t matter if the proceeds of the policy exceed the amount required to buy out the deceased’s interests. What is required to be determined is the value of the shares or the interest, or as Section 5(1)(f)bis states: “the value of such shares in the hands of the deceased at the date of his (sic) death”.
The question is whether the value, as agreed on in the buy-and-sell agreement, is to be used as the value of the property in question for the purposes of estate duty.
The first observation to be made in this regard is that the buy and sell agreement is separate to the memorandum and articles of association, founding statement, association agreement or rules of the company. If it was part of these documents, it would be disregarded under Section 5(1)(f)bis.
The clause in the buy-and-sell agreement relating to the purchase price of the deceased’s interest is not a “provision … whereby or whereunder the value of the shares of the deceased or any other member is to be determined …” It is only where the value of the shares exceeds the proceeds, that the value had to be determined in terms of the agreement. Whilst it is not a bona fide purchase and sale in the course of the liquidation of the estate of the deceased, it is a price realised by a sale in terms of the buy-and-sell agreement.
As the values of the shares and the two companies at the date of death of the deceased, that was done by an independent valuator, were R6 million and R2 million respectively, it is these values that will be used for purposes of estate duty. The own valuation done by the parties to the contract for purposes of the contract, and the amount of the proceeds payable in terms of the policy, must both be disregarded.
THE NORMAL TAX CONSEQUENCES
It was not intended to deal with the income tax consequences, but a comment would be appropriate.
The proceeds of the policy will not have any normal tax consequences for the deceased—at the date of death, that is. Under Paragraph 55(1)(c), and based on the same requirements as the ones for the exclusion of property in the estate discussed above, the capital gain arising at death will be disregarded.
The capital gain at date of death will be the difference between the market values at date of the death (the R6 and R2 million amounts above) and the base cost of the shares to the deceased.
The estate of the deceased acquires the shares at a base cost of R6 million and R2 million respectively and disposed of it, the very next day, at the values received from the survivor under the policy. This will result in a capital gain in the estate of the deceased person and the tax will be payable by the executor, but not from property included in the estate.
A buy-and-sell agreement entered into by co-owners of a business has complex estate duty, income tax, and CGT consequences. Appropriate professional advice is strongly recommended.
Piet Nel is the project director for tax at the South African Institute of Chartered Accountants.