Overvalued policy proceeds on buy and sell agreements

Granted, it may not be often that proceeds of a policy, which is used to fund a buy and sell arrangement, is overvalued. If it is, as long as the planner can prove to SARS that there is / was a viable commercial reason for the decline in the share value of the company, this would not present a problem.

What if, for some reason, it was planned to implement a sum assured that was far greater than the share value, due to the belief that the company share value may grow by 15% within the next year or 2 and, it does not. Then, it could possibly be overvalued at time of a shareholder’s death.

This also depends on the provisions in the buy and sell agreement itself. If a provision alludes to the surviving shareholders buying the deceased’s share at the greater of market value or value of the policy proceeds – it could cause a favorable or, not so favorable position.

A provision such as the above, ensure that should, at time of death of a shareholder, the surviving share holder will have to buy the shares with the higher value of share value of policy proceeds.

An example:

Shareholder A and B each have 50% share in a company with a value of R10 000 000 in total. A policy is effected to the value of R8 000 000 on each life – effectively R3 000 000 more than the share value. Shareholder A dies and at time the value of the shares are R 11 000 000. This equates to R 5 500 000 each shareholder. The agreement states that the shares must be bought from the deceased estate at the higher of the two amounts. R8 000 000 is the higher amount. The surviving shareholder has to pay the deceased estate and amount of R 8 000 000 and will get shares to the value of R5 500 000 – effectively making a donation to the value of R 2 500 000! If the surviving shareholder is deemed to have made a donation , there is donation tax.

(R2 500 000 – R100 000) x 20% = R480 000 donation tax payable!

The heirs of the deceased estate are smiling as they have just scored additional inheritance!

Continuing with the above example, we look further into any other possible tax implications:

The Estate Duty Act will exempt a policy, for the purpose of a buy and sell agreement, if all the requirements as listed are met. One of the requirements is that the policy was effected with the ”intention of buying the deceased”s share”. If the surviving partner may have a difficulty to prove intention as the policy was overvalued. The policy is now no longer exempt as it does not meet all the requirements for exemption. The surviving shareholder is liable for the estate duty of 20% on R8 000 000. R1 6000 000 that the surviving partner must have somewhere – he cannot use policy proceeds as this is for the purchase of the shares.

The surviving shareholder has donation tax of R 480 000 and estate duty of R1 600 000, a total amount of R2 080 000.

Now – this is what happens at death of the one shareholder. I think though it does not end here for the surviving shareholder. Use a very simple example for capital gain tax.

He acquired shares at a value of R5 500 000 which is the base cost at disposal. The fact that he paid R8 000 000 for these shares is irrelevant as he made a donation for the difference. If one assumes that he, a few years later sells the shares for R10 000 000, he makes a gain of R4 500 000 and not R2 000 000 (10 000 000 – 8 000 000). He may however take a portion of the donation tax paid and add this to base cost.

Summary:
Donation tax R 480 000, Estate duty R1 600 000

Capital gain in our scenario R 4 500 000 – 216 000 (part donation) = R4 284 000 – 40 000 x 40% x 45%= R763 820 capital gain tax.

An expensive exercise only because of the clause in the agreement or, an overvalued policy that is not considered.

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