This article was first published in the third-quarter 2015 edition of Personal Finance magazine.
In the past, it was common practice for employers to provide employees with medical scheme cover for themselves and their dependants as part of remuneration packages. In many cases, it was part of the contract of employment that the company would continue paying medical scheme contributions in retirement. Even if an employee died in employment, contributions would continue for his or her dependants.
Accounting practice now requires provision for this future liability to be made in the company’s financial statements. This can be onerous, because the calculation of the liability is dependent on factors such as inflation, expected future returns on investment, the life expectancy of beneficiaries, and so on. Since these factors are variable, they introduce uncertainty into the financial statements. In order to promote more certain cash flows and to minimise management involvement in non-core business, most companies have stopped offering post-retirement medical scheme subsidies.
Not surprisingly, many companies that are already committed to subsidies would like to remove the liability from their balance sheets. One way of doing this is to compensate employees by way of a once-off lump-sum payment in exchange for relinquishing their right to monthly medical scheme subsidies in future. The lump sum is intended to provide additional pension benefits on retirement to cover the medical scheme contributions that the employees will be required to make in retirement.
In March 2015, the South African Revenue Service (SARS) issued a binding class ruling (BCR 045) dealing with the taxation of post-retirement medical scheme benefits where such benefits have been cancelled and replaced with a once-off contribution to the employees’ pension funds. BCRs are guidance issued by SARS to provide clarity about the application of tax law to a specific group of persons in respect of a specific transaction.
The company that applied for the ruling offered its employees a once-off additional contribution to their pension funds in exchange for their agreement to the company being released from its obligation to fund medical scheme contributions. The lump sum is an actuarial calculation using estimates of expected future medical inflation, investment returns, and so on. There is no guarantee that the lump sum will generate an additional pension that will be sufficient to cover future medical scheme contributions. On the other hand, the additional pension could turn out to be more than is required to cover the contributions.
Generally speaking, benefits paid by an employer to an employee, including contributions to pension funds and medical schemes, have fringe benefit and other tax implications. However, in terms of this ruling by SARS, the once-off additional lump-sum contribution to the pension fund will not give rise to:
* A taxable fringe benefit;
* A taxable lump sum in respect of services rendered; or
* A taxable amount received in commutation of amounts due under a contract of employment. (“Commutation”, in this case, means substitution of an upfront lump sum for a series of regular payments.)
This is useful, because it indicates that a lump-sum payment into a pension fund in lieu of a post-retirement medical scheme subsidy will not be taxed. The ruling is valid for three years from March 12, 2015, but it cannot be relied on by any other group of taxpayers without a ruling being made for their specific case. The rulings are published for transparency and provide an indication of the direction SARS is likely to follow in respect of similar transactions. Note that BCR 045 applies specifically to employees of the applicant company who were in full-time employment at January 1, 2007 and who are still employed by the same company at the time of the transaction. No mention is made, for example, of retired employees who might already be receiving the subsidy.
Employees with a post-retirement medical scheme benefit can expect to be approached by their employers with a view to ending the company’s obligation. It is important that the variables used to calculate the lump-sum compensation are reasonable in light of expected future conditions and that the lump sum is sufficient to cover the employees’ expected future medical scheme contributions. Medical inflation, in particular, is an important consideration. Several surveys have shown that medical costs have increased at a higher rate than the Consumer Price Index.
* Kari Lagler is a registered tax practitioner.