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One of our clients, an independent financial adviser (IFA) operating as a sole trader, has just sold her business.
The purchaser was not prepared to take on responsibility for any claims in relation to business sold up to the date of the business sale. Our client, therefore, is obliged to take out run-off insurance cover to provide for any claim in relation to her time trading as an IFA.
The annual premium for this is approximately £4,000 and there does not appear to be any time limit on how long cover has to be maintained – presumably until her death. She is aged 62 at present, so premiums may have to be paid for a considerable time.
From my reading of FRS 12, it would seem that a provision is required in my client’s final trading accounts. The amount of the provision would appear to be the present value of all future premiums to be paid. I would then imagine that the tax treatment should follow the accounting treatment.
Readers’ views would be appreciated on whether my interpretation of FRS 12 is correct and, if so, how would I go about calculating the provision to be included.
Query 17,586 – Black Sheep
Reply from Thicket
Tax relief for post-cessation expenses is generally unsatisfactory. The relief is covered in ITTOIA 2005, Ch 18 and is given against post-cessation receipts only – rather than against profits of the final period of trading, which is where the relief really belongs.
It is certainly better, therefore, if at all possible, to make an accrual or provision in the final set of accounts for all possible expenses relating to the trade even though they might be incurred some time after cessation.
ITTOIA 2005, s 25 requires that profits of the trade must be calculated in accordance with generally accepted accounting practice (GAAP) as adjusted by the requirements of tax legislation. So there are both accounting and specific tax rules to think about.
Professional indemnity (PI) insurance will generally be an allowable expense against profits of the period to which it relates – it satisfies tax law as being of a ‘revenue’ (rather than capital) nature and the ‘wholly and exclusively’ test. (See HMRC’s Business Income Manual at BIM45515.)
But what exactly is the position for post-cessation run-off insurance?
The accounting standard for UK GAAP covering accruals, provisions and contingencies is FRS 12. A provision (defined as a liability that is of uncertain timing or amount) is recognised in the accounts when there is a present obligation (legal or constructive) as a result of a past event, and it is probable that a transfer of economic benefits will be required to settle the obligation, and a reliable estimate can be made of the amount.
Examples of provisions are given in the standard and include a warranty provision, where goods are sold with a warranty, and past experience has shown that future claims will arise in respect of goods sold before the year end. The second example is where a store offers a refund policy to dissatisfied customers. In this case a provision for refunds is recognised.
How does this apply to potential future PI claims? The past event was the sale of the financial product, and the present obligation is to meet PI claims.
I suggest that if the client is able to make a reliable estimate of the cost of future uninsured PI claims as at the end of the accounting period, then this could be included as a provision in the accounts.
This might be based on a history of such claims on which to base a reliable estimate – unlikely in most cases, I would suggest.
However, what we are really concerned with is the cost of insurance against such claims. Insurance is written on a claims notified basis.
The sale of the product is still the past event, but is there a legal or constructive obligation at the period end to incur the cost of run-off cover?
I am not sure about the position with IFAs, but certainly the ICAEW requires a member to maintain its compulsory insurance scheme for a minimum of two years after ceasing to practise – six years’ cover is recommended to give greater peace of mind in line with the Statute of Limitations.
The client will need to check the position with their regulator and any professional body. If there is such a requirement, then I would argue that this creates the present obligation for FRS 12.
Measurement can be satisfied by actual costs or quotes from a broker (assuming the cover is available).
Typically, run-off cover costs have risen recently in line with PI claims experience and now represent a significant cost on the sale of a business. A single premium for a number of years’ cover might be attractive, if this is available.
A cautious purchaser, not wanting to take on prior claims, may insist that the sale contract includes a term that the seller provides evidence that he has taken PI run-off cover. This suggests an alternative argument to support the legal obligation for such cover at the time of sale.
Reply from The Dude
If Black Sheep refers to HMRC’s Business Income Manual at BIM46520, he will be reassured that a provision can be included in the final accounts for the cost (or estimated cost) of the run-off insurance. BIM46520 explains that FRS 12 allows a provision ‘when and only when at the balance sheet date:
- the business is under a present legal or constructive obligation…;
- the obligation is as a result of a past event; and
- it is probable that there will be a ‘ transfer of economic benefits’ arising from the obligation...; and
- a reliable estimate of the amount of the provision can be made’.
Even if she does not have a legal obligation under the contract of sale of the business, it would seem that the IFA is under a constructive obligation to provide cover.
The obligation results from the past event of the sale of products. If sued, it is likely that there will be a ‘transfer of economic benefits’ as described above and finally, it should be possible to arrive at a reliable estimate of the costs of the premium.
