- Measures affecting life and general insurance companies
- General insurance companies and Lloyd's corporate members
- Life insurance measures
The Chancellor restated his commitment to make the UK the most competitive tax system in the G20. The insurance sector will be keen to see this commitment delivered upon.
Positive announcements for UK business, and the UK insurance industry, are the 2% reduction in the corporation tax rate from 1 April 2011 to 26% and the ultimate reduction in the corporation tax rate to 23% in 2014. This headline corporation tax rate is one important element in delivering a competitive tax system. Companies will also have to consider the deferred tax implications.
Foreign profits reform is also continuing, and is another fundamental component for insurers. Draft legislation has previously been released on foreign branch profits of UK companies and on the interim improvements to the controlled foreign company ('CFC') regime. One improvement announced to the foreign branch profits legislation is that, following industry representations, long term insurance business that is not BLAGAB will now be eligible to quality for the proposed opt-in exemption. We will, however, have to wait for the Finance Bill next week to see the revised detailed legislation, including the form of interim anti-avoidance provision, pending the final CFC reform (at which point the branch anti-avoidance legislation is likely to be aligned with the CFC rules).
In respect of the CFC rules, the Government's main announcement was an improvement to the proposed finance company partial exemption resulting in a reduction in effective rate to 5.75%, as a result of the change in imputed debt equity ratio to 1:3 from 1:2 and the reduction in the main corporation tax rate to 23% from 2014. This is a positive step and work on the final CFC regime continues with a consultation document due in May. A number of key issues for the UK insurance industry need to be resolved and the industry will need to contribute to the process to help deliver a competitive regime. Key issues that remain to be resolved include the treatment of intra-group reinsurance companies, and how these can qualify for exemption from a CFC charge; and what criteria could be used to determine whether any 'excess capital' (which could in principle be subject to the CFC regime) is an insurance or reinsurance company. The specific insurance tax measures affecting life and general insurers are discussed in more detail below. At headline level however:
- Life protection business written from 2013 will be taxed on a profits basis rather than within the I minus E regime;
- The framework for the post Solvency II life tax regime has been announced;
- Further consultation is proposed on whether and how to continue with Claims Equalisation Reserves for general insurers;
- The timing rules for member-level reinsurance premiums paid by Lloyd's corporate members are likely to change in Finance Bill 2012.
A number of measures that were previously announced have been either confirmed or changed. Of general interest are:
- The corporation tax rate will now fall to 26% from 1 April 2011, after which it will fall in 1% increments to reach 23% from 1 April 2014;
- A number of changes were announced to the draft legislation in respect of the taxation of overseas branches and the interim improvements to the controlled foreign companies ('CFC') regime. (The amended legislation will be available when Finance Bill 2011 is published on 31 March.) The life insurance industry will be pleased that long term business that is not BLAGAB will now be eligible for the proposed opt-in exemption regime for profits of foreign branches of UK companies.
- The consultation in respect of the revised CFC regime remains ongoing. The Government has announced that a consultation document describing the new regime will be published in May 2011 with draft legislation in the autumn of 2011, for inclusion in Finance Bill 2012. In the informal consultation, the effect of the finance company partial exemption would have been an effective UK tax rate of one third of the full corporation tax rate on profits derived from overseas financing arrangements. Today's announcement reduces that to one quarter.
- The annual limit for receiving pension tax relief will be reduced from £255k to £50k, with the lifetime allowance falling from £1.8m to £1.5m;
- The effective requirement to annuitise by age 75 will finally be removed;
- A technical amendment to Life Insurance Apportionment Rules - s432C(9) has been confirmed; this reduces the number of cases where the denominator is nil.
Comment: The further reduction in corporation tax will be welcomed by industry, as will the measure bringing non-BLAGAB long-term business within the foreign branch profits exclusion rules from the start of that regime.
3. General insurance companies and Lloyd's corporate members
3.1 Claims Equalisation Reserves
The Government has announced that it proposes to move forward the discussion on Claims Equalisation Reserves ('CER') for general insurers over the spring and summer 2011. The relief needs to be reconsidered as it is based on a regulatory requirement that will disappear under Solvency II. The Government has said that it recognises there may be a need to take account of the volatile nature of business to preserve the effectiveness and competitiveness of the UK tax system and that is minded to legislate to retain a CER tax relief provided the industry is able to provide a robust justification for its retention. If it does not continue the relief, legislation will be introduced to bring the reserves back into tax over a transitional period of 6 years. The case for CER retention will be reviewed again when possible volatility implications for Phase II of IFRS4 accounting standards Insurance Contracts become clear.
Comment: It is good news that the Government is still open to the retention of a CER tax relief following the move to Solvency II and that, even if they are repealed there will be a 6-year transitional period. The 'robust justification' will however need to be based on the volatility that is inherent in certain types of business, rather than the insurance cycle. The possible outcomes from further discussions include either retention of the existing rules and 'tax only' rules, or a new set of CER rules both for general insurance companies and Lloyd's corporate members that are modified to be better targeted on the tax policy objective.
3.2 Lloyd's Corporate members member-level reinsurance
HMRC have recognised that their current guidance in the Lloyd's Manual is incorrect and that under existing law insurance premiums ceded by Lloyd's corporate members (so-called 'member level' premiums) are deductible in accordance with the normal accountancy principles subject to any specific statutory provision. HMRC will be amending their guidance shortly. However, they have stated that they will be consulting during 2011 with the intention of introducing legislation in Finance Bill 2012 to align the timing of deduction with the recognition of the profits to which they relate.
Comment: This is a long-running issue and the intention to legislate is to bring the law in line with the interpretation that HMRC took at the beginning of last year. There may be significant cash flow implications for some Lloyd's members which have been taking deductions on a calendar year basis, and the period of consultation beginning April 2011 will give affected parties an opportunity to make suitable representations.
As expected, the framework of the life tax regime, which will apply from 2013 and the introduction of Solvency II, was announced. In the main, the framework is largely as expected and as the industry had lobbied for. There remains much detail to be worked through in the next phase of the consultation process to develop the framework through to draft legislation.
The Government has also announced that from 2013, new life protection business will be taxed on a profits basis rather than within the I minus E regime. Again, this announcement follows a consultation process, but it is a matter on which the views of the providers of this business were divided. Some will welcome this change; others will be disappointed. Again, the detail of the change remains to be developed.
Finally, acting on advice from the Office of Tax Simplification, the Government has announced a proposal to abolish LAPR, subject to further consultation. A number of other policyholder taxation provisions were also reviewed and retained.
We discuss here measures that affect life insurance companies in the following order:
- The taxation of protection business
- Solvency II tax regime
- Office of Tax Simplification - final report on reliefs
- Venture Capital investment partnerships
4.1 The taxation of protection business
Life protection business written on or after 1 January 2013 will be taxed as part of a single trading profit computation for business other than BLAGAB, rather than under the BLAGAB I minus E. There will be consultation on how 'protection business' should be defined for this purpose, and what special provisions may be required around commencement, including provisions dealing with variations of pre-1 January 2013 policies. Pre-existing protection business will continue to be dealt with under the I minus E regime.
Comment: There has been a very wide divide amongst industry players as to whether the treatment of protection business should change. Those arguing for change say that it would provide a more competitive playing field, as well as increasing Exchequer yield. Opponents of change note that it would mean higher policyholder premiums, and question whether the playing field really would be level. We now have a clear statement from the Government that there will be change. The Red Book shows a benefit to the Exchequer of £60m in 2013-14 rising to £90m in 2014-15 and £120m in 2015-16.
4.2 Solvency II tax regime
As noted above, the framework of the life tax regime that will apply from 2013 was announced. Whilst there is a lot of material to cover under this heading, it is important to note that there is still significant detail to be developed to move from this framework to draft legislation. On many issues we do not yet have the full picture, and there will be unexpected gaps and issues that companies will have to work through, and lobby on where appropriate.
We approach our discussions systematically in this order:
- Summary of the key decisions;
- Other decisions and confirmations;
- Our commentary on the overall effect of those decisions;
- The way forward and the April 2011 consultation document.
1. Summary of the key decisions
- As already indicated in the March 2010 ConDoc, and confirmed today, from 2013 trading profit computations will be based on the pre-tax results in the financial statements.
- Gross Roll-Up Business will be merged with PHI, with this expanded GRB/PHI category taxed under a normal trading basis (s35 CTA 2009). GRB and PHI losses brought forward into the new regime can be utilised against future GRB/PHI profits, possibly with streaming of pension business and PHI losses. Protection business written from 2013 will also be part of this category.
- The minimum profits test and the tax rate calculation will compare BLAGAB I-E with BLAGAB trade profits. A proportion of life insurance trade losses brought forward into the new regime will convert to BLAGAB trade losses for use in the minimum profits test.
Comment: These two related measures are billed as a simplification. They also represent a fundamental change in the way the life tax computation will work. In particular, the expanded GRB/PHI will be subject to all the normal trading profit - and trading loss - rules. In practice, the loss rules may be the most important - GRB losses will be capable of relief; on transfers of business, loss streaming rules will apply. Companies will welcome the statement that pre-2013 GRB losses can be utilised against post-2012 GRB/PHI profits - although there is clearly a debate to be had with HMRC over streaming. Companies will also be keen to ensure not only that they obtain full value for GRB losses brought forward into the new regime, but that they obtain that value at an early opportunity. Exchequer cost may well be an issue here. The statement gives less clarity in respect of BLAGAB trade losses - it is not clear that all life insurance trade losses referable to BLAGAB will become BLAGAB trade losses, nor why those BLAGAB trade losses should not be available in the tax rate computation.
- Investment return will be allocated on a factual commercial basis insofar as possible. HMRC recognise that different companies will have different commercial methods of allocation, and so no one methodology will be prescribed. To provide some certainty, it is stated that companies will have the opportunity to discuss their methodology with their HMRC Customer Relationship Managers before the relevant tax returns are filed. If an agreed factual approach is not feasible or appropriate, companies will default to a simple (but not yet specified) statutory rule. There may be a need for special rules to deal with BLAGAB chargeable gains and profits arising from non-profit business written in with-profit funds. The Government will consult on how all of this is to be achieved.
Comment: This is a real potential game-changer. Alignment of the tax and commercial allocation rules would significantly reduce the distortions between the tax and commercial measures of profits and thereby facilitate commercial understanding of the tax consequences of proposed transactions, products, pricing decisions etc. Companies will need to consider the impact of the new rules on their current models. Issues to consider include whether models should be amended or re-built from scratch, whether the new regime offers the opportunity to consolidate different tax models used within a group into a smaller number of coherent models - and when the company expects to have sufficient information to make those decisions.
The consultation process will be important - there is a lot to be determined in a short timeframe, and within the industry there will be winners and losers. Companies should seek to identify their lobbying position early so they can take an active part in the consultation.
We are disappointed that HMRC seem to continue to misunderstand the commercial reality of non-profit business within with-profit funds. The trading profit arising on the fund as a whole belongs (as to 90% or the appropriate participation ratio) to with-profit policyholders, and should be apportioned on the bonus ratio.
- Transitional rules will provide for a factual allocation of adjustments related to deferred acquisition costs and deferred income reserves, with a ten year spread for other adjustments. The ten year spread will apply in respect of amounts that, as a result of Court Schemes, have been recognised as profits in the financial statements, but not as surplus in the FSA return. This is subject to a two year deferral where there is a bar on the grandfathered amounts becoming available to shareholders. There will be consultation on whether similar rules are necessary for new Court Schemes.
Comment: The transitional rules are better than many in the industry expected, although there will be disappointment that the industry proposal of tracking (on a factual or actuarial basis) of amounts whose reversal could be so tracked has apparently been dismissed out of hand. A ten year spreading rule is at the upper end of precedents in other legislation (such as the loan relationship change of accounting basis rules). A factual rule for DAC and DIR is only partly in line with industry representations, which suggested having an elective factual rule for everything that could be factually tracked.
The aspect of the rule for Court Schemes that taxes amounts that will never become available to shareholders will be unwelcome, and it is unclear what the underlying policy reason for this is.
2. Other decisions and confirmations
- Shareholder and long-term insurance funds are to be merged from 1 January 2013 - subject to grandfathering of shareholder fund assets and structural assets of the long term insurance fund. For new assets, a 'first principles' basis will be applied to determine whether they are trading or investment assets.
Comment: This decision will disappoint those who had hoped that internal records could form the basis on which to continue to recognise a separate shareholder fund.
- The FFA/UDS will be deductible
Comment: The real interest will be in whether a FFA/UDS deduction will be available after the introduction of IFRS 4 Phase II, on which the Government refuses to be drawn until there is more certainty about the accounting regime.
- There will be a deduction for policyholder current tax, tied into the amount of cash tax paid at policyholder rates. However, the Government would be willing to consider an approach which includes deferred tax if the industry can, in consultation, put forward a method which fully meets the principle that it should be simple, consistent between companies, transparent, and reflect tax payable at policyholder rates.
Comment: We remain concerned that the Government appears to have set its face against a deduction for policyholder deferred tax in advance of detailed consultation. The overwhelming concern seems to be for simplicity and for a mechanism that can be applied to all companies. Many will be concerned that to disallow in full deferred tax movements on 'policyholder' items will result in a distorted profit measurement.
- The dividend exemption will not apply to GRB within the combined GRB/PHI trading profit computation. The Government will consult on the treatment within the new category of dividends relating to what is now PHI.
Comment: The industry had been lobbying for the shareholders' share of GRB dividends to be exempt, and will be disappointed that the Government has not accepted that recommendation. We note though, that general insurance currently is the only financial trading activity where dividends are exempt, and the proposed treatment of GRB dividends in the new regime maintains that position.
- Transfers of business rules to be simplified - follow the accounts for third party transactions, 'step-in-shoes' rules for connected party transfers. Additional rules may be necessary where the transfer is to a non-UK resident company but not to its UK permanent establishment
Comment: This will be a very welcome simplification that should significantly reduce the amount of tax work required for Part 7 transfers.
- The Government will consult to explore further the extent and impact of unpredictable volatility of I-E results and its effect on the interaction between I-E and the BLAGAB trade profit, and if appropriate explore options for reducing I-E volatility. The Government recognises that there is likely to be volatility in trade profit computations after the introduction of IFRS 4 Phase II, and will consider the impact of that volatility in conjunction with the industry once the content and timing of IFRS 4 Phase II is clear.
Comment: It is clear that the onus is on industry to justify why any measures to deal with I-E and trade profit volatility are required - but equally clear that Government has not shut the door on further discussions.
- There is a clear statement that the Government does not intend that there should be any change to the principles underlying the tax treatment of mutual business as a result of Solvency II. The tax-exempt businesses of friendly societies will be unchanged.
Comment: This announcement will be important for mutual insurers and friendly societies, who will now be looking to ensure that detailed legislation is fully consistent with this Ministerial decision.
- There will be no special provision for untaxed surplus originating in mutual companies and now held in proprietary companies (ie the demutualisation surplus rules will be repealed and not replaced). Any untaxed unappropriated surplus will fall within the scope of the transitional provisions outlined above.
3. Our commentary on the overall position
Taken as a whole, these proposed changes, when enacted, could represent a fundamental simplification of life insurance taxation. There is an opportunity - if new legislation is drafted with simplicity, rather than the complexities of the past, in mind - to have a set of tax rules that can be understood by those who are not life tax experts. More importantly, three announcements - merging GRB into PHI, making the minimum profits and tax rate tests BLAGAB-only comparisons, and using commercial allocations of investment return - should make it much easier for actuarial, accounting and other departments to understand the tax environment and tax risks a UK life company is subject to.
Particular benefits include:
- Greater transparency from using financial statements as the starting point (and fewer deferred tax issues, especially post-transition);
- Better product design for non-linked products (as tax effects can be more readily understood by actuaries);
- Easier to monitor post-tax product profitability;
- Tax consequences of transactions easier to understand - for actuaries, the Board, and investors;
- Tax attributes will better reflect the commercial position - the GRB result won't impact the BLAGAB result, and vice versa;
- Easier governance of tax - as a company can more readily understand its own tax risk.
There are, however, a number of issues that will have to be grappled with:
- Systems and tax models will have to be developed to deal with the new trading profit and investment return methodology. These will be complicated for some companies - particularly the larger ones. There may also be arguments - both internal and with HMRC - about what a commercial allocation is, and how it ties in with Solvency II calculations. Companies will have to be able to prepare deferred tax calculations under the new rules in 2012, which may include large deferred tax amounts in relation to transitional adjustments. However, once they are up and running, annual maintenance should be easier.
- How stable will tax attributes be? At present there are no proposed measures to deal with I-E or trading profit volatility. The Government is open to being persuaded that some measures are needed, but industry will have to justify any particular measure.
- Transitional rules could have a significant cashflow effect, even with a ten year spread. This will need to be understood quickly, especially if the company wishes to lobby HM Treasury about the details.
- Consideration will have to be given as to what extent tax models need to be amended or re-built. This will in part depend on their complexity and what they are intended to do. Certainly the tax inputs will have to change to take account of commercial allocations. From now on, EV models, for example, should probably take account of the new tax regime.
- Companies writing protection business will need to put in place systems to identify post-31 December 2012 protection business.
- Companies will need to determine whether adjustments need to be made to how they are building the tax rules into their Solvency II provisioning calculations in the light of today's announcement (and how to adapt those calculations as more information becomes available over the summer about the new regime).
- Not only the tax department, but actuarial, accounting and other departments will need to be briefed on the new regime. The tax department will also need their input to inform the next stage of consultation and lobbying.
- Soon after the introduction of the Solvency II regime, IFRS 4 Phase II, and other revisions to IFRS standards, will go live. The effect of these, including any relevant transitional rules, will be of interest to tax departments. But even before those changes, in order to estimate the size of the potential Solvency II transitional adjustments, companies will need to compare their FSA return provisioning basis with what they expect to be the provisioning basis in their post-2012 financial statements (which may well be different from the provisioning basis currently used).
4. The way forward
Today's announcements were made in response to a request by industry for greater direction in respect of key points. This was required so that companies could properly prepare for the new regime. Now we have the Minister's decisions on the direction of travel, it will be important for companies to make the most of the available time to ensure that they are fully ready for the new tax regime. As discussed elsewhere in this Bulletin, it is not enough for tax departments to know the new rules; these have to be communicated to actuarial and accounting colleagues in order for the consequences to be fully understood.
A lot remains uncertain. Detailed legislation for enactment in the 2012 Finance Bill will be published this autumn. Between now and then companies need to assess what today's announcement means for them, and which areas they want to lobby on. This may require some modelling of what the new rules will mean for them under a variety of scenarios. Effective representations need to be made. Tax departments will need to work with actuarial and other colleagues so that the new tax regime is properly taken account of in Solvency II calculations and programmes. Tax departments will have to start putting in place systems that will allow them to report deferred tax having regard to the new regime potentially from H1 2012. Projecting 2012 effective tax rates in 2011 will require some understanding of what the new regime means for accounting purposes as early as this year.
A further HMRC/HM Treasury consultation document will be published in April 2011, which will discuss the issues that we identify above as being subject to further consultation.
Alongside the formal consultation, HMRC will invite industry members, representative bodies and advisers to continue discussion of the issues. There will also be a programme of open meetings to consider specified issues. These open meetings will be based around an HMRC paper on the subject. There will also be a single working group constituted with a membership to be agreed with representative bodies. This group will consider, distill and refine outcomes from the open meetings so that all options are identified and their implications for industry are fully understood. It is also expected that the existing Friendly Societies and Mutuals working group will be retained - with it keeping its current role of identifying sector-specific implications arising out of the main discussions. The sector will also be keen to ensure that the Ministerial decision that Solvency II changes should not affect the tax treatment of mutuals as laid down in case law is properly reflected in the final legislation.
Alongside this, many companies will be wishing to enter into one-to-one discussions with representatives of HM Treasury and HMRC, who have indicated that they will welcome such bilateral discussions.
4.3 Office of Tax Simplification ('OTS') recommendations
As part of its review of current tax reliefs, the OTS considered a number of life policyholder tax measures. The OTS made the following observation in relation to insurance taxation:
As a general observation, we have to comment that the taxation of the life insurance industry and its products is one of the most complex areas of the tax code. It would be a clear candidate for an overall review with a view to simplification. But we do, equally, have to point out that the number of insurance companies is small, most have expert tax teams and extensive IT systems to assist them; and there would be a concern that any simplification might impact adversely on the considerable number of policyholders.
Only the future will tell us whether either the OTS, or the opportunities for simplification given by the necessity to draft a post-Solvency II corporation tax regime, help produce a less complex system of taxation policyholder reliefs. The OTS recommended retaining:
- The 5% rule (under which up to 5% of premiums can be withdrawn from a life policy without giving rise to an immediate chargeable event);
- Top slicing relief;
- Insurance premium tax ('IPT') exemption for life insurance.
The OTS recommended removing:
- Life insurance premium relief - after consultation with industry, to ensure, for example, that the OTS's understanding that this relief creates additional administrative burden for the insurer is correct;
- Relief for life insurance premiums paid by employers under E-FRBS;
- Payment for the benefit of family members (relief of up to £100 at the basic rate for contributions made to provide for the spouse or children of the individual);
- Relief, of up to £100 at the basic rate, for contributions for superannuation, life insurance or funeral benefits where the premium comes from police organisation or trade union subscriptions
The most significant of these would be the removal of life insurance premium relief. The Government's estimate is that the current annual cost of LAPR is £20m.
However, the OTS also noted that:
- Consideration could be given to excluding protection only life business from the IPT exemption. However this would raise complications such as distinguishing protection only elements within mixed contracts, addressing potential avoidance (and possibly adding a number of new insurers to the IPT register).
- Chargeable gains calculations for companies are complex and out of line with capital gains tax. The OTS suggests that the abolition of indexation should be consulted on, with areas to consider including whether it would be a simplification, and what alternative non-complex method could be used to exclude the inflationary element of gains. Most capital gains tax on share disposals is paid by insurance companies. The OTS asks, 'Could the simplification of these be swept into a wider reform of insurance company taxation?'
The Chancellor has accepted the OTS's recommendations in respect of the abolition of reliefs (with the exception of one relief not of particular relevance to insurance companies). No comment has been made in respect of IPT on life protection business, or on chargeable gains calculations for companies.
Comment: There would have been general alarm had there been a recommendation to do anything other than retain the 5% rule. The retention of the top slicing rule is also welcome - although, as the OTS said, it does nothing for those in the 60% marginal tax band that kicks in at £100k.
The £20m annual cost to the Exchequer of LAPR is not evenly spread within the industry. There are many companies for whom LAPR has largely run its course. For them, the abolition of LAPR would remove an administrative burden that may be disproportionate compared with the benefit provided to policyholders. However, for a small number of companies LAPR still provides a significant benefit to policyholders, often in relation to an industrial branch back-book with many policyholders on low incomes, and the systems to administer it are in place. Those companies are likely to press strongly for LAPR to be preserved in some form. The Budget announcement would not remove LAPR until at least 2012, with scope for the effective date of any removal to be later. This may thus give the framework for a continuation of the regime until the relief has run its course across those companies for whom it is still significant.
We also note the OTS's view that the IPT exemption does not sit easily for protection only products, but that it would be difficult to define them. With new life protection business being treated as GRB/PHI from 1 January 2013, from that date companies will have a mechanism for distinguishing protection and savings business. In theory this definition could also be for IPT purposes, either from 2013 or from a later date. Given that moving protection business to a trading profit basis is expected to increase policyholder premiums over time (or at least work against further efficiency-driven price reductions), any levying of IPT would present a double whammy for policyholders.
We agree with the OTS that chargeable gains calculations are complex, and many life insurance companies have had practical IT difficulties in complying fully with the tax rules. They are ripe for reform, and in the context of the wider Solvency II tax regime reforms the question has been raised about how to reduce volatility within the I minus E regime. Changes to the chargeable gains regime could be addressed as part of that exercise. However, the industry will be concerned to ensure that life savings products can compete against investment funds, many of which are exempt on their chargeable gains.
4.4 Venture Capital investment partnerships
- It has been announced that the Government will continue consulting on the viability of making changes to primary legislation to deal with the tax treatment of life insurance companies' investment in Venture Capital Investment Partnerships and other fund of fund investments
Comment: The practical difficulties of complying strictly with the legislation on taxing investments in Venture Capital Investment Partnerships are a long-standing problem for the industry. A sensible practical method of dealing with them would be welcome.