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The Actuary The magazine of the Institute & Faculty of Actuaries
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‘New accounting standard reduces published pre-tax profits’

A problem affecting pre-tax profits reported on a statutory, modified statutory, or an embedded value basis, is caused by a new accounting standard called FRS16 (Financial Reporting Standard 16). This new standard applies to all accounts prepared in respect of any company year ending after 23 March 2000.
This article considers some of the background to calculating pre-tax embedded value profits and reviews the possible impact of this new standard on the tax rate assumed for grossing up profits.

Grossing up profits
Many companies report profits on an embedded value basis. These profits are normally calculated net of tax and results have to be ‘grossed up’ using assumed tax rates to obtain pre-tax profits.
Standard actuarial practice calculates embedded values net of policyholder tax and deducts shareholder tax at the ‘marginal’ tax rate. This marginal tax rate is normally around 10% for life business profits, and the corporation tax rate (30% from April 1999) or slightly less for pensions business profits. The key issues relate to life business profits and so pension business profits are not considered further.
Simplistically, we could calculate the pre-tax embedded value by reversing the deduction for shareholder tax described above. However, the net embedded value is normally grossed up at the full corporation tax rate. There are three possible reasons for using the higher tax rate. First, the resulting pre-tax profits may be higher than by using the alternative. The second reason could be that 30% is the current rate of corporation tax, which is the rate of tax at which shareholders would expect their profits to be taxed. The third is that it is (almost) theoretically justified.

Sound basis
To illustrate the justification, consider profits arising in just one year on life assurance business. A classical actuarial viewpoint would be as follows:
– Life business is taxed on income less expenses (IE profit) at policyholder tax rates that are currently either 20% or 22%.
– Additional tax is payable on a notional amount of shareholder profit (NC1 profits), which is considered to be part of the IE profit, in order to raise the tax rate to corporation tax rates on these profits. This additional tax is the marginal tax referred to above.
– Since future NC1 profits are effectively the profits valued in an embedded value calculation, the value of future net shareholder profits needs to allow for this additional tax as well as the standard IE tax.
Hence there is a sound basis for the standard actuarial approach to calculating net embedded values.
However, an ‘alternative view’ is set out in the Inland Revenue’s Life Assurance Manual. This shows the I-E profit to be divisible between policyholders and shareholders as set out in figure 1 (left).
We can see that shareholders obtain their profits by deducting pre-tax investment income from policyholders. This implies that net shareholder profits are equal to the total pre-tax income deducted from policyholders, less tax at corporation tax rates. Hence shareholders’ pre-tax profits are equal to their post-tax profits grossed up at corporation tax rates.
Does this view apply in all circumstances? Consider the embedded value of a simplified unit-linked bond. All investment income is allocated to policyholder units. Shareholders’ profit is equal to the annual management charge. An actuary might argue that the charge is neither income nor expense and so is not taxed in the IE calculation, although the charge does increase NC1 profit. Surely this profit is only taxed at the shareholder marginal rate!
This ‘actuarial view’ would obtain the correct answer but it has not correctly identified the source of the profit. Figure 2 (across) reconciles this ‘actuarial view’ with the ‘alternative view’. Assume that a £10,000 unit-linked bond in the life business fund receives fully taxable income of 10% at the end of a year, pays an annual management charge of 1% at the end of the same year and that there are no expenses or other revenues.
Figure 2 shows that the ‘alternative view’ would consider an annual management charge of 1% to be a deduction from income of 1.25% which would then be taxed at full corporation tax rates.
In this example, the shareholders’ marginal tax rate is 12.5% but a lower rate normally applies when some of the income arises from UK equity dividends. Since the corporation tax rate applied to UK equity dividends is now 0%, no marginal shareholder tax arises on this income and so the marginal tax rate is normally an average of 0% and 12.5%.
Impact of the new FRS 16
This brings us to the change to accounting standards that require UK equity dividends to be reported net in both the Companies Act accounts and the statutory returns to HM Treasury.
Until the 1997 budget, UK equity dividends were paid net of tax but included reclaimable tax credits. The budget stopped most tax credit reclaims, and the value of the tax credit changed to 10% from April 1999. However, companies continued to report the dividends showing gross income (including tax credits) but with a tax charge that included the unrecovered tax credits. This justified reporting gross shareholder profits, including the value of tax credits.
However, FRS 16 says: ‘Incoming dividends should be recognised as the amount received or receivable without any attributable tax credit.’ (Paragraph 9)
This effectively treats UK equity dividends as non-taxable income, and the concept of tax credits becomes obsolete. Although this proposed standard is written specifically for reporting in annual Companies Act accounts, guidelines will require the same standards to be applied to HM Treasury returns.
Is this appropriate? Surely the dividend has been taxed at source and so tax already paid could be imputed into the account of the life assurance company. However, previous practice only imputed the value of tax credits at an assumed tax rate of 20%, rather than the full corporation tax rate ultimately paid by companies on their profits. Hence pre-tax life assurance profits have not reflected ‘true’ gross profits for some time, and this change simply removes all credit for tax paid at the source of the dividends.

Pre-tax embedded value profits
The principles for calculating pre-tax profit in one year should readily extend to embedded value profits. Embedded value is normally the difference between the values of two profit streams calculated at the start and end of the year, plus the profit emerging during the year, all net of tax. Tax implicit in the embedded value profits calculation could be:
– the implicit tax allowed for in the closing embedded value; less
– the implicit tax allowed for in the opening embedded value; plus
– the actual tax in the current year statutory profit.
However, there are likely to be differences between the bases and assumptions used in the calculation of the opening and closing embedded values, and the result of this calculation may not give a coherent figure for the tax that should be associated with the embedded value profit.

ABI recommendations
The ABI’s statement of recommended practice (SORP) on accounting for insurance business recognises these difficulties and recommends that net-of-tax embedded value profits should be grossed up to provide pre-tax profits. The grossing up should be at the ‘effective rate’ of tax but could be at the ‘full rate of corporation tax’ unless this produces a ‘material mis-statement’.
A suitable effective tax rate could be the average shareholder tax rate implicit in the closing embedded value calculation. This would be a weighted average of the rate of tax on UK dividend income and the full rate of corporation tax. However, the tax rate for UK dividends would need to be 0% to be consistent with the presentation in the Companies Act accounts.
Hence, unless the proportion of shareholder UK dividend income is a small proportion of shareholder profits, using a grossing-up tax rate of 30% may materially mis-state the pre tax profit result.
The ABI recommendation has an interesting consequence that may lead to a mis-statement regardless of the tax rates used. If part of the change in embedded value arises because of a change in the shareholder tax assumptions, then the post-tax embedded value profit may reflect this assumption change. This element of the profit would then be grossed up when calculating the pre-tax embedded value profit. However, the pre-tax embedded value profit should not be affected by changes to shareholder tax assumptions, and so there is clearly a mis-statement of the pre-tax result. This is particularly pertinent in view of the reductions to corporation tax rates that have occurred in the last few years.

Summary
FRS16 proposals may have a sufficient impact on average tax rates to force life assurance companies to reduce their assumed tax rates for grossing up embedded value profits. However, the impact on individual companies will depend on the materiality limits that are applied to their reported results.

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