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The Actuary The magazine of the Institute & Faculty of Actuaries
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Taxing times for Solvency II

On 10 March 2010, HM Treasury and HM Revenue & Customs (HMRC) issued a formal consultation document (Consultation) on the taxation of insurance companies under Solvency II. The taxation of life companies is at present based on regulatory reporting, including the use of ‘regulatory surplus’ as currently reported in the Financial Services Authority’s return to define shareholder profit. The regulatory returns will change so changes will be needed to the life company tax system.

Since a reporting regime should have no impact on income, gains and expenses, it was generally considered that the current income-expenses (I-E) regime (which is effectively the sum of shareholder profits plus policyholder profits, hence the logic of the regime) would continue. However, the Consultation also notes the complexities of the current system and the potential for market distortion caused by certain contract types and HMRC wishes to canvas views on the desirability of wider reform to the taxation of life companies, in particular the future of I-E.

Various methods of determining taxable profit (regulatory surplus, UK GAAP, IFRS) serve to vary the timing of tax payable but not the amount. The Consultation proposes the use of statutory accounts (rather than Solvency II movements in own funds) as the basis for computing the trading profits of life companies. The Consultation seeks views on:
>> The implications of the proposed move to using company accounts as the basis for computing trading profits of life companies
>> The desirability of wider reform to the taxation of life companies, in particular the future of I-E.

The Consultation also refers to the tax impact of Solvency II on reserves maintained by general insurance companies, but this aspect is not covered in this article.

Taxation of shareholder profits
The Consultation proposes the use of profits as reported in statutory accounts as the basis of determining taxable shareholder profits. Currently, it is unclear how statutory accounts will be affected by the introduction of the Solvency II regulatory reporting regime since there is clearly no current reference in current accounting standards or the IFRS Phase II proposals for insurance contracts that refer to the Solvency II proposals.

Should it be possible to use the policy provisions as currently proposed for Solvency II in the statutory accounts, the profit emerging year on year will reflect the changes to the capital position of a company, as in Figure 1.

For some products it is possible that the technical provisions (best estimate liability including risk margin) will be less than the current statutory reserve. Unit-linked policies are likely candidates. Conversely, for other products it is possible that the technical provisions will be more than the current statutory reserve. Annuity policies may have this feature.

The Phase II accounting standard for insurance contracts may modify this assessment of policy provisions, although there is no discussion of this currently. One potential issue may be the recognition of profits at the issue of a policy under Solvency II, even though those profits would be extinguished if the policy were immediately surrendered. Such profits recognised under Solvency II may not be distributable and perhaps also not taxable, in which case they would need to be identified.

If Solvency II provisions are recognised as a suitable basis for statutory reporting and hence taxation, it is possible that the increased sensitivity to long-term assumptions, such as persistency and equity market growth, will increase volatility of taxable profits. This feature, combined with the asymmetric nature of taxation (profits taxed immediately; losses are carried forward), may lead to significant distortion of tax revenues, probably with a net benefit to the Exchequer, especially if losses become orphaned.

Taxable profits for non-insurance companies are derived from accounting profits subject to adjustments. It will be necessary to consider whether any of these adjustments should be applied to insurance companies and whether there should be additional or alternative insurance company specific adjustments. In particular, HMRC does not envisage taxing the Fund for Future Appropriations or Unallocated Distributable Surplus (UDS) as profit although the future of the UDS is uncertain pending completion of the IFRS Phase II consultation and implementation process.

Developments in accounting standards are ongoing and the implementation of IFRS Phase II will happen later than the introduction of Solvency II. Transitional arrangements may be needed each time either the accounting or regulatory basis changes.

Wider reform of I-E
The above comments refer to ‘shareholder profits’. In reality, the taxation of life companies is applied to the total of income less expenses (the I-E calculation). The resulting taxable profit is then divided between shareholders as discussed above (taxed at the full corporation tax rate of 28%) with the balance attributed to policyholders (effectively viewed as their taxable income and gains on Basic Life Assurance and General Annuity Business or BLAGAB and so taxed at 20%). In this calculation, shareholder profits on gross rollup business (pensions, reinsurance business, and so on) are added to the ‘income’, and actual income and expenses on this business are ignored.

The Consultation does, however, note the complexities of the current system. Although the advent of Solvency II does not necessitate a move away from I-E, it does provide an opportunity to rethink it. No concrete proposal for an alternative is made, however there was a proposal in the life assurance tax consultation of 1988 for an approach entitled Schedule X. The idea was to tax life assurance business in two separate components:
>> A charge (at corporate tax rates) on shareholder trade profits (the former ‘Case I’ profits)
>> A separate charge (at a rate to be determined) on investment returns as they accrue for the benefit of policyholders.

One concern HMRC raises in connection with the current regime is the tax synergy that arises where protection and savings (life) businesses are written in the same company. Typically, protection business generates more E than it does I, and that excess in the I-E calculation can be offset against the savings business income (policyholder profits that the revenue wishes to tax), reducing the overall I-E result and hence tax payable. Companies that cannot secure this tax synergy are placed at a competitive disadvantage when writing protection business. HMRC might see Schedule X as removing this disadvantage and generating more tax for the Exchequer.

If Schedule X was introduced, the key impacts for life companies might be:
>> Significant financial impact on the profitability of in-force protection and savings business
>> Possible reduction in the scope to utilise existing unused tax losses
>>New entrants into the UK protection business market (particularly overseas companies) who were previously deterred by not having a large UK savings book to access the tax synergies
>> Upward pressure on new protection premiums caused by loss of tax relief, only partially offset by downward pressure if new entrants significantly increase competition
>> A changed competitive landscape for life savings products compared with other products, such as collective investment schemes
>> Potential ‘treating customers fairly’ consequences in respect of existing savings policyholders
>> Systems implications to ensure compliance with the new regime.

Furthermore, moving to a Schedule X basis would introduce significant new transitional complications that could not realistically be resolved either for legislation to be enacted or for consequential systems changes to be implemented by the end of 2012. An alternative approach might be for HMRC to treat new protection business on a gross basis within the current regime — this would alleviate much of the concern over the consequences of wholesale replacement of I-E while removing the potential distortion in the protection business market.

2010 Budget — apportionment of income
The Budget included further detail on anti-avoidance measures in relation to investment reserves held in non-profit funds of insurers with significant with-profit business. Investment reserves within such nonprofit funds typically arise in companies where shareholder-owned capital, often arising from estate attributions, is held back to support capital requirements or to enable a riskier investment policy.

Increases (or decreases) in the investment reserves are not taxed immediately. Instead, tax is generated when the investment reserves are ‘brought into account’ on Form 40 of the FSA returns, either to support mathematical reserves or to fund a distribution of surplus to shareholders. The amount of tax paid when this happens depends on the mix of liabilities between life, pensions (gross roll-up) and permanent health insurance business.

HM Treasury published a ministerial statement in July 2009 that referred to instances where companies had sought to minimise the tax payable by manipulating the mix of their liabilities. The intention to stop this happening was made clear and the Budget statement included more information on how this will happen in practice.

In essence, the investment reserves as at 31 December 2009 will be ring-fenced so that any subsequent distributions of those reserves will be taxed using the mix of business that applied at 31 December 2009. Similarly, any distribution of investment reserves generated after 2009 will be taxed using the mix of business in the year the reserves were first generated, on a ’last in, first out’ basis.

These rules are not relevant for investment reserves within the with-profit funds themselves. They also do not apply to companies with no with-profit business at all, since for those companies any investment reserves are brought into tax in the year that they are generated. The rules have been enacted in the Finance Act 2010.

What’s next?
The consultation has been published on the HM Treasury website at www.hm-treasury.gov.uk/consult_eusolvencydirective.htm. The Consultation closes on 2 June 2010 and responses will be used as a basis for further discussions with interested parties. It is envisaged that legislation will be in the Finance Bill 2011.

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Trevor Fannin (pictured) and Andrew Rendell are both members of the Faculty and Institute Tax Working Party