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The Actuary The magazine of the Institute & Faculty of Actuaries

Taxation of long-term business

Long-term business is defined in the Insurance Companies Act 1982. For tax purposes it is
divided into the following categories:
– Life assurance business, which is itself split into:
basic life assurance and general annuity business (BLAGAB);
pension business (PB);
overseas life assurance business (OLAB);
life reinsurance business (LRB);
individual savings account business (ISAB).
– Other long-term business, principally permanent health insurance (PHI), capital redemption business (CRB), and pension fund management (class VII).
It is important to note that, in a tax context, the expression ‘life assurance business’ includes PB, OLAB, LRB, and ISAB, as well as BLAGAB.

Bases of taxation
Trading profits
The conduct of insurance business is a trade, but for tax purposes a company writing life assurance business is treated as having a separate trade from other insurance business, including other long-term business. The Inland Revenue has the option (the Crown option) to tax life assurance business on investment income and chargeable gains less expenses (the I minus E basis), more or less as if it were the business of an investment company. It would be most unusual for the Inland Revenue not to exercise the Crown option and it has indicated that it will normally only do so if the income and chargeable gains on the I minus E basis are likely to be persistently lower than the taxable profits on a trading basis.
One special circumstance where the Crown option cannot be exercised is with a pure reinsurer. Such companies are always taxed on trading profits.
An important feature of the life assurance tax regime is that the basis of determining the trading profit is the surplus in the regulatory returns, rather than the profits in the Companies Act accounts. This reflects the legal restriction on the distributability of profits by reference to actuarial surplus. PHI and class VII business are, however, taxed on the basis of the Companies Act accounting profits, although class VII business is often aggregated with PB and treated as life assurance business for tax.

Notional case I
When the Crown option is exercised, special provisions ensure that the profits on the I minus E basis are at least as great as the taxable profits on a trading basis. The mechanism for achieving this is commonly known as the notional case I test, because it involves calculating the trading (case I) profit and deferring relief for expenses in the I minus E computation so as to achieve equality of profits.
For the purpose of this comparison, BLAGAB franked investment income (UK dividends plus tax credit) is included as the top slice of the I minus E figure. Franked investment income is also treated as forming part of the notional case I profit. Normally, this franked investment income is derived by multiplying the BLAGAB franked investment income by the ratio of the notional case I profit to the investment return less expenses and interest taken from the revenue account in the regulatory returns. If, however, this ratio would give a result greater than 1 or less than zero and there is a notional case I profit, the ratio is treated as being 1, and the whole of the BLAGAB franked investment income is treated as the top slice of the notional case I profit.
The notional case I profit is determined after deducting the cost of bonuses and any tax on I minus E profits in excess of the notional case I profit itself. The notional case I test is only applied in the computations of a proprietary company and not in those of a mutual.

Policyholder taxation
The principal effect of the use of the I minus E basis is to tax the investment income and gains arising from the investment of policyholders’ premiums, thus ensuring that the fund out of which claims will be paid has borne taxation. This in turn means that many policyholders do not need to be taxed when the policy proceeds are received. The policyholder tax regime reflects this and only imposes tax at the higher rate. Certain regular premium policies lasting more than ten years are exempted from this higher rate tax.
The taxation of investment income and gains is not applied to categories of life assurance business other than BLAGAB in the case of PB and ISAB as a matter of public policy, in the case of OLAB because the policyholders are not resident for tax in the UK, and in the case of LRB because tax on investment income and gains is applied in the cedant not the reinsurer. PB, OLAB, LRB, and ISAB are therefore taxed only by reference to surplus available for shareholders. Strictly, this would be a trading profit, but if the Crown option is exercised and the I minus E basis is applied, it cannot technically be case I and is described as case VI. PB, OLAB, LRB, and ISAB may be described collectively as the case VI businesses. In contrast, CRB, which is not strictly life assurance business, is taxed as if it were BLAGAB. BLAGAB expenses may only be relieved against the investment income and gains of the BLAGAB business and not against case VI profits of other categories of life assurance business.

Three broad bases of taxation are thus generally applied to long-term business:
– taxation on trading profits as shown in the modified statutory accounts for PHI and some class VII;
– taxation on surplus as shown in the regulatory returns for pure reinsurance, PB, OLAB, LRB, and ISAB; and
– taxation on income and chargeable gains less expenses of management for BLAGAB and CRB.

Rates of tax
Four rates of tax are currently applied in the tax computations of companies writing long-term business:
– The full rate of corporation tax (30% for 1999/2000 and 2000/01) is applied to PHI and class VII profits and to the I minus E profit up to a maximum of the notional case I profit less any part of the BLAGAB franked investment income treated as forming part of it.
– The basic rate of income tax (23% for 1999/2000 and 22% for 2000/01) and the savings rate (20% for 1999/2000) are combined to give a rate of policyholder tax which is applied to the remainder of any I minus E profit. The combination is a weighted average by reference to chargeable gains, rental income, and case VI profits treated as taxable at the basic rate and the balance of the investment income treated as taxable at the savings rate.
– A tax credit rate (10% for 1999/2000 and 2000/01) is applied to convert UK dividends to franked investment income. Franked investment income is only now required in connection with notional case I profits and as the top slice of the I minus E in undertaking the comparison form the notional case I test. Apart from those referable to ISAB, the tax credits here cannot now be repaid, although until 2 July 1997 repayment was made of tax credits referable to PB or where expenses of management were relieved against BLAGAB franked investment income.