Interest on Deposit backs
Deposit-back arrangements are a fairly common security measure used by insurance companies in conjunction with a reinsurance contract as protection against risk of default by the reinsurer. Typically, the reinsurer deposits back an agreed amount with the main underwriter of the business, in the same way as a bank deposit, subject to a contractual rate of interest being paid by the main underwriter to the reinsurer over the life of the deposit. Depending on the structure of the reinsurance contract, the amount on deposit may be topped up or withdraw under specific conditions in the contract.
The Government has noticed that in certain cases, where the main underwriter is a life insurance company writing both pension business and ordinary life insurance business, there was scope for beneficial distortions in the way the interest under the deposit-back was deducted by the main underwriter. A particular example considered was where for instance large blocks of pension annuities were reinsured, and the pension business profits were covered by large losses brought forward because of past mis-selling provisions. Existing tax legislation operated to deduct a proportion of the interest from ordinary life insurance profits, resulting in a more attractive result.
The change will make sure that where the main underwriter is a life insurance company writing different categories of business, for instance, pension business and ordinary life insurance business, it may only deduct interest for tax purposes from the profits of the category reinsured.
The measure will apply to periods beginning on or after 1 January 2008 and ending on or after 12 March 2008, which means that for companies with calendar year ends they have immediate effect.
The aim is to put the underwriter broadly in the same tax position as if there were no deposit-back arrangement or there were an alternative security arrangement such as an escrow deposit which would not affect the profits of the main underwriter.
It is hoped that any distortions in the opposite direction will be corrected by the detailed legislation, which must be reviewed carefully.
Regulatory Waivers: targeted tax legislation for the life insurance industry
In certain circumstances, the FSA may grant an insurance company’s request for a waiver from the full effect of the Rules in its Handbook. However, because the corporation tax rules applicable to life insurance companies are firmly tied to the regulatory return in many instances, a waiver or modification could result in an unexpected tax distortion.
The Government will in future give consideration to whether regulatory waivers given by the Financial Services Authority to life insurance companies should be ignored if they are likely to result in a serious loss of tax to the Exchequer, indeed by making Treasury Orders to nullify the effect swiftly.
This introduction of secondary legislation on a case by case basis is a major departure from the way business is normally taxed. The Government has promised that specific waivers will be discussed with the interested parties before going ahead. They will also indicate in guidance which types of waiver it has no concerns about and which types may potentially of concern.
Impact of the 18% CGT rate on investment bonds of life insurance companies
The Government has chosen not to take any measures in the Budget to ensure that life insurance bonds remain competitive for higher rate taxpayers compared to investment funds and direct investment.
We hope the Government’s inaction will not cause prejudice to a very important investment product for the retail market, and we are willing to suggest solutions if they are prepared to reconsider.
A possible solution would be to agree a definition for bonds invested in equities or property as opposed to fixed interest investment, with some agreed thresholds for “balanced bonds” along similar lines to the tests for bond funds in the investment fund industry. This ought to be easy for unit linked policies, and perhaps a formula could be agreed for unlinked policies. All bonds falling within that agreed definition should be made exempt from the chargeable events legislation.
Fronting reinsurance arrangements
An announcement was made in the Pre-Budget Report to the effect that BLAGAB expenses of life insurance companies exceeded commission received from the reinsurer would be disallowed in so far as they related to certain life insurance policies which were reinsured. The disallowance would be in the proportion of liabilities reinsured at the year end.
The change has an element of retrospective legislation in that it can apply to a proportion of the expenses incurred in acquiring policies before 9 October, based on the fact that the tax deduction of those expenses is spread forward over 7 years.
This was intended as an anti-avoidance measure, on the basis that BLAGAB acquisition expenses were deducted under the I-E computation but then recovered from the reinsurer in a form which would not result in a receipt in it I-E computation, for instance a premium reduction. Initially, the rule was cast too widely and unfairly caught many innocent transactions. Representations have been made to this effect and the Government has now announced that the legislation will be more precisely targeted for the type of transaction which triggered the proposal.
The new legislation will apply to Fronting Reinsurance Arrangements. These are reinsurance contracts arising in the following situation:
1. A life insurance company issues a policy for term assurance
2. The life insurance company then reinsures the policy with one of the following:
a. A reinsurer which is connected with the policyholder
b. A reinsurer entitled to receive commission from the company
Where the above conditions are met, they will normally apply whether the reinsurer is intra-group or a third party.
The rules will not apply where the reinsurer is a “BLAGAB Group Reinsurer” because such a reinsurer would anyway be taxable under the I-E basis of taxation, and would therefore have a corresponding receipt in its I-E calculation for commissions deducted by the cedant company.
This means that most normal reinsurance transactions will now remain unaffected, and this is a welcome development.
Structural assets
As expected, it is announced that the primary legislation giving powers to HMRC to modify the computation of chargeable gains and losses from the disposal of structural assets (shares in insurance dependents held in non-profit funds) will be repealed, on the basis that they are unnecessary.
The way the primary legislation is drafted means that by default structural assets will be subject to the same rules for Corporation Tax on chargeable gains as assets of the shareholders’ fund.
Now that the treatment of chargeable gains has been resolved, the addition of other categories of assets (for instance non-insurance dependents) to the definition of structural assets is likely to become more of a priority for the industry and HMRC.
Foreign business assets supporting Gross Roll-up Business
In 2007, in the context of merging Overseas Life Assurance Business (OLAB) into Gross Roll-up Business (GRB), the cumbersome Overseas Life Assurance Fund (OLAF) rules which designated assets to OLAB for the purpose of attributing investment returns were replaced with a simpler attribution of all foreign currency assets to GRB (which included the OLAB as merged).
Foreign Currency Assets were defined as either
(a) Assets managed at an overseas permanent establishment of the life office or
(b) Assets denominated in a foreign currency and certified by a director of the company no later than 3 months after the end of the period of account as being all of the assets of the company's long-term insurance fund which are held at that time during the period of account to enable the company to meet liabilities of its GRB which are denominated in that currency. This responsibility and deadline made apportionment difficult in the everyday context of a life office.
The following changes are to be brought in with effect for periods beginning on or after 1 January 2008 and ending on or after 12 March 2008
(a) Foreign Currency Assets (to be renamed “Foreign Business Assets” will have a new definition, as a result of which the certification requirement will be abolished.
(b) For 2007, the certification deadline will be extended to 12 months,
(c) Companies will be able to elect to be subject to the new rules in respect of 2007 as well, which will obviously depend on how beneficial the new definition will be to them.
(d) Companies will also be able to make an irrevocable election that none of their assets will be treated as a foreign business asset, and such assets will be apportioned using the formulae in s432A.
Shareholders, policyholders and orphan estates: Reform of the apportionment rules
In the Pre-Budget Report on 9 October 2007, HMRC announced that the compromise rules on “orphan estates” would be abolished with effect for periods of account beginning on or after 1 January 2008 because they were not working as intended and that the Exchequer yield did not justify their legislative complexity. It is now announced that they are retrospectively abolished with effect from 1 January 2007.
This means a return to first principles for the entire rules apportioning the returns of life insurance companies for tax purposes.
The apportionment rules are now the subject of considered consultation between HMRC and the life insurance industry, and this review includes the question of inherited estates which have been reattributed.
Historically it has not always been easy to allocate returns to specific investors. For instance, not all policies are linked to specific investments and the return arising to orphan estates are also a question in point.
The apportionment rules are strict formulaic rules therefore apply to determine the split of a company’s returns between those different categories for tax purposes .
These rules are complex and do not always achieve the result aimed for. In some cases the same returns may be accounted for twice, under different categories, or they may fall in a gap, causing tax distortions in both directions.
The legislation is expected to be enshrined in the 2009 Finance Bill, although a detailed clarification of s432A is proposed for the 2008 Finance Bill.
The legislation in its final form will be very relevant to any work conducted by proprietary life insurance companies seeking to reattribute any part of their inherited estate and discussing points of detail with their policyholders’ advocates. Clearly a reform which is intended to remove both overlaps and gaps of taxable income will have winners and losers. The aim of the consultation however is to achieve coherence and transparency both for the industry and HMRC based on the regulatory and commercial realities of a life office.
Financing arrangements of life insurance companies
Tax legislation is to change with effect from 1 January 2008 to align the tax treatment of contingent loans or certain types of financial reinsurance contracts entered into by a life insurance company for its non-profits fund(s).
Typically, the loan advance or the amount of liabilities insured is based on an estimate of the Present Value of Future Business, and repayments are made out of those profits as they emerge. In both cases, the arrangements may simply be there to create Tier 1 Capital and protect solvency margins, or to accelerate future profits to distribute to shareholders or allow the company to develop a new line of business separate from the long term business being carried on.
Tax rules on financial engineering have significantly changed over the years where HMRC addressed various situations where these arrangements could be used by life companies for tax planning and until now different rules applied to contingent loans and financial reinsurance contracts.
The legislation for contingent loans was always based on the fact that it was necessary to distinguish situations where the funding is obtained purely to maintain solvency and those where it is obtained to crystallise future profits for the benefit of shareholders. The new legislation is expected to extend that treatment to financial reinsurance, in recognition of the common aims of these two financial engineering methods.
The detailed application of the new rules will be a priority for finance directors and actuaries of life offices already in or intending to enter such arrangements.
Regarding the question of what is a significant or insignificant transfer of risk, companies will apply the same tests for tax as they currently apply in accounting for the loan under UK GAAP. There does not presently appear to be a specific test, even though the FASB currently have a project in the US to define these measures and this may eventually be relevant in the implementation of Solvency II.
It is hoped that adequate transitional rules will be put in place.
It is not excluded that HMRC will consider extending this legislation to other methods of adding capital to the long term insurance fund in the future.
Friendly Societies
The Government has agreed to introduce legislation to ensure that where an “old” Friendly Society transfers “Other Exempt Business” to a new Friendly Society, the exemption will be preserved. The rules will have effect for transfers taking place on or after the date that the Finance Bill 2008 receives Royal Assent.
