UK: Life Tax Proposals - Response To IR Consultation

In response to your invitation, we set out below our representations on the draft legislation published on 21 January 2003. References to paragraphs below are to the paragraphs of the draft Schedule. As well as the note published on 23 December last year ("the Press Release") and the explanatory note published with the draft legislation ("the Note"), we have had the benefit of a discussion with representatives of half-a-dozen or so leading life assurers. Our representations reflect a number of points which those representatives made. We and the representatives of the life assurers to whom we have referred have no objection to the publication by the Inland Revenue of this letter.

Our representations deal mainly with the proposed changes to the Case I and Case VI computations of life insurance companies. Therefore we have not made a response to numbers 1, 2, 3, 5, 6 or 9 of the particular points on which readers are asked to give their views in the Note. Our views on point 4 are set out in paragraph 2.2.6 below, on point 7 in paragraph 2.2 below, and point 8 in paragraphs 2.2 and 2.3 below.

The "headline" points which we make in our representations are set out in brief below:

• The Case I and Case VI changes represent significant changes to the basis of taxation for life insurers, with the result that they, unlike ordinary trading companies, would not be able to rely on established case law and generally accepted notions of profit to argue whether an item is taxable or not. The proposals will cause items such as loan proceeds and intra-fund transfers to be taxed, which would not represent taxable income for trading companies. This discriminates against life assurers.
• The proposals are likely to give rise to retrospective taxation in respect of business already written at the date at which those insurance business transfers were made. Retrospective taxation has, historically, been considered constitutionally unacceptable except in cases of very blatant avoidance, which do not include cases where there has been a statutory clearance mechanism in respect of the transactions to be targeted. Furthermore, the words of the legislation must be explicit and precise if it is intended to have retrospective effect. To the extent that there is any ambiguity on this point, uncertainty may result, in view of the courts’ presumption in construing statute against retrospection.
• We consider that the proposals are one-sided, and do not address existing anomalies which work against the taxpayer companies, such as Section 83(3) FA 1989, an anti-avoidance measure which is capable of catching innocent trading losses incurred in the writing of new business.
• Many of the "anomalies" at which the proposals are targeted arise because the FSA return and the layout of its forms are not designed for the identification of taxable profits. Whilst the returns and the concept of actuarial surplus are a sound basis for Case I profits, the interaction of the tax rules and the regulatory accounting requires flexibility, not increased rigidity. The proposals will exacerbate those anomalies rather than cure them. A key issue is that the forms do not contain lines which deal with capital as opposed to revenue, whether the capital be proceeds of the issue of share capital, loan proceeds, intra-fund transfers or any other capital amount and the taxpayer company must, for the integrity of the system, retain the ability to adjust such items.

It is evident from the Press Release and from points raised in these representations that the present machinery for tying the tax result to the regulatory return is not working fairly or logically, either for the Inland Revenue or for the taxpayer. The proposals contained in the draft legislation are essentially ad hoc reactive repairs to that machinery and appear likely to lead to taxpayer companies paying tax purely on the basis of the line of the return on which an item is based. It should be open to the Inland Revenue and the companies, subject to the specific statutory provisions as to investment return and bonuses, to ensure that the tax base does not extend beyond taxable profit as generally understood. This is recognised in the current drafting of SP4/95 which recognises that achieved surplus may not be apparent from the face of the regulatory return.

The remedy is, we suggest, for the Inland Revenue and the taxpayer companies to discuss and agree at a more fundamental level what profit should be taxed, and then to ensure that the proposals achieve that. It could still be possible for such changes (once content has been agreed by both sides) to come into effect for periods of account beginning on or after 1 January 2003. Taxpayer companies may well prefer a period of uncertainty followed by a set of rules which are right, rather than certainty of rules which are unsatisfactory in a number of ways.

The remainder of this letter is arranged as follows:

2. Suggested Changes to Case I and Case VI Computations

2.1 Our understanding of the scope of the proposals

2.2 Specific representations on the suggested inclusion of Form 40, line 15 "Other income" as a receipt (suggested new FA 1989 Section 83(2)(d))

2.3 Specific representations on the suggested taxation of amounts paid or transferred from investment reserve (suggested new FA 1989 Section 83(2B) to (2F))

2.4 Representations regarding timing and effective date of any changes

(a) the Rees criteria

(b) the European Convention on Human Rights

2.5 Interaction of the proposed changes with FA 1989 Section 83(3)

2.6 Conclusions on suggested Case I/Case VI changes

3.1 Representations on proposals

3.2 Maintaining fairness for companies without a share capital

4. Bed and Breakfasting

2.1.1. Our understanding of the scope of the proposals is that their main target is the making of a contingent loan either as part of or following an insurance business transfer, where the receipt of the loan proceeds is accounted for as revenue on line 15 of Form 40 and made the subject of a downward fiscal adjustment to recognise that those proceeds are not income (and certainly not taxable income), but the repayment of the loan is debited to the investment reserve.

2.1.2 It is correspondingly our understanding that the proposals are not aimed at contingent loans accounted for consistently (with the proceeds and repayment accounted for both on the face of Form 40, or both through the investment reserve).

2.1.3 We consider that in reality this legislation (except for proposals in respect of tax charged to the investment reserve) is targeted at situations other than those which would arise in connection with an insurance business transfer, albeit a historic one.

2.2. Specific representations on the suggested inclusion of Form 40, line 15 "Other income" as a receipt (suggested new FA 1989 Section 83(2)(d))

2.2.1 It is our view that the treatment of amounts included in the annual regulatory return as "other income" on Line 15 as a Case I trading receipt is inappropriate in principle for life assurance companies. The main reason is that the regulatory return is aimed at the calculation of the solvency position of a life insurer. The forms contained therein have not been designed to make a distinction between revenue and capital. The starkest example of this is that the issue of share capital in a trading company is never capable of giving rise to a trading receipt, whereas the long term fund has no equivalent of share capital, so that any capital transfer into the fund increases the excess of assets over liabilities, and therefore causes a surplus to arise. This should not enable the Inland Revenue to conclude that such amounts are taxable.

2.2.2. Moreover, Line 15 has been used by life insurance companies as the line on which to place items which are not taxable under ordinary Case I principles. The proceeds of a loan received by the life insurance company may be accounted for on that line. For example (and importantly) that line discloses transfers in from other sub-funds, because, unlike for transfers to and from the shareholder fund, there is no specific line on Form 40 for intra-fund transfers. The placing of an item on that line, as rightly stated in the Note, is no guarantee that the item is non-taxable. However the suggested change would mean that items which are not Case I receipts cannot be excluded and hence not taxed, as should be the case, by reference to the principles established in case law applicable to ordinary trading companies and corresponding to profits as commonly understood, by means of a fiscal adjustment. It follows that the suggested change is an extension of the scope of Case I, specific to insurance companies, rather than a mere closing of loopholes and the significance of this is spelt out in paragraph 2.4(A).

2.2.3 Furthermore, the result of treating "other income" as taxable would differ significantly as between a with profits fund and a non profit fund. In a with profits fund, if a contingent loan received was used to fund the result for the year, an adjustment would be made to the amount brought into account from the investment reserve. On the other hand, in a non profit fund the amount would be taken directly to unallocated surplus. This means that a receipt of a contingent loan made into a with profits fund might not change the ordinary result that is taxed, but in a non profit fund the result for the year would be taxed and so would the introduction of the loan proceeds. This would discriminate as between companies which write with profits business and those which do not. However, the stated aim of the proposals was to promote fairness between life companies.

2.2.4 The comment made in paragraph 100 of the Note states that "where the receipt of amounts of this sort [those brought into account in the revenue account and "fiscally adjusted out"] have depressed the taxable surplus, it is proposed that on repayment the amounts will be brought into account as additional trading receipts". In most cases, if the receipt of the loan has been shown on Form 40 then the repayment of the loan will be disclosed as "other expenditure" on Form 40 and will not be deductible on basic Case I principles, in the same way as the receipt of the loan is not taxable because it does not represent a profit. Therefore the taxation of the repayment of the loan would already be achieved under current legislation, except in the rare case that a loan is introduced into Form 40 (with a fiscal adjustment) and repaid from the investment reserve. It would be much better if the Inland Revenue were to target that particular situation specifically rather than introducing legislation which disturbs the neutrality of situations where the receipt and repayment of the loan are accounted for consistently.

2.2.5 In respect of transfers between sub funds, the position of such transfers is already unsatisfactory. A transfer from a with profits sub-fund, which is required to fund bonuses as well as the intra-fund transfer, requires the bringing into account of surplus to fund the transfer. This causes the profits distributed on that transfer to be taxable at the point of transfer by the transferring fund. The treatment of the receipt of the transfer between sub-funds as automatically a trading receipt would cause the transfer to be taxed a second time in the hands of the transferee fund. Again this gives rise to double taxation, unless the "other expenditure" shown in the transferor fund and representing the transfer is deductible by statute.

2.2.6 The suggestion that further exclusions be introduced in the proposed new Section 83(2A) FA 1989 is also unacceptable. Currently, an efficient method of financing the long term fund is to make a contingent loan into the fund. Specific exclusions are (it is assumed) to be written into the legislation to ensure the tax neutrality of such a loan. However, it is not possible for us to predict what structures will be adopted for future methods of capital financing for the long term fund. Therefore the automatic taxation of "other income" risks making companies hostages to fortune and needlessly inhibiting innovation. The representation is that the change should not be introduced in the form now proposed, and that any change requires further discussion and consultation.

2.3 Specific representations on the suggested taxation of amounts transferred or paid from investment reserve (suggested new FA 1989 Section 83(2B) to (2F))

2.3.1 Before considering a number of specific points below, it is noted that accounting through the investment reserve (i.e. treating items as directly adding to or reducing the investment reserve, without making entries on Form 40 or Form 58) has been adopted by companies in respect of contingent loans and other transactions largely because the "bringing in" of part of the investment reserve in a with profits fund and the related provisions of Section 432E ICTA 1988 can create unexpected and capricious results.

2.3.2 Examples of such capricious results are the creation of an up-front loss on the receipt of a contingent loan (given the restrictions on the use of life company losses and the provisions of Section 83(3) FA 1989, companies are unlikely to wish to create a net Case VI and Case I loss position), and the results of fiscal adjustments (see further below).

2.3.3 It is accepted that the current machinery for linking the taxation of a with profits fund to the regulatory return could also give rise to anomalies which are capable of working in the taxpayer company’s favour. However the way to deal with this is not to strike out the ability to account for transactions through the investment reserve as the only way of preserving neutrality, but to consider, along with the industry, what defects exist in the current system for the taxation of with profits business, and the extent to which it should be remedied.

2.3.4 We understand that the Inland Revenue are already aware that the inclusion of the repayment of a contingent loan as a taxable receipt in circumstances where the loan has been introduced into the investment reserve (and has therefore created no fiscal adjustment at the point of introduction) could in principle give rise to double taxation – both of the surplus of the life company, and the capital amount of the loan. Consistent accounting for contingent loans either on Form 40 or through the investment reserve should achieve tax neutrality, and it is unacceptable to introduce proposals which affect that neutrality in order to catch a minority of cases, involving insurance business transfers, where the accounting and tax results are not neutral, or merely represent deferral.

2.3.5 It appears that the provisions are capable of causing a taxable receipt to arise in a mutual life insurance company in respect of its Case VI pension/OLAB/ISAB/LRB computation. Paragraph 6(5) would add the taxable receipt to the amount currently determined in Subsection 2 of Section 432E of the Taxes Act. The legislation as it stands requires that, for a mutual, the Section 432E(2) amount is such that the net amount equals the bonuses, which has the practical effect that any surplus in excess of bonuses is directed towards BLAGAB (and, because mutuals carry on no trade, falls out of the charge to tax). Consequently if the receipt is added on to the Section 432E(2) amount, this would potentially leave a mutual insurer with a Case VI taxable receipt, whether it accounts for the repayment of the loan through Form 40 or through the investment reserve. Since the Press Release and the Note do not refer to any intention to make any such change, paragraph 6(5) should (unless it becomes otiose) be redrafted either so that the provisions do not apply to a mutual, or so that the additional receipt is included in the surplus amount which is equal to bonuses (so that it defaults into BLAGAB as is currently the case).

2.3.6 Furthermore, to respond to the comment made in paragraph 101 of the Note that payments are made from the investment reserve in respect of items which would not be deductible if they were included on Form 40, this approach seems reasonable at first blush but because of the capricious effects of the current system is inappropriate. The current effect of the investment reserve/needs basis in a with profits fund is that the taxable surplus is set by Form 58 surplus less bonuses (i.e. shareholder transfer, or unallocated surplus). The fact that those surpluses are effectively figures set by the actuaries, and the fact that the investment reserve tends to replenish itself, means that no effective tax relief is achieved for expenses, and artificial taxable profits are created where there are fiscal adjustments. This is particularly stark in the case of a mutual where a taxable profit of nil (bonuses = surplus) may be increased by (say) the adding back of capital expenditure charged in Form 40. (Given that the existing system produces uncommercial results of this nature, it is not surprising that companies would seek to make payments from the investment reserve rather than accept a fiscal adjustment against surplus).

2.3.7 This may be illustrated by a simple example. With Profits Co has £100 of surplus (which is required for distribution and shareholder transfer) and an investment reserve of £500. It incurs tax-deductible expenditure of £50. Because it requires the £100 to distribute, it charges the expenditure in Form 40 but draws another £50 from the investment reserve to make up surplus. Therefore the amount of tax which it pays is unchanged, only the investment reserve changes in quantum from £500 to £450. If however the amount of £50 was non-tax-deductible and the amount was charged to Form 40, the same operation would increase the tax payable by the amount of the fiscal adjustment. Only the charging of the expense to the investment reserve could With Profits Co ensure that the tax charge is not increased by the non-deductibility of the expense, in the same way that the tax charge is never reduced by the deductibility of the expense.

2.4 Representations regarding timing and effective date of any changes

(A) The Rees Criteria.

2.4.1 A separate issue from the content of the changes is their effective date.

2.4.2 It is unacceptable in principle that legislation imposing tax should have a retrospective effect. The matter seems to have been last debated in detail in connection with the 1978 Budget. The background was that the then Chancellor of the Exchequer proposed wholly retrospective legislation to restrict loss relief in relation to a particular type of commodity dealing scheme and indicated that future schemes would also be subject to retrospective legislation. The avoidance schemes at which that legislation was specifically targeted were artificial in the extreme and fairly obviously had the sole purpose and benefit of obtaining loss relief, and to that extent were in sharp distinction to most business transfers effected by insurance companies. Further significant differences included the absence of any third party sanction for the transactions concerned (transfers of insurance business must be sanctioned by the Court and (in practice) approved by the regulator as well), and most crucially the fact that transfer schemes are normally the subject of a notification by the Inland Revenue that they are effected for bona fide commercial reasons and do not have as their main purpose or as one of their main purposes the avoidance of corporation tax (ICTA 1988 Section 444A(7). (Of course, the criticisms made in 1978 of the then Chancellor’s approach apply a fortiori where one of the relevant transactions is a transfer of business.)

2.4.3 These proposals would affect the tax position of business already written at the date on which a transfer of business took place.

2.4.4 It is recognised in embedded value accounting for life insurance business that the profit or loss on the policy emerges over the life of that policy. Losses may be incurred up front on the life of that policy if one considers the policy on a cash accounting basis. Liabilities are calculated and provided in respect of the policy, but there is also an "embedded value asset" which represents the expected future cash flow on those policies. This embedded value, although in most circumstances not valued in the annual regulatory return or recognised as an asset in the Companies Act accounts, is published information, and is relied upon as the value of the company, by analysts, lenders and other stakeholders in the life insurance company. At the time when the Court gave sanction to the transfer schemes affected by the proposals, the law as it then stood applied to the taxation of surplus on policies already written at that date and the embedded value would have been based on that law.

2.4.5 Information is made available to the regulator at the time when an insurance business transfer scheme is considered, and is included in public information made available to policyholders and shareholders in the company. The Court sanctions the scheme in the knowledge of this information.

2.4.6 The proposed changes in the law insofar as they materially affect those assumptions are therefore in effect retrospective. It can of course be accepted that there will inevitably be changes in rates of taxation over the life of business in force at the date of an insurance business transfer which can only be made year by year by the then Government and any erosion of (or increase in) the value of in force business flowing from such change in rates must follow. However, the suggested changes referred to above go beyond this and virtually amount to a new tax regime for shareholder profit of life companies. Key changes in the treatment of life insurance taxation in the past have generally been introduced in respect of business written on or after the date of change. This is the case, for example, in respect of the abolition of life assurance premium relief, merger of old general annuity business into BLAGAB, and the introduction of the imputation of investment return in respect of the reinsurance of BLAGAB business.

2.4.7 The Rees criteria (found in the Debates in Standing Committee A on the Finance Bill 1978) deprecate the backdating of legislation to some time earlier than that at which the intention to legislate was clearly signalled ("the signalling date"), and have been generally followed over the succeeding 25 years. They should certainly apply in the case of such a fundamental change to the taxing system for life insurance companies.

2.4.8 In the result it is our view that the timing of the proposed changes breaches the Rees criteria. They perhaps would not do so if the taxation on the "other income", or payment or transfer from investment reserve, was restricted to the advance or repayment of loans made in pursuance of, or in pursuance of a loan required by the terms of, a transfer of business scheme and arose from business written on or after the effective date of an insurance business transfer. Our representation is that the scope and effective date of any changes should be determined accordingly.

(B) ECHR issues.

2.4.9 The relevant provisions of the Finance Act 1978 were considered by the European Human Rights Commission in 1981. The case was A, B, C and D v the United Kingdom (case 8531/79). The Commission had this to say about retrospective tax legislation:

"[The Commission] recognises that a retrospective provision imposing a tax liability or restricting the availability of tax relief must be regarded as more severe than a similar prospective liability especially by virtue of the uncertainty which it is bound to engender. Furthermore, although all tax legislation affects the interests of those thereby charged to tax, retrospective provisions prevent the reorganisation of the taxpayer’s affairs to mitigate the new tax liability which remains possible in the case of prospective provisions."

As regards the particular scheme in issue, the Commission observed that the challenged provision was enacted to counteract a specific form of tax avoidance (individuals generating Case I losses through participating in a supposed commodity dealing trade), the effectiveness of which was already in doubt, and especially that the loss relief claim related to the applicant taxpayers’ entitlement to have an artificial loss, incurred in a non-commercial venture taken into account in reducing the applicant taxpayers’ existing tax liabilities. As far as the proposed changes to the Case I charge on life companies are concerned the changes do appear, prima facie, to constitute an interference with property within Article 1 of the First Protocol to the Convention, and, given that life assurance is indisputably a trade, it is by no means so clear as it was in the case of the commodity dealing schemes that the life assurance tax changes are "proportionate" in the relevant sense and therefore do not breach the Convention. It would be embarrassing for all concerned if they were later found to do so. No doubt the Government has taken or will take its own advice on the issue, and make any necessary amendments.

2.5 Interaction of the proposed changes with FA 1989 Section 83(3)

2.5.1 One criticism of the current measures is their one-sidedness. There are a number of provisions within the tax legislation affecting life insurance companies where a provision introduced to counteract a specific result is drafted more widely and catches innocent situations. One such is the current drafting of Section 83(3) FA 1989, which causes the striking down of ordinary trading losses in a life insurance company as a result of monies being injected into the fund in the circumstances of an insurance business transfer or similar transaction such as a portfolio transfer by way of reinsurance. In the context of a "loophole-eliminating" exercise, the current drafting of Section 83(3), which has caused considerable difficulties and uncertainties in the context of transactions whose exclusive main purpose is the achievement of a commercial objective, should be rectified so that ordinary trading losses arising on business written post the insurance business transfer are not caught by Section 83(3). This might be achieved, for instance, by requiring "connection" (with the transfer) not only in respect of the addition to the long term fund but also in respect of the losses. Furthermore, "connection" is an unhappily wide word in this context and its retention or substitution by something more apposite should be the subject of careful and critical review, as we understand the ABI have represented separately. The representation is that amendment to Section 83(3) FA 1989 should be made as part of the introduction of these measures.

2.6 Conclusion on Suggested CaseI/Case VI changes

2.6.1 In short, we consider that the proposed changes to Case I are not targeted with sufficient precision. Furthermore, the suggested measures in our view go further than merely "removing anomalies" by creating novel computation methods, departing significantly from the core notion of trading profit which, if confusion and unfairness are to be avoided, ought not to be introduced without more careful consideration than is likely to be possible in the limited time between now and Report Stage of FB 2003. More thought should be given as to how the use of the regulatory return as the basis for identifying taxable profits and the need to ensure that those profits bear some relationship to taxable profits as generally understood should be reconciled. The end result of such a measured process should provide welcome certainty both to the Inland Revenue and to the companies themselves. Making the result excessively dependent upon the regulatory returns, modified ad hoc in a number of significant respects, opens up the risk of giving rise to yet further anomalous results and making both the Inland Revenue and the companies hostages to fortune.

2.6.2 It is unclear to us that there are any situations at which such measures are targeted which do not involve an insurance business transfer or which have arisen as a result of such a transfer. Therefore it would seem preferable to target the legislation directly at that area rather than introducing a measure which is likely to hit much more widely than anticipated. Although the Inland Revenue view this legislation as merely the closing of loopholes, (which must be the justification for its inherently retrospective nature), this characterisation is undermined by the potentially wide reach of the Case I changes.

2.6.3 One way of dealing with the proposals may be to specifically target them at insurance business transfers. However the industry will not want to see a repeat of Section 83 FA 1989 saga where the wording "in connection with" is unacceptably wide, leading to the position where insurers are at best "untaxed by concession". It may be acceptable to the industry to have a provision of this nature together with a notification procedure along the lines of that in Section 444A(7), in other words a case by case "clearance" procedure, with the normal recourse to a Special Commissioner for a swift and impartial review. This would be over and above the existing procedures.

2.6.4 We suggest that the Inland Revenue and the industry should work more closely together on these changes. It could possibly be acceptable to the companies for the changes (once their content has been agreed by both sides) to come into effect on 1 January 2003.

3.1 Representations on proposals

3.1.1 There is considerable concern in the industry about the restrictions to be placed on Case VI losses on an insurance business transfer.

3.1.2 Case VI losses are already considerably limited in their use, due to the fact that they are ring-fenced in terms of the business against which they may be set. It is not possible to set them against BLAGAB business or any other business categories.

3.1.3 To the extent that a company has Case VI losses, they are likely to arise on non profit business (due to the fact that the needs basis generally restricts ability to generate Case VI losses on items such as pensions misselling if bonuses and shareholder transfers need to be maintained), such as stakeholder business. Companies writing significant new business in this area will suffer losses from the expenses of writing the business (new business strain), which are recovered throughout the life of the policy. It is not clear what the justification would be for restricting the transfer of such losses if the business was transferred to a third party (and therefore not within the common ownership required by Section 343). It would encourage artificial transactions in order to ensure that the common ownership provisions were met.

3.1.4 To the extent that a life company has suffered excessive losses from the writing of such business, transfer of the business to a third party may be a solution. It is not clear why it would be appropriate to restrict the use of the losses against profits of the acquirer's pension business. This would reduce the efficiency of the acquirer's ability to run off the weaker business.

3.2 Maintaining fairness for companies without a share capital

In the case of many life companies there are likely to be difficulties in demonstrating the 75% ownership required for Section 343, as they have no share capital. In other tax contexts the legislation deals with the issue in a satisfactory manner (see for example ICTA 1988 Section 254(1) "share" and TCGA 1992 Section 136(5)). In the context of a loophole-eliminating exercise it would seem sensible to include the correction of this matter for statutory and other life companies without a share capital in relation not only to Section 343 but also to the distributions, stamp duty group relief and group transfer/capital gains tax sub-codes and our representation is that this is corrected.

We leave it to the ABI and the companies to make representations on this issue. However, Companies have suggested to us that any change should be applicable for periods of account beginning as late as practicable in 2003 to allow for the systems changes necessary to permit box transfers and matching trades to be captured to be advanced, but certainly no earlier than 1 January 2003, and not for transactions from 23 December 2002. (A review of possible box transfers and matching trades is onerous and disproportionate to anything likely to be found for a period of 8 chronological days, far fewer working days). Any necessary systems changes could then be made for the calendar year 2003. Our representation is that the change is made applicable as of no earlier than 1 January 2003.

If you wish to discuss any of the above, please contact Lindsay J'afari-pak or Ross Fraser.

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