UK: Deloitte Insurance Market Update (Part 3 of 3) - Technical Updates – News in Brief

FSA consultation and discussion papers

In November 2004 the FSA published policy statement PS04/24 which confirmed that it still intends that the EEA group capital adequacy will become a hard solvency test to be met by EEA insurance groups containing a UK insurer but as expected the introduction of the hard test will be deferred from 1 January 2005 until 31 December 2006.

For 2005 the EEA group capital adequacy calculation will continue to be a private calculation reported to the FSA and used as one factor in the FSA’s overall supervision of insurance groups. The FSA intends that the calculation should be reported publicly from 31 December 2005 and will consult during 2005 on the form of that disclosure.

The rules for calculation of group capital adequacy are in chapter 8.3 PRU but the rules and guidance for preparation and submission of the group capital adequacy report are in paragraphs 9.40 to 9.43 and appendix 9.9 of IPRU. Although a detailed format is set out in IPRU appendix 9.9, insurers are not required to use this form.

In November the FSA issued FSA instrument FSA 2004/87 as an annexe to PS04/24. It contains the text of the new integrated prudential sourcebook section of the FSA handbook PRU that took effect from 31 December 2004 for insurers but has been revised in minor respects by an addendum approved on 14 December. PRU replaces most of the rules relating to the prudential supervision of insurers previously located in the Interim Prudential Sourcebook for Insurers (IPRU) in force since N2. The exception is that rules relating to preparation of the annual prudential return for insurers "the FSA return" remain in chapters 3 and 9 and related appendices of IPRU. The guidance notes previously in Volume 3 of IPRU have all been deleted including those parts of GN9.1 which relate to the majority of the FSA return which remains largely unchanged within IPRU. Although there is now guidance within PRU relating to certain prudential rules, there is now no extant FSA guidance in relation to the preparation of the FSA return save for the instructions for completion of the FSA returns set out in the appendices to IPRU.

PS04/25 issued in November set out the FSA’s policy on updating IPRU but did not contain the text of the changes to be made to IPRU. These were approved by the FSA in December and published as FSA instrument 2004/98 (again with an addendum for minor matters added later in December). The new version of IPRU effective for 31 December 2004 incorporating all new FSA forms and revisions to existing forms is now available from FSA website. In December, the FSA made further transitional provisions relating to certain detailed disclosures in the realistic valuation report and the auditors responsibility for them.

The most significant changes affecting life insurers are the responsibility of the board for the actuarial function with the cessation of the appointed actuary role and extension of the auditors’ responsibilities. This will cover the methods and assumptions underlying the actuarial valuation of liabilities as well as the amounts of the actuarial liabilities and capital resources requirement. With the requirement for auditors to have regard to the advice of a reviewing actuary independent of the insurer, rather than relying on the appointed actuary. The new realistic balance sheet regime also applies to the larger with profit insurers with the new forms 18 and 19 and the realistic valuation report within the audit scope. In addition, the new prudential rules defining capital resources on a basis similar to that already in place for banks and other FSA firms apply from 31 December 2004 and are presented in new FSA forms 1 to 3. In determining capital resources insurers will need to have regard to the new prudential rules on market and counterparty exposure in chapter 3.2 of PRU and the new admissible assets rules in Chapter 2 of PRU, in particular Annexe 1R which lists admissible assets. This annexe was revised to include debts arising from the sale of investments but although it does not make specific reference to other debtors (apart from those arising under insurance and reinsurance contracts) it is understood that the FSA expect such debtors will fall within the admissible asset categories listed in Annexe 1R. The directors’ certificate has been shortened and now focuses on overall compliance the FSA handbook rather than the previous more detailed list of FSA requirements. It is no longer reported on by the auditors.

In January the FSA published instrument 2005/3 setting out the changes to the 2005 FSA returns following consultation in CP202 and cp04/1. A detailed policy statement is expected from the FSA in February 2005.

The FSA has made a number of further changes to the detail of its TPF proposals to reduce the practical difficulties highlighted by respondents and the costs of compliance, while still achieving the objective of their proposals. These changes include:

• requiring at least 90% of maturity payments to fall within the target range in situations where individual policy asset share calculations are used, as well as in those where specimen policy asset share calculations are used;

• giving guidance on how firms can demonstrate whether their surrender values meet the new standards; and

• implementing the TPF proposals as a whole on 30 June 2005 but with a transitional period of up to six months (up until 31 December 2005) for firms to implement the TPF requirements on target ranges and surrender values.

The FSA has made the following main changes to its consumer friendly principles and practices of financial management (CFPPFM) proposals requiring firms to:

• provide CFPPFM information with the next annual statements (if any) they send to existing with-profits policyholders;

• provide CFPPFM information with any notification of proposed changes in Principles of Financial Management; and

• highlight on their websites the availability of CFPPFM information.

The FSA has given firms until 31 December 2005 to implement the CFPPFM requirements. The removal of the requirement to produce with-profits guides will also take effect on 31 December 2005.

In CP04/14 the FSA sought further views on the definition of "inherited estate" Some respondents commented that the definition should exclude such things as risk margins, capital to support future business plans, parent company capital support, shareholder support and distributions. However, the FSA has decided not to amend the definition as the FSA consider issues such as these should be considered alongside a firm’s circumstances and as part of its detailed reattribution proposals. As proposed in CP04/14, these rules and guidance will take effect at the same time as the TPF proposals, on 30 June 2005. Only technical changes have been made to the near-final text published in CP04/14.

VAT

On 1 June 1997 a special business unit of the Accenture Group (formerly Arthur Andersen & Co), known as Accenture Insurance Services (Accenture), entered into a ten year agreement with Universal Leven N.V ( Universal Leven), a Dutch life assurance company. Under the agreement, Universal Leven performs the development and sales of special life insurance products and Accenture concentrates on carrying out the "back office" administrative functions.

Background

Under the agreement, Accenture is engaged in the back office activities consisting of the following: acceptance (underwriting) of new applications; handling policy and commercial changes; the issue of policies; termination of policies; handling of claims; management of policies; determining and the paying out of commissions to intermediaries; building and managing the necessary information technology function; supplying information to Universal Leven and the intermediaries; and, either in the name of Universal Leven or not, supplying reports to policy holders and any other third parties. Almost all contact for carrying out its activities is with intermediaries but some direct contact with policy holders will also occur in relation to claims. Accenture staff will state their own organisation’s name when dealing with queries rather than that of Universal Leven. Generally, Accenture will make binding decisions on behalf of Universal Leven, for example regarding the conclusion of a life insurance policy or a claim.

Issue

The Dutch tax authorities consider that the services supplied by Accenture to Universal Leven did not fall within the VAT exemption permitted under Article 13 B (a) of the Sixth Directive and therefore VAT was due on the value of the supplies made. Following a hearing in the Dutch Supreme Court the following question was referred to the European Court of Justice (ECJ)."Where a taxable person has concluded an agreement with a (life) assurance company, such as the agreement at issue between Accenture and Universal Leven, under which that taxable person undertakes, for a certain remuneration and with the aid of qualified personnel who are expert in the insurance field, most of the actual activities relating to insurance — including, as a rule, the taking of decisions that bind the insurance company to enter into insurance contracts and maintaining contact with the agents and, as the occasion arises, with the insured — while the insurance contracts are concluded in the name of the insurance company and the insurance risk is borne by the latter, are the activities undertaken by that taxable person in execution of the agreement "related services performed by insurance brokers and insurance agents" within the meaning of Article 13 B (a) of the Sixth Directive?"At the ECJ hearing on 11 November 2004, in addition to the plea notes presented, the judges inquired about whether or not Accenture has the authority to bind Universal Leven in case of entering into insurance contracts as well as in case of settling claims. The answer to this question is affirmative. The only party to make a submission to the ECJ other than the two parties was the European Commission who was fully supportive of the Dutch Government’s position. It is fair to say that based on the UK interpretation of the Sixth Directive, it is extremely unlikely that the UK Government would consider that the services supplied by Accenture were anything other than VAT exempt.

Advocate General’s Opinion

On 12 January 2005, the Advocate-General (A-G), Poiares Maduro, presented his Opinion to the ECJ.

The A-G started his analysis by stating that there is no legal definition of insurance broker/agent and therefore to determine the VAT liability of "related services performed by insurance brokers and insurance agents", as stated in Article 13 B (a) of the Sixth Directive, it is important to consider VAT case law and not the insurance mediation directives. The A-G states that these directives merely provide guidance on freedom of establishment for such services and they have no relevance for determining the VAT liability of any supplies.

The case law the A-G refers to in his opinion consisted of Forsakringsaktiebolaget Skandia C-240/99 (Skandia), Card Protection Plan Ltd C-349/96 (CPP), Taksatorringen C-8/01 and CSC Financial Services Ltd C-235/00 (CSC). With reference to Taksatorringen in particular, the A-G confirms that an insurance broker/agent must have "direct contact" with the (potential) insured party.

The A-G states that Accenture do not have any direct contact with the policy holders, as such contact is made by the independent brokers who sold the policies. We believe this is factually incorrect as Accenture do have some contact with the policy holders in relation to claims. However, the A-G goes on to state that even if there was direct contact with the policy holder in this case the services would still not qualify for VAT exemption under Article 13 B (a). This is because the services provided by Accenture are not those normally performed by an insurance broker or agent. He regards an insurance broker or agent as someone who acts in a professional capacity in bringing together the two parties to an insurance contract with an element of mediation required in order to conclude the contract, as detailed in the CSC case. This consideration is not affected by the fact that Accenture has the authority to bind the insurer to insurance contracts with the insured. In his view the authority to bind the insurer cannot be the decisive factor to qualify a person as an insurance agent.

In the A-G’s view, Accenture has been engaged to perform some of the services that would normally be carried out by the employees of Universal Leven, and has been acting in a form of sub-contractor relationship. As these services are therefore something normally performed by the insurer, they cannot be considered to be services performed by insurance brokers and agents. This poses the question as to whether such a strict interpretation would exclude VAT exemption for "chains" of brokers to all but the broker that has direct contact with the policy holder.

The opinion also leads to one the conclusion that only "related services" performed by brokers and agents will qualify for VAT exemption. But how far does "related services" extend? For example, if an insurance broker also provides claims handling services to a third party insurer, does the exemption apply to all their services or simply to the broking services?

Finally, the A-G gave his view on of whether the charging of VAT on this type of outsource contract is against the principle of fiscal neutrality, as argued by Accenture. His opinion was that such an argument is "devoid of relevance" as the exemptions allowed under Article 13 must be construed narrowly and therefore would not apply simply because a business chose to outsource part of its business to a third party.

Future developments

The ECJ judgement is expected in a few months time, but in the meantime the A-G’s opinion will be sending shockwaves throughout the UK outsourcing and insurance sectors, as the potential cost of adding VAT to a number of services currently received by insurers and brokers from third parties will be very significant. If the ECJ does follow the A-G’s opinion it is inevitable that the UK VAT legislation would require amendment. It is not expected that Customs will provide any response on this case until after the release of the ECJ judgement. It seems unlikely that Customs will take any retrospective action but there is as yet no indication of whether existing arrangements may be grandfathered. However, long-term outsource contracts that currently qualify for VAT exemption may become more expensive in the not too distant future.

Tax

Accompanying the chancellor’s pre-budget report on 2 December 2004 were a considerable number of tax changes directly impacting on UK life insurance companies, some of the changes taking effect from that date and others taking effect from 1 January 2005. The legislative changes largely counter features of life taxation that the Inland Revenue consider have been abused. Specific proposals are:

• Measures governing the attribution of investment income and gains arising on excess free assets within the long-term fund, including any attributed orphan or inherited estate, effective for periods of account beginning on or after 1 January 2005.

• Specific anti-avoidance legislation on transfers of long-term business, effective as from 2 December 2004.

• A measure effective for periods of account ending on or after 2 December 2004 on the treatment of "notional income" included in the revenue account of the regulatory return (Form 40).

• Measures effective for periods of account beginning on or after 1 January 2005 amending the rules for determining which revenue accounts are recognised for the purposes of the apportionment of investment return.

In addition, amendments to existing tax legislation to reflect changes to the layout and content of the annual regulatory return made to the Financial Services Authority, effective for the most part for the year ended 31 December 2004, are proposed.

Finally, consultation is promised, within the current process of consultation on corporation tax reform generally, on the future of the separate computations for certain categories of business, such as pensions business. These notes were written in mid-January and the process of consultation might modify some of the proposals by the time this Insurance Market Update is published.

Excess free assets

The Inland Revenue has proposed a radical change to the treatment of investment return arising on what are perceived as free or excess assets held within the long-term fund which are surplus to the requirements of the company but which have not been distributed. It was proposed initially that this new legislation be introduced by a Statutory Instrument in December 2004 so that the legislation would be effective from 1 January 2005. Following a considerable outcry and forceful representations the proposal for an immediate Statutory Instrument was withdrawn by the Inland Revenue. The proposed measures are now to be regarded as draft clauses for the 2005 Finance Bill which will be subject to consultation and parliamentary scrutiny. However, the effective date will remain as 1 January 2005.

The legislation as currently drafted has been described as both defective and wrong in principle and it is to be hoped that considerable amendments will be made through a genuine consultation process. The comments below are based on the legislation as currently drafted but it has to be noted that this may change significantly during the next few months.

Frequently, as a result of regulatory capital requirements, life insurance companies have a surplus of assets held within the long-term fund in excess of those needed to meet policyholder requirements and expectations. This excess can have arisen through the introduction of capital or the non-distribution of emerging surplus. In addition, surplus assets in a proprietary company may have been allocated to shareholders following the attribution of an inherited or orphan estate. In many instances distribution of attributed surplus assets outside the long-term fund to shareholders has been prohibited by the FSA (or its predecessors). It should be noted that mutual insurers, including Friendly Societies, may also have such accumulated and potentially surplus assets which have not been distributed to policyholders (or members).

Where there has been either an attribution but no distribution of the inherited estate to shareholders or simply where there has been capital introduced, the taxation treatment of income and gains arising on such assets should follow the normal rules governing long term insurance business. The position here can be regarded as somewhat analogous to circumstances where the Inland Revenue has argued that the investment return on assets held outside the long-term fund but available to provide support to and at risk in the life insurance business should be taxed as longterm fund income and gains.

It is now proposed by the Inland Revenue that the appropriate tax treatment of investment return arising on such "excess assets" be codified under two guiding principles:

(1) Funds surplus to the requirements of the company but which have not been distributed to shareholders are not to be treated as referable to tax-exempt business such as pension business.

(2) Income and gains arising on such surplus assets are to be taxed at the standard rate (currently 30%) rather than the lower policyholders’ rate.

The basic methodology proposed by the Inland Revenue to implement the above principles relies on the determination and arithmetical manipulation of two aspects of the new realistic balance sheet (RBS) regime, the "Form 19 excess" and "the free assets amount". The relevant figures are used to arrive at appropriate ratios for the purpose of investment return apportionment under section 432A ICTA 1988, producing a figure of investment return not attributable to policyholders and taxable in full at the appropriate shareholders’ rate. Where this exercise is conducted for a mutual life insurer, including currently a Friendly Society, the figure of investment return is taxable in full as BLAGAB in the I-E computation, but subject to taxation only at the policyholder rate.

The ratios produced are applicable in certain closely defined circumstances and determined for the most part by the business mix, where the assets are held, and to an extent, whether the excess assets are a result of a reattribution of the inherited estate.

A key factor in this overall process is the use of figures reported on Form 19 of the periodical return, the realistic balance sheet for a with-profits fund; in particular, the so-called excess assets which are described in line 66 of that form as the "realistic excess capital for fund" and now defined for tax purposes as always attributable to BLAGAB with income and gains taxed at the appropriate shareholder rate.

There appear to be a number of flaws in the Inland Revenue approach which it is to be hoped will be addressed or rectified in the course of a proper consultation process. Whether the fundamental aims proposed are adopted is of course a matter for parliamentary decision but within this consideration should be given to a comprehensive re-think of the proposed methodology. Specific points for consideration include the following:

(1) It is currently proposed by the FSA that Form 19 – the Realistic Balance Sheet - be prepared only in respect of with-profits funds of a size greater than £500m, though any life insurer is free to complete the form and there is recognition that the scope of compulsory completion may extend at a future date to smaller with-profit funds and/or non-profit funds. Consideration needs to be given to legislation which will cover all types of fund and provide equal treatment to all.

(2) Form 19 is a brand new form and at the time of writing the final format and instructions for completion have not yet been determined, so the tax references to specific lines may be defective. In addition, Form 19 is not designed for the use to which the Inland Revenue is attempting to put it – the figures can include, for example, the present value of in-force business (PVIF) of non-profit business written within the with-profit fund and the expected volatility of the figures appears hardly conducive to a stable system of taxation.

(3) The position of mutual insurers, large and small, and of Friendly Societies in particular is not at all certain and should be clarified. Clearly mutual insurers would fall within this proposed legislation as currently drafted with the investment return taxed in full in the I-E computation but at a policyholder rate. This appears to run counter to the expressed logic underlying the proposals as it is a policyholder rather than shareholder tax that arises.

(4) There have been a considerable number of demutualisations over the last decade and in a great many instances the capital arrangements within the long-term fund have been sanctioned by the relevant court such that asset distribution has not been possible or is limited. In such circumstances it is likely that although the additional tax produced under the current proposals is calculated at the shareholder rate it could be charged to the stand-alone former mutual fund as tax attributable to policyholders. It is arguable that any such tax should be allowed as a deduction in calculating the profits of the company.

(5) Account should be taken of circumstances where the capital adequacy requirements set by the FSA mean that excess surplus or capital in the relevant fund cannot be distributed without endangering the capital resources and viability of the fund in question or, perhaps, of the long-term fund as a whole.

(6) The computational methods proposed could lead in some circumstances to at least double taxation as between the I-E and Case VI computations. In addition, where the so-called excess assets have not yet been declared as surplus arising in a particular period of account - but could be – account has to be taken of the amount of this which will be attributable to policyholders as otherwise the double taxation position will be exacerbated.

Finally, the fact that the current tax base for UK life companies is largely driven by the FSA return’s statutory measure of capital suggest that reference to elements of the RBS are inappropriate. This would also seem to add to the complexity of the proposed changes.

Transfers of long-term business

The taxation implications and treatment of transfers of long-term business continue to be an area of concern to the Inland Revenue, notwithstanding anti-avoidance measures introduced in the 2003 and 2004 Finance Acts. These previous measures were designed to close perceived loopholes, both before and after a business transfer. Specific areas targeted by the Pre-budget report in relation to business transfers, including non-EEA transfers, occurring on or after 2 December 2004 are:

• Transfers with excess liabilities.

• Transfers where shares in the transferor are assets of the transferee’s long-term fund.

The Inland Revenue states that there have been instances of transfers where the liabilities transferred exceed the assets transferred under arrangements designed to exclude profits from tax. In future any such excess of liabilities (disregarding any reduction in liabilities under a relevant financial reinsurance contract) is to be taken into account by the transferee as a taxable trading receipt for Case 1 and Case VI purposes, unless both of the following conditions are met: transferred liabilities of an amount equal to the deficiency are not taken into account in the relevant computations of the transferee for the period of account in which the transfer takes place and the closing liabilities for that period of account are not adjusted for any such disallowance but are taken as the opening liabilities for the next period of account.

The other main area of concern to the Inland Revenue is where the shares of the transferor are owned directly or indirectly by the longterm fund of the transferee, and as a result of the transfer, the fair value of those shares is reduced. This will generally occur when there is an excess of assets transferred and there is no consideration given for the transfer of business other than the assumption of liabilities. A restructuring of this nature is not uncommon within proprietary groups or as part of a de-mutualisation process so the proposals may well have a wider impact than that intended by the Inland Revenue. In summary, the new legislation will treat an amount equal to the reduction in the fair value of the shares as a taxable trading receipt of the transferee for the period of account in which the transfer takes place. Such a receipt will be included in a Case 1 computation and also in any Case VI computation.

Notional income

Specific tax legislation provides that in computations of profits prepared on a Case I basis all items shown in lines 12 to 15 of Form 40 of the periodical return are automatically to be included. However, there is an exception to this rule where the amount concerned ‘is entirely notional because an amount corresponding to it would fall to be brought into account as an expense…’. This could include items such as a notional property rental charged. The Inland Revenue has stated that some companies are seeking to use this exception to argue that amounts brought into account in lines 12 to 15 constitute notional income and are therefore not taxable, even though the amounts are not notional in any sense. The Inland Revenue does not accept this argument and has introduced new legislation, effective from 2 December 2004, defining notional income to comprise only amounts created as a result of a bookkeeping entry in the regulatory return that creates a corresponding entry for a notional expense; such a notional expense will not in itself be deductible for tax purposes, but would have been so deductible had it represented an amount paid or payable to another person.

Meaning of "Brought Into Account"

There are a number of extant tax provisions governing the allocation of investment return for tax purposes to different categories of business. Included within these are provisions based on the long-term revenue account (form 40) within the periodical return and on whether separate revenue accounts are required to be prepared for periodical reporting purposes. The use of separate forms 40 for different classes of business can affect the overall taxable profits and so the validity for tax purposes of such separate revenue accounts has been an issue between the industry and the Inland Revenue for some years, an issue likely only to be resolved by litigation.

However, legislation effective from 1 January 2005 has now been introduced to clarify the position and not incidentally to give statutory backing to the Inland Revenue’s position on this point going forward.

Key features of the proposed new rules are:

• from a revenue account prepared for the whole of the company’s long-term business, the only other account to be recognised for tax purposes will be one prepared for a "withprofits fund", as defined in the PRU.

• les are introduced to deal with instances where a withprofits fund for which a separate revenue account is required to be prepared forms part of another with-profit fund.

• es are introduced to cater for instances where a residue of the long-term fund remains after considering all of the withprofits funds recognised for these purposes.

• he revenue accounts recognised change from one period to another and there are excess "needs" amounts carried forward under section 432F ICTA 1988, excess needs amounts carried forward are to be allocated in an "appropriate manner".

Changes resulting from regulatory reform

A considerable number of minor legislative amendments have now been made to take account of the changes made by the FSA to the periodical returns and consequent upon the introduction of the Integrated Prudential Sourcebook (PRU) with effect on 31 December 2004. Many of these tax changes are consequential but there are also some changes in principle.

Following the introduction of RBS and the "twin peaks" approach to regulatory capital requirements, the government has made a policy decision that, notwithstanding the regulatory reporting changes which affect companies in different ways depending particularly upon the types of business written, there will be a common treatment for tax purposes. Accordingly, the definition of "liabilities" for corporation tax purposes is to be changed to "mathematical reserves", as used for all regulatory reporting purposes in the PRU.

Following the regulatory reporting changes made by the FSA, resilience reserves will, for many companies, cease to be included within mathematical reserves but will be a component of capital resources. A major tax effect of this is likely to be an increase in taxable surplus recorded in the periodical return, resulting in additional shareholder tax payable. However, there have been no proposals on legislation to rectify or mitigate this tax side-effect even though the problem was identified by the FSA in July 2002. The Inland Revenue has asked simply to be advised if this reporting change creates any particular tax difficulties for non-profit funds and what the scale of any such surplus increases will be.

The future of Case VI Computations

The overall industry consensus is that there is considerable merit in the merger of corporation tax computations for all business categories where there is a gross roll-up of the investment return. Such a move would greatly simplify complex tax legislation and facilitate greater offset of tax losses, which are currently ringfenced.

A major difficulty recognised is the considerable accumulated pension business tax losses and so it has been suggested by the Inland Revenue that on any merger of different categories of business there would have to be some "streaming" of these accumulated and brought forward losses. The proposal is for restricted offset of such brought forward losses against a proportion of the future total business profits which on a mean liabilities basis would be attributable to the business category with the brought forward losses.

There are also further consequential changes which may be necessary; in particular the rules generally for the apportionment of investment return and for the treatment of income arising from investment properties. This suggested change is within the overall process for the reform of corporation tax but with the current complexities of life insurance taxation it is likely to constitute a discrete consultation exercise.

Other developments

Legislation has been introduced to facilitate the entry of life insurance companies into the market for Child Trust Fund (CTF) business when such funds are generally available after 1 April 2005. Any such business for a life insurance company will comprise a separate category of tax-exempt business similar to Individual Savings Account or Pension Business. Profits or losses arising to the insurance company on this business will be taxed under Case VI of Schedule D and there is an unprecedented provision allowing the offset of losses on CTF business against profits from Individual Savings Account business and vice versa.

To qualify as CTF business, specific restrictions must apply to the insurance policy written. These include:

(i) the policy must be on the life of the child;

(ii) there can be no payments of any proceeds on termination or early surrender while the insured is still a child;

(iii) the policy cannot be assigned or otherwise disposed of except to another provider; and

(iv) the policy cannot be an annuity or a personal portfolio bond or constitute pension business.

Legislation was introduced in November 1994 to deter life insurance companies from entering into certain reinsurance contracts, usually with offshore reinsurers, which had the effect of providing a tax-free gross roll-up of investment return. The legislation operated to impute a taxable investment return to the cedant, generally calculated at a punitive rate of interest.

Exemptions and exceptions were provided for and in November 2003 new amending regulations were introduced exempting certain financial reinsurance contracts from this regime. However, these regulations were revoked ab initio by new regulations in September 2004 returning the position to where it had been and introducing some further tightening of the existing rules.

As discussed in the previous issue, specific anti-avoidance legislation directed at certain financial reinsurance contracts was introduced in Finance Act 2004, applicable to all periods of account ending after 17 March 2004, no matter when the financial reinsurance contract was entered into. Part of this legislation may become otiose and be deleted if the proposals affecting transfers of long-term business (discussed above in the section dealing with the Pre-budget report) are enacted.

At the end of November 2004 the House of Lords delivered its judgment in two high-profile cases, Barclays Mercantile Business Finance Ltd v Mawson and IRC v Scottish Provident. The decisions provide up-to-date guidance on the current state of anti-avoidance case law. The key points emerging from the judgments are: (1) Planning which reduces, perhaps to a negligible level, the commercial risk of a transaction does not necessarily prevent the tax advantage sought, so long as it does not affect the reality of the transaction. (2) Where there is in no reality no commercial transaction, terms inserted just to create a commercially irrelevant contingency may be ignored.

In the pre-budget report on 2 December 2004 the government announced its intention to change the tax status of Authorised Investment Funds (Unit Trusts and OEICs) where any investor holds more than 10% of the fund. This could impact adversely the annual deemed disposal and spreading rules for such investments held by life insurance companies. It appears this may have been an unintended consequence and the Inland Revenue has agreed to re-consider the issue.

A consultation on the introduction of property investment funds (similar to the US Real Estate Investment Trusts) was launched at the time of the 2004 Budget with the aim of introducing such funds in 2005. However, the Inland Revenue has confirmed that the introduction of PIFs will be delayed for at least a year.

As forecast in the previous issue, regulations have been issued governing the tax treatment of derivative financial instruments with property as the underlying subject matter (including derivatives based on a property index or indices but excluding property-based total return swaps). The new legislation came into effect on 17 September 2004 and provides for capital gains treatment, rather than the usual income treatment, where a life insurance company enters into such a derivative. There is, however, no allowance for indexation but instead there is a facility for the carry-back of any losses for up to two years.

These are essentially hybrid financial instruments such as convertible securities where the tax treatment of returns has usually been as income under the loan relationship provisions, but with some exceptions, for example, where the loan relationship was linked to the value of chargeable assets. Finance Act 2004 provided that hybrid financial instruments could be bifurcated for tax purposes into a "host" contract subject to the loan relationship rules and an "embedded" contract subject to the rules governing the taxation of derivatives generally. The latter taxes derivatives as income subject to some specific exceptions, including where a life insurance company enters into such a contract for the purposes of the life assurance business being carried on. Where the embedded derivative is an option or an exactly tracking contract for differences it will be taxed on a capital gains basis in the same manner as a property derivative.

We understand that the Inland Revenue Audit and Pension Schemes (APSS) office is likely to undertake audits under the Insurance Companies (Overseas Life Assurance Business) (Compliance) Regulations. APSS, as part of its audit programme, will visit the LBO responsible for the life company to review the company returns and any technical issues arising from the APSS audit are likely to be taken up by the LBO Inspector.

The audit programme is scheduled to commence in April 2005. Initially OLAB audits will be carried out separately but it is likely that from April 2006 they will become part of the current chargeable events audit regime.

The response to the consultation on the draft Regulations resulted in a large number of comments on those for the Provision of Information. The Inland Revenue has held a workshop with those organisations who responded to the consultation to discuss regulation 3 – Provision of information by the scheme administrator to the Board of Inland Revenue and regulation 10 – Information between scheme administrator and member: anticipated benefit crystallisation events. The most radical proposals were in relation to regulation 10 with the Revenue broadly supporting the option of retaining only 10(4) and 10(5).

Currently, amended draft regulations are expected to be issued by the end of January 2005 and the final regulations in Spring 2005. The Inland Revenue has also confirmed that Guidance Notes on Pensions Tax Simplification will not now be published until the end of Summer 2005.

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