UK: Corporation Tax Reform and Life Companies

Last Updated: 20 August 2003

On 12 August the Inland Revenue published the second consultation document on the reform of corporation tax (following on from the August 2002 publication).

The consultation document proposes the next steps in relation to:

  • enhancing the role of commercial accounts in the calculation of tax liabilities and abolition/reform of the schedular system
  • distinction between investment and trading companies
  • taxation of capital assets

The consultation documents also set out proposals for reform of the rules on transfer pricing and thin capitalisation. This article highlights the issues raised by the publication in so far as they are particularly relevant to life insurers.

General

The stated objectives of the contemplated reforms include greater coherence, transparency and flexibility. However the discussions which followed the 23 December 2002 press release "Making taxation of life insurance companies fairer" showed that the current system for taxing life companies is far from displaying these features.

Moreover, there is an allusion to possible structural reform of life taxation - the Government say at A.59 of Background Note A that the I minus E regime may change "as a result of various pressures on the system". It is assumed that the pressures referred to are the combination of accounting and regulatory change which is likely to revolutionise the way in which life companies report their financial results.

Implicit in the allusion is the assumption that the structural change would mean that the I minus E system is dismantled. The natural question arising from this assumption is why time should be spent on amending a system which has no shelf life.

The Inland Revenue pre-empt this concern by pointing out that transitional rules would probably require a survival of the I minus E system for business written prior to the date of change.

This is not an altogether convincing rationale to justify a wholesale change to the I minus E system, involving significant redrafting of complex legislation, followed by abolition of that system.

The underlying concern is more likely to be that a move to gross roll-up is yoked to the timetable of the international accounting standard on insurance contracts, which is something of a long game. If the FTSE has turned about and started upon an ascent, significant unrealised gains might arise on assets backing existing business and on new business written between now and a move to gross roll-up.

Reform of the schedular system

The Government is considering various options for reform of the schedular system. The main driver for change is increasing reliance on the accounting profit as the basis for calculating taxable profit, which is scarcely compatible with a schedular system.

The main shortcomings of the current schedular system are perceived to lie in the inflexible and intricate rules regarding the use that can be made of losses (which, incidentally, appear to discourage UK companies from investing outside the UK). Two main methods are canvassed for a new, non-schedular, basis of corporate taxation.

In short they are:

  • pooling of trading and property income
  • full pooling

A preference seems to emerge for the former. Currently, life insurance companies are generally taxed on the I minus E basis on profits other than the shareholder profits from pension, ISA, overseas life assurance, life reinsurance and permanent health business. The I minus E profits therefore comprise income and capital gains from real property and other investments within the life fund. The latter are computed on Case I principles but taxed under Case VI, the profits from each category of business being seen as arising from a separate Case I or Case VI source.

Pooling of a life company’s trading income (which typically is a shareholder matter) with its property income (typically an I minus E matter because the property is normally an asset of the life fund) would appear not to be possible for the purposes of I minus E.

It is not clear that such a change would, therefore, make any significant difference to the existing regime so far as the I minus E tax is concerned.

The Inland Revenue envisage that a move to full pooling would require a significant re-write of the I minus E rules, probably with reference to the legislation as it stood in Australia or New Zealand, both of which historically operated I minus E regimes similar to that in the UK but on a non-schedular basis.

The consultative document raises the possibility that it might become appropriate to reduce the number of computations to just two – a modified I minus E for BLAGAB (inclusive of the shareholder/trading profit attributable to BLAGAB) and the shareholder/trading profit computation for business other than BLAGAB (the latter possibly including PHI). This might permit the offset of losses of one of the current shareholder/trading profit Case I/VI categories against profits of another. Currently there is strict ring fencing between the categories. Life insurance companies would welcome such a change.

The Government state that this would also bring an end to most of the complex rules for overseas life assurance business. In addition, life insurance companies would welcome the ability to carry back expenses of management (within the I minus E computation) and Case VI losses to the previous year.

Expenses of management

In the light of the consultation on the distinction between trading and investment companies (and, no doubt, recent case-law) the Government appears to be concerned about the way the law is developing with regard to expenses of management and the basis on which they are relieved. These concerns extend to life companies.

Specifically the main concerns in the life company context are that currently the deduction for management expenses is to be taken for the year for which the expenses are "disbursed" rather than as reflected in the profit and loss account, and the rules for identifying management expenses diverge (at least on paper) from those applicable to trading expenses.

Some reform may therefore be proposed to align the definition and treatment of such expenses more closely with those of trading expenses.

Life insurance companies would welcome a "business expenses" rule which should ensure that a deduction is obtained for expenses which would be deductible on Case I principles but are not deductible in the I minus E computation, although they are incurred for the business, because they do not qualify as expenses of management, and vice versa.

The Government are also considering relaxation of the restrictions on the substantial shareholdings rules as they apply to investment companies.

If such relaxations are implemented, life companies are likely to wish to see a reduction in the current 30% holding condition for shares held in the long term insurance fund. This wish will be intensified if equity holdings are to be taxed on an accounts basis (see below).

Taxation of capital assets (I minus E)

Despite mixed feedback on consultation on the taxation of capital assets, the Government still intends to replace the current chargeable gains regime with rules that align more closely to the accounting treatment.

The key aspects of the proposals are (besides use of accounts as the starting point for the taxation of capital assets):

  • Abolition of indexation relief
  • Further debate on the issue of deductions for capital

There has been much discussion about the treatment of unrealised gains, which pass through a life company’s accounts but not through the I minus E computation. So far as real property is concerned, the Government appears content to allow gains to remain untaxed until realised, as now. However this is not true of shareholdings not qualifying for substantial shareholdings relief, which it is intended shall be taxed on an accounts basis. The main impact of these proposals for life companies would be that they would be taxed on unrealised gains on their portfolio equity holdings on an accounts basis.

Life insurance companies make a very large proportion of the UK’s capital gains. The potential increase in annual tax charges, required systems changes and the effect of volatility of equity returns means that it would be unfair to life companies and their policyholders to tax the gains on an accounts basis.

(Although the I minus E basis is usually thought of as taxation of the policyholder by proxy, capital gains in a life fund are generally much less kindly treated than gains accruing to individuals on assets directly held. The Government has launched a pre-emptive strike against any argument that the proposed reform should be used as an opportunity to re-align the two bases of taxation, by pointing out that they already diverge substantially – not perhaps the best of arguments to support further divergence!)

The potential unfairness has been recognised in the consultative document, to the extent of putting forward three options:

  • Exclude all remaining capital assets (i.e. assets not taxed within an income regime e.g. loan relationships, intangibles, financial instruments) from the new rules
  • Exclude policyholder share from new rules
  • Include all the remaining capital assets within the new rules but adjust the rate of corporation tax on the policyholders share to reflect the new rules

Life companies are likely to prefer that capital assets be excluded from the rules. Any major changes to the life tax regime should not be introduced as part of a wider reform of corporation tax but as a result of separate debate on the scheme of life insurance tax.

If such a system is introduced, it is difficult to comprehend why there should be any limitation on the use of other "losses" (e.g. loan relationship deficits) against unrealised equity gains, or the use of unrealised equity losses against other I minus E income.

The coherence of the system would require that if the "upside" is fully taxable as income, then the "downside" is fully deductible as expense. The way in which the loan relationships rules were implemented for life insurance companies is a good model for an accounts-based taxation of equities.

Need for discrete debate

However, the debate generated by a move in this direction would be likely to put some urgency into discussions about the future of the life tax system, and whether it is time for a move to a gross roll-up regime.

Central to, or even the driver to, such debate is the taxation of policyholders, and the creation of a level playing field for life products and other forms of investment. Although the Sandler report recommendations on the reform of policyholder taxation were not taken forward as part of the 2003 budget process, it was expected that the recommendations would be considered further within the context of regulatory and accounting changes and the reform of corporation tax. The representation process is likely to act as a catalyst for this debate.

The consultation document and background notes The consultation document is available on the Inland Revenue website at: http://www.inlandrevenue.gov.uk/consult_new/corp-tax-reform.pdf

By Ross Fraser and Lindsay J'Afari-Pak

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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