UK: Technical updates – News in brief - Insurance Market Update – June 2005

Article by Mike Brien, Peter Wintersgil, Peter Wright, Geoff Chivers and Tony Crook

FSA CONSULTATION AND DISCUSSION PAPERS

Financial risk outlook 2005

In January 2005, the FSA published its annual Financial Risk Outlook highlighting economic, financial and social developments that could affect the FSA’s ability to meet its statutory objectives. Issues noted for the general insurance sector include:

• weakening rates are to be anticipated;

• direct distribution has become more popular;

• climate change is a key long term risk;

• threat of terrorism is complicating the pricing of insurance;

• a range of potential long tail liabilities can be identified;

• claimant fraud is estimated to cost the industry £1 billion a year;

• outlook for reinsurance sector has stabilised;

• contract certainty is an area of particular concern.

Policy Statement 05/02 Insurance Regulatory reporting:

changes to the publicly available annual return for insurers In February 2005, the FSA published feedback on its consultation on the annual return and included the proposed text of rules and guidance to be effective for years ending on or after 31 December 2005. The main impact upon general insurers will be to have:

• a standardised set of reporting categories with certain materiality criteria;

• a new Form 20A intended to be a simple high level summary together with extensive supplementary notes.

Insurers should review the proposed rules and consider the system changes that will be required to enable them to complete the appropriate forms under the new reporting categories.

On 1 June 1997 a special business unit of the Accenture group, 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.

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; 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.

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 were 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.

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 does 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 has 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 have been engaged to perform some of the services that would normally be carried out by the employees of Universal Leven, and have 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 posed 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 one to 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 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.

The Court issued its judgement on 3 March 2005 with the conclusion that the services supplied by Accenture to Universal Leven did not qualify for VAT exemption. Although the ECJ’s judgement is less detailed than the A-G’s opinion, the basis of its ruling fundamentally follows the general logic expressed by the A-G.

In common with the A-G the ECJ judgement considers that even if Accenture possessed the necessary relationships with either or both of the insurer and the insured, the services provided are not those of an insurance broker or agent. Again the ECJ decided that an insurance agent is essentially involved in the selling process whilst Accenture are clearly not and are simply providing supportive back office services that are normally provided by the insurer through its own workforce.

The ECJ rules that a broker would not have any exclusivity with the insurance company it is involved in, i.e. they have freedom of choice of insurer when advising its customers, the potential policy holders. Accenture on the other hand only supplies its services to Universal Leven.

It also concludes that an agent would be involved in some form of mediation between the two parties before the contract is concluded. As with the A-G the Court is of the opinion that the power to commit the insurer is insufficient to qualify the provider’s services as being those of an insurance agent and therefore falling within the exemption allowed under Article 13 B(a).

The Court’s final conclusion was that the provision of out-sourced services does not qualify for VAT exemption, regardless of any relationships and that VAT exemption should only be restricted to the services of brokers and agents involved in bringing the two parties to an insurance transaction together.

Customs have announced that they will enter into a period of consultation with interested parties before announcing any changes to existing policy or even legislation. It may therefore be a number of months before the full impact of the ECJ’s judgment for UK insurers and service providers is known. In the meantime, both insurers and service providers should review the VAT clauses contained within existing contracts with a view to estimating potential costs that may arise as a result of the judgment and establishing to whom the responsibility for any VAT cost will fall. The need to take into account the potential changing VAT position for any new contracts being entered into will also be important during the period of uncertainty.

There should also be scope available to ensure arrangements can be structured in a way that VAT costs can be kept to a minimum if, as expected, all back office support services provided to insurance companies become subject to VAT. Advice on the measures that could be considered should be sought before contracts are finalised.

The ECJ released its judgment on the Banques Bruxelles Lambert (BBL) case. As a result, UK established fund managers can continue to supply services VAT free to foreign investment funds and recover input VAT on the related costs.

The decision of the Court was very narrow: it has confirmed the UK treatment for UK fund managers and UK funds, called into question the VAT treatment in some EU member states and failed to answer a number of key issues in the fund management industry.

For the time being UK fund managers that are providing management services to Luxembourg SICAVs and other off-shore funds should be able to continue to effectively zero rate their services and obtain VAT recovery on related costs.

The judgment does not comment on the availability of VAT exemption for management services to local funds. Consequently, the UK VAT exemption will continue to apply only to the management of UK Authorised Unit Trusts and Open Ended Investment Companies. This treatment is currently the subject of a joint challenge by the AITC/JP Morgan Claverhouse and so we will have to wait for confirmation from this case.

The Court has confirmed, following the Advocate General’s Opinion, that SICAVs are taxable persons for VAT purposes. This is based on the fact that their activities go beyond the mere acquisition and sale of securities and so constitute economic activities.

The decision confirms only the taxable status of SICAVs and does not address the VAT status of other non-UK funds. However, it does raise a wider concern in respect of non-UCITS funds that purchase services that do not qualify for VAT exemption. The risk being that as a result of becoming a taxable person the reverse charge provisions apply and VAT would be chargeable on certain overseas services that were previously acquired tax free.

The judgment also confirms that as management services are effectively financial transactions the place of supply would be deemed to be where the SICAV is established (i.e. management services are deemed to be Article 9(2)(e) services within the EC Sixth Directive): the treatment broadly adopted by most member states. The Court did not provide any clarification on the services that fall within the definition of "management". As neither the EU Sixth Directive nor the UK legislation defines the term "management", we will have to await the Court’s decision in another case, before the position will become clearer.

We understand that an appeal has been lodged to the VAT Tribunal to challenge Customs’ position on the treatment of costs associated with the issue of bonds. The taxpayer is arguing that bond issues are not a supply for VAT purposes. Thus the VAT incurred in issuing the bond represents a general overhead of the business, and is recoverable accordingly. There may therefore be an opportunity to recover input VAT that Customs has previously restricted.

A bill allowing the merger of the Inland Revenue and Customs has been included in the Government’s legislative programme. The bill proposes a new single integrated department to be known as H.M. Revenue & Customs (HMRC). A new office to prosecute HMRC cases in England & Wales will also be created.

The ECJ is currently considering its verdict in the case of Banca Popolare di Cremona, which will determine whether the levying of Italian Regional Tax is contrary to EU law. If the ECJ rules in favour of the taxpayer, then any company that has paid IRAP will be entitled to submit a refund claim. Significantly, the European Commission has submitted its opinion to the court, and has strengthened the taxpayer’s claim by supporting its argument that the levy of IRAP contravenes EU law.

Under EU legislation, member states are able to impose "any taxes, duties or charges which cannot be characterised as turnover taxes". This restriction exists to prevent any member state from introducing its own tax that is judged to be "sufficiently similar" to VAT, a judgment based on several factors such as whether the tax is levied at each stage of the production of goods and services, and whether it is proportional to their price.

Although the ECJ has yet to return its verdict, it is possible that the ECJ or the Italian government could impose a limitation period for claims if the taxpayer is successful. Accordingly, a business with Italian branches or subsidiaries that have paid IRAP should submit protective claims prior to the ECJ’s decision.

A further development in Italy has been the introduction of the requirement to make a pre-payment of 12.5% of the IPT paid in the previous year. Consequently, for 2004, this up-front payment, which would be 12.5% of the calendar year 2003’s IPT liability, had to be paid by 15 December 2004. This is despite this change only being announced on 29 November 2004.

As announced in the Pre-Budget Report on 2 December 2004, the Government has introduced legislation in Finance Act 2005 to restrict double tax relief for foreign tax suffered on trading income. The intention of the new rules is to ensure relief is only available against UK tax on the net profit produced by that specific item of income. Previously, practice in certain industries was to restrict relief only by reference to total UK tax on the trade the income forms part of. This practice had recently been upheld by the Special Commissioners in the Legal & General case.

Where it is impossible or impracticable to do the calculations in respect of every single item of income, calculations on an aggregated basis will be acceptable. It will be necessary to demonstrate that such aggregate or approximate calculations use all information that is available or can be made available, and produce a result that is not likely to be materially different from the result that would be produced by a more resource-intensive method. Equity traders will benefit from a transitional safety net ensuring that the new rules will not deny credit for more than half of the foreign tax suffered on dividends received between the effective date of the new rules for companies (Budget Day, 16 March 2005) and 31 December 2005.

Three anti-avoidance measures have been introduced by Finance Act 2005 as follows:

1) From 16 March 2005 (and in one scenario 10 February 2005) companies, individuals or partnerships, entering into a scheme or arrangement to claim double tax relief where tax avoidance is one of their main purposes, may be affected if the arrangement falls within one of five prescribed circumstances. The double tax relief claim will be limited so as to cancel the effect of the scheme or arrangement on a just and reasonable basis. The legislation will only apply where the double tax relief claim is not minimal.

The prescribed circumstances will apply where one or more of the following are true:

• the foreign tax is not properly attributable to the source from which the income is derived;

• the payer of the foreign tax and any person associated with the transactions have not together suffered the full economic cost of the foreign tax;

• a claim or election that could have been made and which would have reduced the foreign tax credit eligible for relief was not made, or a claim or an election that was made increased the amount of relief;

• the foreign tax credit reduces the tax payable to less than would have been due if the transaction had not occurred (with effect from 10 February 2005);

• the income subject to foreign tax was acquired as consideration for a tax deductible payment.

Furthermore, the legislation will only apply where the Revenue issue a notice directing that it does. The taxpayer will then need to consider how the legislation applies and self-assess in the normal way. Penalties will not arise if a notice has not been issued before a return has been made since the return can not then have been incorrect.

Notices may be issued before or after a tax return is made and on a discovery basis after the enquiry window has closed. The legislation will only apply to underlying tax credits in circumstances where a foreign company is being interposed to avoid the application of the legislation to a UK company. Guidance published on Budget Day includes reference to the availability of advice under Code of Practice 10 on whether the rule will apply as well as ‘general clearances’ where the legislation will not apply.

2) Certain payments may be characterised as interest for tax purposes in another jurisdiction but as dividend under UK law. In these circumstances, the payer obtains a tax deduction in another jurisdiction for the payment, but credit for the underlying tax is given in the UK against the receipt. No underlying tax relief will be given in these circumstances with effect from 16 March 2005.

3) Changes made limit the scope of Section 803A ICTA 1988, which treats all group companies in a foreign jurisdiction as a single entity for the purposes of calculating underlying tax credits, so that it does not apply from 16 March 2005 to a controlled foreign company for which exemption is available under the Acceptable Distribution Policy test.

The Pre-Budget Report on 2 December 2004 indicated that some minor amendments to Schedule 29 to Finance Act 2002 were proposed, to remove some perverse effects which could have arisen in relation to the taxation of Lloyd’s syndicate capacity upon the adoption of international financial reporting standards ("IFRS") by a corporate member.

Following the Budget on 16 March 2005, paragraph 116A of Schedule 29 has been amended by Finance Act 2005 to ensure that any taxable credit which arises as a result of the write up in value of capacity upon the move to IFRS is capped at the level of net debits previously given; that is, the amortisation charged in the corporate member’s accounts claimed as tax deductible since 1 April 2002. Finance Act 2005 also removes a potential problem with paragraphs 5 and 6 of Schedule 29. As previously drafted, the Inland Revenue could seek to impose the indefinite life treatment of capacity where the consolidated accounts are prepared under IFRS, even though the member’s accounts are prepared under UK GAAP. This would allow them to argue that there should be no deduction for the amortisation. This provision has now been amended to ensure that the Revenue may not challenge the deduction of the amortisation in situations where capacity is amortised in the member level accounts prepared under UK GAAP, but not amortised in the consolidated accounts which are prepared under IFRS.

Lloyd’s Market Bulletin Y3530 dated 29 March provides further information; note however that it includes references to the clauses in Finance Bill 2005, issued on 24 March, not to the Finance Act which received Royal Assent on 7 April.

The Budget Report of 16 March 2005 referred to a proposal to repeal Schedule 19 of Finance Act 1993 and replace it with Regulations made by Statutory Instrument. Schedule 19 contains provisions relating to the administrative rules under which Lloyd’s managing agents make returns of syndicate profits and losses, computed for tax purposes.

The Inland Revenue considers that the administrative procedure for the assessment and collection of tax should be modernised and made more efficient. For instance, changes could be introduced to allow for electronic filing of syndicate tax returns and to apply self-assessment principles to the calculation of syndicate profits rather than the current determination system. Revisions to the current obsolete penalties regime are also possible.

Due to the General Election on 5 May, this was not included in Finance Act 2005 (given Royal Assent on 7 April). It is expected that this legislative change will be made in Finance (No. 2) Act 2005 later this year. Draft regulations have not yet been made available. Lloyd’s was consulted on this proposed change to the legislation as part of the wider review of the basis of taxation of Lloyd’s members. The Government’s decision to leave the basis upon which Lloyd’s members are taxed as it is for the time being (ie, the declarations basis), and the above proposed legislative change does not in any way affect the current system of taxing Lloyd’s members on their syndicate results or give the Inland Revenue any power to change the basis unilaterally.

The Revenue has confirmed that Lloyd’s will be consulted on any proposed changes to the administration under the Regulations. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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