UK: Life Tax Measures
Including Iimportant Proposals Affecting Corporate and Finance Transactions

In a mixed bag of life tax measures announced just before Christmas, the Inland Revenue set out proposals to reform:

• treatment of capital losses (the provisions in question being apparently designed mainly to prevent ‘bed and breakfasting’, by ‘box transfers’ and other means, and to restrict use of ‘I – E’ capital losses against shareholder gains)
• treatment of Case VI losses from gross roll-up categories of business such as pension, overseas life assurance business, and ISA business on a transfer of insurance business
• restatement of the scope of Case I receipts

The stated aim is to improve the effectiveness and fairness of the tax rules for life companies. Draft legislation has been promised but has not yet appeared. The capital gains proposals, if enacted, will apply to gains accruing and deemed disposals on or after 23 December 2002. The other proposals, if enacted, will apply to periods of account beginning on or after 1 January 2003.

The proposals are set out in more detail in the rest of this note. The press release describing the changes said that "the proposed measures will not change the broad structure of the current regime for taxing life insurance companies".

Whilst there has been press comment that the proposed changes to the use of capital losses will have a negative impact on life insurance companies, and may in some cases affect policyholder returns and put more pressure on life companies to cut bonuses, there has been less coverage on the measures which affect transfers of business and Case I receipts. Certain of those changes, whilst affecting certain transactions in particular, are very relevant to the whole conceptual basis on which life insurance companies are taxed, and seem to us to introduce anomalies into the taxing regime rather than to remove them. We are particularly concerned at the move closer to Form 40 of the regulatory returns as the basis for identifying Case I receipts, without any similar basis for the identification of Case I deductions, and the treatment of payments out of the investment reserve as made out of taxable profits, without any equal and opposite effect for payments into the investment reserve.

We are also concerned at the restrictions on the transfer of Case VI losses on an insurance business transfer. The restrictions move a step away from treating the transferee as standing in the shoes of the transferor – which in our view was what the regulatory legislation is intended to achieve – and may, in the case of pension business, place a significant restriction on the viability of transferring that business, and encourage companies to undertake more complex transactions in order to facilitate the transfer of bona fide losses relating to the business which is being transferred.

In summary, it appears that the changes are more substantive than suggested by the press release. While one of the aims is to "prevent a small number of companies exploiting particular circumstances to pay much less tax than other companies writing similar business", it would seem that an additional result of the measures may be to introduce tax charges in respect of transactions which would previously have been tax neutral. This would seem to punish the "innocent" as well as the "guilty".

Under current law, there are a number of circumstances under which assets may be transferred into or out of the long term business fund of a life company without any Case I consequences. Such circumstances include the receipt of the capital proceeds of, and repayment of the capital value of, a loan, the transfer of assets as part of an insurance business transfer, and a transfer between sub-funds.

The proposals appear to remove the tax neutrality of such transactions. They may cause significant mismatches, or even double taxation, to occur in respect of historic transactions (where assets have been transferred into a long term fund on a tax neutral basis), but the basis of taxation on their transfer out of the long term fund will, if the proposals are enacted, change.

It is proposed that, for periods of account beginning on or after 1 January 2003 where a life insurer makes payments or transfers assets directly out of the investment reserve (including in the course of or in connection with a transfer of insurance business), the amount of the transfer will be treated as an additional amount of investment return and included in the computation of profit.

This legislation is aimed at surplus and therefore there are "carve-outs" for

• discharge of certain Form 14 liabilities; or
• disposals in the ordinary course of business; or
• where the assets are transferred directly into the investment reserve of the transferee (in the context of an insurance business transfer, by election); or
• where payments made by the transferee under such a transfer directly or indirectly derive from amounts on which the transferor was charged to tax under the main proposal described in the above two paragraphs.

In addition, Section 83(2) of the 1989 Finance Act is to be rewritten to "make it clearer" that what is brought into account is the amounts as disclosed on lines 12 to 15 of Form 40, subject only to purely notional amounts. Lines 12-14 are the lines used for investment return. Line 15 is "other income".

The potential impact of these proposals can be illustrated by applying them to a contingent loan raised from a third party (as might occur on the securitisation of future surplus by a proprietary company).

Had the proceeds been introduced directly into the investment reserve, there would have been under existing law no tax deduction or fiscal adjustment on the introduction of the funds, and no change to this is proposed. But, if the measures announced by the Inland Revenue are enacted, the making of a repayment directly from the investment reserve will tend to give rise to a tax charge not balanced by any corresponding deduction and not covered by the proposed carve-out (because the liability to repay the loan is not recognised for regulatory purposes). The result is that the profits required to repay the loans would in principle be fully taxable.

This distorts the existing analysis – in our view an analysis which is coherent and logical – that the receipt of loan proceeds and the repayment of the loan should be treated as tax neutral because these operations do not and cannot represent profits or gains, as a matter of law.

Subject to the draft legislation, it does appear that the proposals may impact on existing contingent loans. But contingent loans are only one example of the impact of the proposed changes. Similar distortions are likely to occur as a result of historic insurance business transfers, and mechanisms under which transfers are made between sub-funds within one long term business fund. Depending on the terms on which the relevant transfer was sanctioned by the Court, the tax risk on unwind of a historical transaction may not always fall upon the shareholders of a life insurance group, but could fall on the policyholders.

In our view, the move to tie the profit computation more closely to the lines on the regulatory return is inappropriate for more fundamental reasons. First, the return is primarily aimed at calculating solvency, and the descriptions given to particular lines on the forms are often not apt to describe those items for tax purposes. The use of the regulatory return as the basis for taxation does not justify the inclusion in a computation on Case I principles of amounts which have never been taxable income as a matter of law, but which are included on a particular line because of the lack of a more appropriate category on the form.

Secondly, the timing of measures to tie taxable profits more closely to the regulatory accounting also seems inappropriate, given the current state of flux as to the accounting for insurance business, both in the modified statutory accounts and the regulatory returns. As the FSA stated in Discussion Paper 12, when considering changes to the regulatory reporting regime:

Finally, the proposals would seem to discriminate against life insurers by introducing a restriction – by removing tax neutrality – on the introduction of capital finance, at least in a contingent form, and by treating items as Case I profits which would not be so treated in an ordinary trading company.

The proposed measures include the following:

• Where assets are left behind in the investment reserve of the transferor when an insurance business transfer takes place, it is proposed that those assets are to be taxed as a post cessation receipt (thus preventing the leaving behind of assets in the transferor, which are then appropriated without incremental tax);
• It is proposed that the apportionment of investment return, as between exempt categories of business (for example pension) and taxable categories (BLAGAB) be weighted where a transfer of business takes place part way through a period of account. This eliminates the benefit which has historically been obtained by transferring the business at "one minute to" or "one minute past" the end of a period of account;
• It is proposed that capital losses may now be transferred under an insurance business transfer, which eliminates a historic anomaly and is to be welcomed. However they will be subject to streaming rules (i.e. the losses transferred may be offset against future capital gains on the transferred business, not on the transferee’s existing business);
• It is proposed that Case VI losses (losses arising on the classes of business which are taxed under Case VI but on Case I principles – pension business, ISA business, overseas life assurance business and life reinsurance business) will be available for transfer only where section 343 ICTA applies, and will be subject to streaming.

• It is proposed that a deemed FSA return will be required for tax purposes where a company is excused by the FSA from preparing one, and where the period ends with or included a transfer of business or falls immediately before such a period.

Both the measures applicable to Case I profits and the other measures applicable to insurance business transfers take effect in respect of periods of account beginning on or after 1 January 2003. Subject to any restrictions introduced for tax purposes by the legislation which implements the proposals, it is possible for a company governed by the British companies’ legislation to change the end of a period of account retrospectively, as long as the accounts filing deadline has not been passed, and as long as the period of account does not last more than 18 months.

The existing position is that there is no limitation from a tax point of view on the offset of chargeable gains and allowable losses attributable to the shareholders or accruing outside the long term business fund or indeed accruing in shareholder companies within the capital gains group against chargeable gains or allowable losses attributable to policyholders.

The measures are summarised as follows:

• A "shareholders’ share" concept is introduced in respect of capital gains and losses, with the effect that allowable losses not arising on the disposal of assets of the long term business fund (e.g. in the shareholder fund) may only be offset against the shareholders’ share of chargeable gains in the long term fund;
• Similarly, the policyholders’ share of allowable losses in the long term fund will not be available for offset against gains on the disposal of assets outside the long term fund;
• The section 171A TCGA 1992 election (to treat an asset as notionally transferred to another company in the group prior to disposal) will be available to life insurers but the deemed acquisition and disposal will be treated as the acquisition and disposal of an asset which is not an asset of the long term fund;
• A loss on transfer between "CGT boxes" (section 440 ICTA) will only be offsettable against gains in the period in which the asset is disposed of by the life insurer (or a member of its group) to a person who is not a member of such group and will be "suspended" pending such disposal. Where the loss arises on an insurance business transfer, the suspended loss will be suspended in the transferee;
• Similar rules will apply to debits arising from deemed related transactions under section 440 on loan relationship and derivative contract assets;
• Rules will be introduced to discourage other methods of bed and breakfasting (apart from the triggering of section 440). No detail is available.

There has already been press comment on the prevention of the offset of policyholder losses against gains attributable to shareholders or accruing elsewhere in the shareholder group environment, and the adverse effect which this is likely to have on life companies seeking to improve their balance sheets, as well as potential adverse implications for policyholders.

It is also worth noting that these measures are very much a "one-way street". It does not seem even-handed, for example, to restrict the availability of losses accruing as a result of the application of section 440 to the period in which the assets are sold outside the group, but to subject companies to an immediate tax charge if the application of section 440 gives rise to a gain.

Another example of the "one way street" is that common ownership is required for the transfer of Case VI losses on an insurance business transfer, but a loss arising on a "deemed disposal" on an insurance business transfer, whilst suspended in the transferee, is not available until the asset is sold outside the insurance company or its group. The change to the loss carry over moves away from the "stand in the shoes" tax treatment of the insurance business transfer, whereas the section 440 loss provision moves closer towards it.

Necessary changes will be made so that the legislation applies to OLICs. (It remains to be seen what effect the proposals, if implemented, will have on the attractions of the UK as a jurisdiction in which to carry on life business and whether companies will look to any form of cross-border restructuring.)

Regulations will be made so that the provisions are applicable to friendly societies carrying on life or endowment business.

The Case I profits basis for computing profits of life assurance is used for the computation of profits attributable to pension business, and for a total company "notional" computation, which is used to determine the element of the company’s taxable profits which should be taxed at shareholder (30%) rather than policyholder rates of tax (22% or 20% depending on the nature of the income and gains).

The Inland Revenue’s published practice, based on legal advice, and long standing practice in the industry, is to use the actuarial surplus for the period as the basis for the profit computations.

However they explicitly recognise in that published practice that "in many cases this surplus will not be apparent from the face of the regulatory return and will have to be constructed from the various elements that make it up". Therefore the link to the regulatory return has not been sufficiently rigid to preclude an analysis of the nature of the items included therein and there has always been a good case for arguing that overriding legal rules should apply to determine what are taxable receipts for the Case I profits basis.

Section 83(2) FA 1989 provides the basis on which investment return is to be taxed in the Case I computation. The existing wording of section 83(2) closely matches the description of lines 12 to 14 of Form 40 (investment income, increase or decrease in the value of non linked assets brought into account, and increase or decrease in the value of linked assets brought into account).

The section was intended to mirror the investment return recognised for regulatory purposes, and "respected" the investment reserve for this purpose.

Section 343 ICTA 1988 applies to allow losses (and certain other amounts) to be carried forward on a transfer of trade in which the losses were incurred from one company ("Oldco") to another company ("Newco"), where both companies are in 75% common ownership (defined by reference to beneficial ownership of "ordinary share capital" (as defined)). The losses are however "streamed", in other words cannot be offset against Newco’s total trading profits, but only against the proportion of them which corresponds to the profits Oldco would have earned had there been no transfer. Many life company Oldcos (mutuals for instance) do not have ordinary share capital as defined.

Under existing law, the concept of shareholders’ share and policyholders’ share is used to determine the element of the I minus E profits which are to be treated as shareholder profits for tax purposes, and taxed at 30% rather than policyholder rates. It is also used to determine the element of I minus E profits against which losses of the life company’s group may be surrendered.

ICTA 1988 section 440 provides that if an asset moves from any one of six categories to another such category, it is deemed to be disposed of, for the purposes of corporation tax on chargeable gains (and on loan relationship and derivative profits) at its market value. The "boxes" are illustrated diagrammatically below:

© Herbert Smith 2003

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