ABI RESPONSE TO THE MARCH 2010 CONSULTATION DOCUMENT SOLVENCY II AND THE TAXATION OF INSURANCE COMPANIES: LIFE INSURANCE

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1 ABI RESPONSE TO THE MARCH 2010 CONSULTATION DOCUMENT SOLVENCY II AND THE TAXATION OF INSURANCE COMPANIES: LIFE INSURANCE 2 June 2010

2 The ABI is the voice of the insurance and investment industry. Its members constitute over 90 per cent of the insurance market in the UK and 20 per cent across the EU. They control assets equivalent to a quarter of the UK s capital. They are the risk managers of the UK s economy and society. Through the ABI their voice is heard in Government and in public debate on insurance, savings and investment matters. 2

3 Summary The I-E regime which applies to UK Life Companies has developed over a very long period of time, changing and adapting as the industry has changed. Solvency II offers a new challenge to the regime, but it is merely the latest challenge; it is not fatal to the regime. As its name suggests, Solvency II is concerned with solvency, and is agnostic in relation to tax. It is an unintended consequence of Solvency II that the legal basis and sources of information for the profit computations within, and a number of secondary calculations required under, the UK s I-E regime will cease to exist. As a result of this, there is no choice but to find another starting point for the determination of profit and another data source for the secondary calculations. In answering the questions put to us by HM Treasury, we have adopted the following core principles: 1. That the I-E regime is sufficiently flexible to accommodate a change of source of data for the computation of profits and secondary calculations, and the change does not suggest that the structure of I-E cannot continue, albeit that maintenance may be required; 2. That Solvency II should not disturb the expected tax profile of companies, for example by causing the write-off of tax assets on the balance sheet, or fundamentally changing the expected tax take from the company (albeit that we appreciate that timing of profit emergence may change, which should be mitigated by appropriate transitional provisions); 3. That there are factors which distinguish Life Companies from other businesses, namely the fact that the policyholders have an interest in the profits and assets of the business, either directly or indirectly, and we believe, mirroring this, that the tax regime should continue to carry out the dual purpose of combining taxation of the Life Companies with a collection mechanism from policyholders. 4. That it is critical to competitiveness and to the rebuilding and maintenance of policyholder and shareholder confidence to assure stability and certainty in what is a long-term business. 5. That Solvency II should not be taken by Life Companies or HMT / HMRC as an opportunity to revisit areas of the Life Tax Regime with which they are uncomfortable but which do not need to change as a result of Solvency II. Consistent with these principles we believe that the trading profits tax base should be kept broadly as it is now. We see three categories of adjustments which would be required to achieve this position: 1. Starting from a new basis the financial statements will lead to variations in measurement compared to the current regime, and life assurance trading profits computations will necessarily require different adjustments to this new starting position to arrive at a tax base broadly similar to the current one. 3

4 2. We also propose a small number of additional adjustments that we believe are required to reflect the changing context that Solvency II and the use of the financial statements will bring. 3. We also believe that some amendments to the wider corporation tax regime around life companies will address the issues life companies have with dealing with the additional volatility that we believe will be introduced by moving to an accounts basis and in particular in the context with the dual tax system (which calculates policyholder and shareholder tax liabilities) A summary of the specific measures needed to achieve this is set out in the table on pages 8 and 9. Once the shape of the new regime is better defined there will be a need to consider further what transitional arrangements will be appropriate. While the responses in this document, where relevant, apply as much to mutual companies and friendly societies as they do to proprietary companies, there may be particular issues on which additional measures relevant only to mutuals and friendly societies are necessary in order to preserve a reasonable and balanced outcome. There are a number of areas that would benefit from further discussion in the HMRC work stream meetings, such as apportionments, the future status of the long term and shareholder funds, the treatment of PHI business, the treatment of shareholder assets and the scope of further direct allocation of income and gains. Our response to the Consultation chapter on the potential wider reform of the I-E regime is contained in section 3 of this paper. The ABI has considered the issues in this chapter at the highest levels and has agreed that it would welcome an open discussion with the Government on the potential wider reform of the I-E regime. The issues raised in this chapter of the Consultative Paper are extremely serious for some members, particularly as regards accumulation of excess E. The ABI as a whole is committed to changes that would support and encourage consumers to save more, and take out protection for themselves and their families. We would welcome a discussion that linked reform of I-E to these important goals. 4

5 HMRC CONSULTATION DOCUMENT: SOLVENCY II AND THE TAXATION OF INSURANCE COMPANIES ABI RESPONSE LIFE 1. Introduction Our unified strategic position The I-E regime which applies to UK Life Companies has developed over a very long period of time it dates from 1915 in the I-E form. During this period, it has changed, adapting as the industry has changed. There is a rich body of case law supporting the regime, and a significant volume of legislation recording how the tax law grew alongside the regulatory and insurance law which supports one of the UK s leading industries. To the newcomer, the regime appears in need of simplification; its complexity is frustrating. But the concept at the centre of the regime is sophisticated and flexible, capable of efficient application to different mixes of business and different phases of the product cycle, and able to change to support innovation and our industry in the UK is world-leading in innovation. Our tax regime needs to support our industry, making it good for companies to be here in the UK, and for inward investors to place their capital here. There are times when the regime has needed greater or lesser maintenance (1989/1990 and 2006 are examples of this), and there are those who believe that quite apart from Solvency II, the regime needs some maintenance now to keep it fit for purpose for the majority of the companies which use it. The efficacy of the regime is affected by case law, taxpayer activity and legislative change, but these influences tend to be taken into account and adjusted as part of the ebb and flow of what is a long-term regime, and do not of themselves suggest that the concept is flawed or outmoded. It is in the interests of the industry to have a regime which works for HMRC and industry alike, and whilst utilitarianism might accept that a small minority of companies at any time find the regime unfair, it must be that the regime should work for the majority of the companies in the industry and be seen as fit for purpose by them (and by the HMRC customer account managers for those businesses). It is important to bear in mind the intimate relationship between the I-E regime for companies and the taxation of life policies. Not only does the I-E regime generate significant cash-flow for the Exchequer but it impacts the performance of life assurance companies through being integral to product design and the determination of policy liabilities and embedded values. It is very possible that change to I-E, whether to its basis or the way in which it operates as this affects quantum or timing, might cause loss of value to Life Companies, in some cases even without giving increased tax take to the Exchequer we should work together to avoid lose-lose outcomes at the very least. Solvency II offers a new challenge to the regime, but it is merely the latest challenge; it is not fatal to the regime. Solvency II should not, of right, offer any challenge to the regime, because it is, as its name suggests, concerned with solvency, and is supposed to be agnostic in relation to tax. It is an unintended consequence of Solvency II that the legal basis for the profit 5

6 computations within and a number of secondary calculations required under the UK s I-E regime ceases to exist. As a result of this, there is no choice but to find another starting point for the determination of profit and another data source for the secondary calculations. In answering the questions put to us by HM Treasury, we have adopted the following core principles: 1. That the I-E regime is sufficiently flexible to accommodate a change of source of data for the computation of profits and secondary calculations, and the change does not suggest that the structure of I-E cannot continue, albeit that maintenance may be required; 2. That Solvency II should not disturb the expected tax profile of companies, for example by causing the write-off of tax assets on the balance sheet, or fundamentally changing the expected tax take from the company (albeit that we appreciate that timing of profit emergence may change, which should be mitigated by appropriate transitional provisions); 3. That there are factors which distinguish Life Companies from other businesses, namely the fact that the policyholders have an interest in the profits and assets of the business, either directly or indirectly, and we believe, mirroring this, that the tax regime should continue to carry out the dual purpose of combining taxation of the Life Companies with a collection mechanism from policyholders. 4. That it is critical to competitiveness and to the rebuilding and maintenance of policyholder and shareholder confidence to assure stability and certainty in what is a long-term business. 5. That we need to tap the expertise of the latest generation of life tax professionals to find the right flexible solutions to ensure that the I-E regime continues fit for purpose through Solvency II. 6. That Solvency II should not be taken by Life Companies or HMT/HMRC as an opportunity to revisit areas of the Life Tax Regime with which they are uncomfortable but which do not need to change as a result of Solvency II. At the core of our principle-based case for the proposed Solvency II trading profits tax regime lies the concept of profits available to shareholders. This concept is derived from (3) above to the extent that our profits are constrained from being at the disposal of shareholders because of obligations to policyholders which may take precedence, the taxation of such profits should be deferred until the constraint is lifted. This keeps assets held for the benefit of policyholders whole and protects solvency. 6

7 Scope of our responses on technical issues The uncertainty over the primary tax base makes it difficult to answer detailed questions about secondary calculation effects, although individual life offices may have more clarity due to their individual circumstances. Our general approach has been to state that we prefer the current functionality and purpose of the legislation, but you will appreciate that once the data and basis are clearer, we may reach different conclusions through the working groups. There will undoubtedly be areas of technical detail which we have not as yet identified and will emerge from the coming period of work. Similarly there will be very particular cases (e.g. OLICs) upon which this response does not touch. These particular cases must be considered in the working groups. Key points for particular consideration The industry is also going through a period of major regulatory change, both in terms of dealing with its distributors and customers (under the Retail Distribution Review), and the capital and solvency position of life companies under Solvency II. Whilst this may not of itself cause surgery to be required to I-E, these changes use scarce resources within Life Companies and may place systems barriers on Life Companies which make very major change difficult to achieve in practical terms. We would ask that HMT give appropriate weight to resource and systems requirements in the course of this consultative process. Our responses We set out responses to specific questions in the Consultation Document below. The numbering refers to paragraph numbers in the Consultation Document and so the numbering sequence is not complete. It should be noted that insurance groups are at different stages in their Solvency II projects and that the Solvency II project itself is not yet finalised. The IFRS 4 phase II project is even less advanced, indeed at the time of writing we understand that the expected date for an Exposure Draft has been pushed back once again to July This means that it is not possible at this stage to provide numerical evidence in many cases. As the wider Solvency II project continues some of this data should become available during Q

8 2. A new basis for the calculation of trading profits for Life Insurers Tax Adjustments to Accounts Profits We believe the best way to achieve the aims set out in our unified strategic position is to keep the trading profits tax base broadly as it is now. We see three categories of adjustments which would be required to achieve this position (which are set out in the table below) together with appropriate transitional adjustments that are discussed at 2.18: (i) starting from a new basis the financial statements will lead to variations in measurement compared to the current regime, and life assurance trading profits computations will necessarily require different adjustments to this new starting position to arrive at a tax base broadly similar to the current one; (ii) we also propose a small number of additional adjustments that we believe are required to reflect the changing context that Solvency II and the use of the financial statements will bring; and (iii) we also believe that some amendments to the wider corporation tax regime around life companies will address the issues life companies have with dealing with the additional volatility that we believe will be introduced by moving to an accounts basis and in particular in the context with the dual tax system (which calculates policyholder and shareholder tax liabilities). Measure Adjustments required for change of basis Adjustments required for changed context Adjustments for increased volatility See section (i) (ii) (iii) Deduction for policyholder taxes To continue the provisions of FA 1989,s82A Deduction for Policyholder bonuses To continue the provisions of FA 1989,s82 An exemption in respect of shareholder share of UK and overseas dividends To continue the effect of FA 1989,s89 Tax relief for movements in FFA / UDS Principle of only taxing profits

9 An exemption for unavailable amounts by virtue of external sanction (e.g. Court schemes, FSA support schemes) Income & valuation gains on structural assets Exclude accounts movements in DAC and value of in-force business. Extending standard corporation tax reliefs to life companies. Deduction for Solvency II technical liabilities in excess of accounting liability Mechanisms to deal with expected increased volatility, such as an equalisation reserve and an extended loss carry back. available to shareholders Principle of only taxing profits available to shareholders To continue provisions in FA89 s.83xa Retain consistent mechanism for deduction Principle of only taxing profits available to shareholders To increase comparability with companies taxed on accounting profits To deal with the expected increased volatility in change of basis & Accounting Developments Source of profit figure under an accounts basis 2.9 (i) Comment is welcome on the proposed starting point for the determination of life assurance trade profits, including whether there might be circumstances where a different figure from the accounts would be more appropriate (for example to take account of exceptional items). 9

10 The starting point for calculating life assurance trade profits is less important than a suitable arrival point. Our view of a suitable arrival point is discussed further below (see 2.12). If the desire is to align more closely the life assurance trading regime with the general trading profits regime then movements that occur beyond the profit before tax line (extraordinary items and movements through the STRGL (UKGAAP) or statement of other comprehensive income (IFRS)) should be taken into account in preparing the tax computation. ASB Proposals on the Future of UK GAAP 2.10 (i) Comment is welcome on the implications for life companies of the ASB s proposals, and in particular on the ASB s proposed timetable and on the question as to whether there are any categories of Life company which would not fall to be classified as publicly accountable. The ASB proposals on the future of UK GAAP will need wide agreement to proceed and the ABI can only speak for its members. In its response to the ASB s consultation the ABI broadly supported a move to IFRS for UK companies but with caveats in respect of: (i) (ii) (iii) (iv) (v) Scope: We do not consider that publically accountable entities should be prevented from applying IFRS for SMEs if they are non-listed. Wholly-owned subsidiaries: We do not agree that entities need have the same accounting requirements whether they are wholly owned subsidiaries or not. We propose that the ASB should carry out a full review of the appropriateness of IFRS standards for UK subsidiaries of UK parents. Impact on tax, distributable reserves and banking covenants: We suggest the ASB needs to undertake more research into these potential consequences of removing its accounting standards and moving to full IFRS or the IFRS for SMEs. Impact on the insurance SORP: The IASB s project to replace the current IFRS 4, Insurance Contracts, will have a significant impact in due course. It would be premature for the ASB s standards to be switched off without a plan to cover any gap up to the introduction of IFRS 4 Phase II for insurance contracts. Time table: we emphasise that the ASB s proposed timetable of an implementation date of 1 January 2012 as ambitious. It should be noted however that many insurers are already using IFRS to prepare their financial statements. It should be noted that IFRS are themselves changing, for example the proposed replacement for IAS 39 will become mandatory from the beginning of The revision proposals are being introduced at the end of 2009 for a 2012 mandatory start date, although the IASB is aiming for a stable platform from mid We agree that life insurers will fall under 10

11 the definition of publicly accountable and will therefore be required to adopt full IFRS potentially for 2013 onwards, barring any limited exemptions that might be obtained. Although not asked in the Consultation Document we understand that the intention is that all general insurers would be deemed publicly accountable however the current wording is ambiguous. It should be noted that HRMC have publicly called for a delay in the replacement of UKGAAP by IFRS in 2012 due to its potential impact on ixbrl filing of tax returns and accounts. Such a delay would not benefit those offices currently reporting under IFRS. Impact of Solvency II on Financial Statements Technical Provisions 2.11 (i) Comment is welcome on the potential impact on the accounts of likely changes in technical provisions for solvency purposes. In particular, for companies applying UKGAAP or current IFRS, do you consider that technical provisions in financial statements will need to change to reflect changes in mathematical reserves for Solvency purposes, or could this remain a matter of choice? We understand that there is no requirement for policyholder liabilities in financial statements to reflect changes in the valuation of those liabilities arising as a result of the introduction of Solvency II. Life and General insurance companies will be free to decide on whether and to what extent they adjust their accounting policyholder liabilities in the light of the position under Solvency II. Under IFRS, policyholder liabilities are either accounted for as investment contracts (financial instruments) or insurance contracts. Investment contracts (e.g. unit linked contracts with insignificant death benefits) are valued under IAS 39 Financial Instruments. However there is no IFRS measurement standard for insurance contracts (e.g. protection, annuities, unit linked contracts with significant death benefits) and these are currently usually valued following FSA rules (in line with guidance in the ABI SORP and FRS 27 Life Assurance).The UK regulatory basis is expected to move to a Solvency II basis from 1 January 2013 and an IFRS standard for the valuation of insurance contracts is expected to be applicable in 2014 at the earliest. An Exposure Draft of the standard is due to be issued in July Whilst investment contracts will continue to be valued under IAS 39 for 2010 to 2014 inclusive, there are various options available to the life company as to how to value Insurance contracts. The uncertainty of the implementation timings of the new regulatory and accounting bases make a decision at this stage very difficult to make. For example, there may be an option to align implementation of IFRS 4 Phase II for insurance contracts and Solvency II on 1 January 2013 if early adoption of IFRS 4 Phase II is permitted. On the other hand, responses to the 11

12 exposure draft may lead to greater congruence of the Solvency II and IFRS 4 Phase II provisions. The options which appear to be available in respect of valuing policyholder liabilities under insurance contracts in each of the years 2010 to 2014 inclusive could be as follows:- 2010/2011 UK GAAP and IFRS based on the ABI SORP/FRS 27 Life Assurance 2012 UK GAAP and IFRS based on the ABI SORP/FRS 27 Life Assurance* 2013 UK GAAP and / or IFRS based on the ABI SORP/FRS 27 Life Assurance** 2014 IFRS Phase II for insurance contracts *The impact of the move of the implementation date of Solvency II to 1 January 2013 on regulatory and accounting requirements in 2012 is not yet clear. ** Three options available:- (i) Continue with the existing basis. (ii) Adopt a Solvency II basis (could base on Solvency II, but adjust for significant known differences in approach with IFRS 4 Phase II) (iii) Early adopt IFRS 4 Phase II for insurance contracts in 2013 (if permitted) Within each of the options above, there are advantages and disadvantages of adopting one basis compared to another for Due to the potential timing of the conflicting drivers (e.g. IFRS conversion and IFRS 4 Phase II introduction) there are difficulties and complexities (both technical and logistical) with all the options. Key factors that the life company is likely to consider are: (i) (ii) (iii) Volatility of results-e.g. moving the valuation basis in 2013 to a more realistic Solvency II basis, where profits are recognised on day 1, and then back to a potentially prudent IFRS 4 Phase II in 2014, where day 1 profits are deferred and released over the life of the contract, is likely to be unhelpful for users of the accounts. The explanation of underlying business performance will need to allow for multiple changes in accounting and regulatory requirements. There will be 3 different reported bases in four years: current basis, Solvency II and IFRS 4 Phase II for insurance contracts. This will create complexity, a lack of track record and superficial volatility. It will be difficult to explain underlying business performance to analysts over a pro-longed period due to the large fluctuations resulting purely from changes in accounting policy. Adverse operational effect on life groups e.g. parallel running of current processes with the Solvency II basis could be onerous. Interim measures may only be for a 2 year period and could increase risk, be time consuming to construct, operate and interpret. 12

13 (iv) (v) (vi) The accounting basis may not match the solvency returns which will be on a Solvency II basis, the latter being a key basis on which regulatory capital is allocated within the business and on which management information will critically focus (and is required to be focused under the Solvency II regime). Comparability with the peer group. Peer group consistency is an important factor across the sector i.e. it eliminates the need for explanations as to potentially differing bases. The current uncertainty over timetables and regulatory and accounting requirements. Fall back options may be required if the timetables for Solvency II/IFRS 4 Phase II for insurance contracts continue to change. (vii) Guidelines for new bases. There may not be accepted interpretation of IFRS 4 Phase II for insurance contracts until 2014, creating a risk for early adopters. This was the experience with IFRS 4 where finalised views were not established until very late in the day. IFRS for Insurance Contracts Phase II 2.15 (i) Comment is welcome on whether special transitional measures would be appropriate for the potential subsequent changes in basis outlined under (b) above, or whether the normal rules for dealing with changes in accounting policies would be sufficient to deal with such potential changes. The normal rules for dealing with changes in accounting policies are understood to mean that the cumulative net effect of the accounting change is tax effected at the beginning of the accounting period in which it happens. A special transitional regime would be justified if the accounting change had a significant impact to ensure that items are neither taxed twice nor omitted from tax and to recognise that transition will have different impacts on life groups. There is a pervasive point here, which is that significant changes either in the accounting basis or in relation to the move from FSA return basis to accounting basis may cause large peaks and troughs in the tax basis. We have included a section below in mitigating factors which explains what issues this may cause; we should look at what solutions would be appropriate in the working groups. The change from UKGAAP to IFRS 4 will impact different companies in different ways. As IFRS 4 broadly maintains the current local GAAP treatment of insurance technical reserves and in other respects UKGAAP has been moving closer to IFRS over time, it is likely to be a less significant change than the move from FSA regulatory returns to UK GAAP or the move from IFRS 4 to IFRS 4 Phase II for insurance contracts. Of course life offices that currently prepare their accounts on an IFRS basis will not be affected by this transition. 13

14 It is important at this point to emphasise that IFRS 4 Phase II for insurance contracts is not yet finalised and that the first proposals from IASB secretariat in respect of the release of the phase II technical reserves were only presented to the IASB in May 2010 with no decision being taken. The impact of this is that at this stage the size and scope of the impact of a move to IFRS 4 Phase II for insurance contracts is not known. We would therefore argue that a special transitional arrangement will be required. (ii) Comment is also welcome on the potential impact on life companies of more than one major change in the basis of life assurance trade profits in quick succession, and on ways in which any adverse impact might be mitigated. The potential impacts of major changes in the basis of life assurance trade profits in quick succession are: (i) (ii) (iii) (iv) (v) (vi) Volatility in the tax charge as the basis of calculation of current and deferred taxes changes. This will affect overall results volatility. Prior years will need to be restated. This makes year on year comparisons difficult for users of financial statements and may depress consumer and investment confidence in individual companies and the sector as a whole. The cost (in monetary and non-monetary terms) in preparing tax provisions and returns on a new basis each year for several years, and recalculating prior year tax provisions. Uncertainty over the tax consequences for strategic business planning. Uncertain and changing tax input into pricing of long term products. Uncertainty will further depress consumer and investor confidence in the individual companies and sector as a whole. Potential mitigating factors would be: (i) (ii) (iii) (iv) The changes to the tax provisions and returns are minimal (i.e. not material). The changes are clear in purpose and application. The changes are and their impacts can be modelled and tested in advance. The nature and impacts of the changes are understood by the industry, policyholders, investors and all other stakeholders. A significant period of stability (i.e. more than 5 years) should follow the period of changes. 14

15 However the main mitigating factor would be an appropriate transitional regime including consideration of whether section 85A provides an appropriate interaction mechanism for LATP and I-E in this one-off transition. We believe that as part of the exercise it would be useful to consider whether it is still appropriate to include GRB in LATP, or whether it might be preferable to restrict I-E and LATP to BLAGAB. We are not at present recommending this as there may be unidentified problems with this option and the whole issue will need to be fully examined in the HMRC Solvency II working groups. Transition from FSA Return to Accounts basis 2.18 (i) Comment is welcome on the need, and justification, for introducing specific transitional measures to deal with step changes in the values of assets and liabilities, including comment on what specific adjustments might be appropriate. We believe that it will certainly be necessary to introduce specific transitional measures to deal with step changes in the value of assets and liabilities. This is true both for changes from FSA Return to Accounts basis, and for changes from one Accounts basis to another (noting that some companies already account on IFRS), or significant changes within an accounts basis driven by Solvency II. Losses and other tax assets brought forward from old regime Losses (pension business, GRB, LATP) and tax attributes (spread expenses and CGT losses) must be capable of being carried forward for relief in the new regime. NPSF Investment Reserve in a With Profits Company (Form 14 line 51) Where the NPSF investment reserve provides policyholder support we are of the opinion that these amounts are not available to the shareholder and thus should not be subject to tax unless and until such policyholder support is no longer required. We discuss this point in further detail below under 2.39 and The special position of such investment reserves was recognised when section 434AZC was enacted last year. In circumstances where the NPSF investment reserve does not provide any policyholder support we believe that the brought forward NPSF investment reserve should be grandfathered similar to the grandfathering of the investment reserve in a non-profit company under paragraph 7 schedule 11 FA

16 Mutual Surplus The move to IFRS profits as the starting point for taxing shareholder profits in a life company will require a redrafting of the current mutual surplus provisions (444AF 444AL TA 88). Sections 444AF to 444AL have been drafted in such a way that attribution of mutual surplus to shareholders in the successor proprietary company escapes tax, where the demutualisation arrangements have been structured in one way, but is taxable in other cases, where there is no economic difference between the various arrangements. We believe that this inequity between taxpayers should be addressed as part of the legislative changes required on moving to using IFRS profits as the starting point for the taxation of shareholder profits in a life company. Release of Reserves to Capital under Solvency II Assuming that IFRS 4 will be interpreted as enabling Solvency II liabilities to be adopted for the financial statements under the more relevant more reliable test in IAS 8, consideration should be given to specific tax adjustments to deal with any release of technical provisions which, in the absence of specific provisions, would be taxable. Such releases of technical provisions may not be freely available to shareholders because of increased solvency requirements and to that extent should not be taxable until that constraint is released. Unappropriated Surplus Amounts brought into account, previously declared as surplus and carried forward in Form 14 line 13 in the FSA return at the end of the period immediately before the implementation of Solvency II, should not be brought into trading profit on transition from the pre-solvency II tax regime. DAC Under the current tax regime, life companies receive a deduction for expenses on a cash basis. However acquisition costs are deferred under current IFRS. It is expected however that no such deferral will be allowed under IFRS 4 Phase II for insurance contracts. Rather than having an initial transition on moving to IFRS and a subsequent reversal of that transition on moving to IFRS 4 Phase II for insurance contracts (if as expected this does not permit the capitalisation of acquisition expenses) and to allow life companies to obtain relief for expenses as they are incurred we suggest that relief in the LATP and GRB computations continues to be allowed on a paid basis. Section 183 CTA 2009 would achieve this on transition to IFRS 4 but specific legislation would need to be enacted to allow this to continue for business written under Solvency II but before the adoption of IFRS 4 Phase II for insurance contracts.. UDS changes It is currently unclear whether IFRS 4 Phase II will treat the UDS as a liability or release the amount as profit notwithstanding the fact that the UDS will primarily be used to pay policyholder bonuses in future. In our view the UDS belongs primarily to the policyholder (in a 90:10 fund 16

17 90% of the UDS will be paid out to policyholders) and none of the UDS is available as shareholder profit unless and until bonuses are declared in line with published Principles and Practices of Financial Management (PPFM). As such any change to the treatment of the UDS under IFRS 4 Phase II should be ignored for tax purposes. This point is discussed further under 2.44 below. Shareholder Fund As is the case under the current regime, there should be an exclusion of income and movements in value arising from shares in and loans to insurance dependants except where such assets are actually used to back insurance liabilities. Overall, we do not believe any element arising within the shareholder fund should be included in the I-E tax computation, and, on the basis that it continues to be separately identified, the shareholder fund should continue to separately taxed as an investment company. Value of In-force Any movement in the value of in-force included in the IFRS result should be excluded for tax purposes. Tax Adjustments not currently applied to Life Companies 2.20 (i) In what instances might it be appropriate to reconsider the application of general tax rules to life companies? (ii) How might the application of such rules be changed, and why? Given the Government s view expressed in paragraphs 2.21 and 2.22 of the Consultation on sector-specific adjustments to accounting periods, it would be appropriate to respond to these questions by stating that all general tax rules should be applied to the trade profits of life companies unless there is a clear and strong case why they should not be. We gave examples of current non-applications : (i) Capital allowances HMRC currently interpret section 257 CAA 2001 such that allowances on management assets are not available in an actual loss calculation for a life insurer. 17

18 (ii) R&D expenditure Relief is denied in trading profit calculations for companies subject to the I-E basissection 1080 CTA09. (iii) Land remediation relief There is a similar restriction here in trading profit calculations section1159 CTA09. (iv) Substantial Shareholding Relief The Substantial Shareholding Relief rules on chargeable gains should apply the same percentage to investments owned by the long term insurance fund of the Life companies as for other Companies. (v) Relief for Intangibles There is a compete exclusion here. in trading profit calculations part VIII chapter 17 CTA It should also be noted that there will be a number of corporation tax measures that apply specifically to Life companies that may fall away on a move to an accounts basis. Volatility Volatility With-profits Business 2.28 (i) Comments would be welcome on: The extent to which FFA / UDS mitigates volatility for with-profits business. How might this change under IFRS 4 Phase II? The UDS / FFA is not primarily intended to smooth volatility for with-profits business although its existence permits smoothing to take place. The smoothing is actually achieved by allowing the life company to allocate the required level of bonuses to policyholders (and potentially a transfer to shareholders),with such level being set with a view to long term policyholder reasonable expectations rather than to distribute the result of the with profits fund of that particular year. The FFA / UDS is an accounting mechanism to reflect the difference between the cumulative value of the long term fund and the accumulated declared bonuses. The treatment of UDS / FFA is not yet decided as part of the IFRS 4 Phase II project, indeed we understand that IASB has not yet discussed it as attention is currently focused on the definition of eligible liabilities in the context of participating policies. 18

19 Volatility Linked Business 2.29 (i) Comments would be welcome on: Whether there is any justification for mitigating volatility in fee income for linked business? How might this change under IFRS 4 Phase II? Under the current FSA basis, assets and liabilities are valued on the same basis and recognised accordingly in the return. Therefore the volatility that currently exists is due solely to the impact that market movements have on the value of the charges arising on the funds under management ("FUM"), which are broadly derived as a percentage of the FUM. If we move to an accounts basis of taxation, the same level of volatility will exist. This volatility reflects commercial reality and therefore we do not consider that there is any particular justification for mitigation volatility in fee income for linked business. However there could be sources of additional volatility arising, and there will be transitional issues which we set out below, and which may be significant. There may be an additional source of volatility caused by accounting mismatches under IFRS between assets and liabilities. There are also other differences that exist between the FSA and IFRS measure of liabilities which will not necessarily be a cause of volatility but may give rise to some transitional issues. Under the current regulatory regime, sterling reserves are required to be held by insurance companies. Tax relief is available for the movements in these reserves. Under IFRS, these sterling reserves do not exist for investment contracts and as such, in the year of transition, the reversal of these reserves will give rise to a one off profit that will be subject to tax absent any transitional provisions. The amount of sterling reserves held can be material. For insurance contracts, sterling reserves do exist under IFRS and are measured on the same basis as the regulatory measure. It is expected however that IFRS 4 Phase II will seek to remove these and as such the transitional issues noted above will arise on inception. In addition, under Solvency II, it is possible that for some products the technical provisions (best estimate liability including risk margin) will be less than the current statutory reserve. Current prudence in the valuation of unit linked business (the reserve is a minimum of the unit fund available on surrender for each policy) will be removed for business comprising insurance contracts so that this business also becomes sensitive in Solvency II capital reporting to changes in assumed cash flows. Hence the profit result will include the capitalised impact (positive or negative) of assumption changes and changes in initial asset values to the extent that future management charges are determined by the initial unit fund values. 19

20 Volatility Business with Fixed Liabilities 2.32 (i) Are there any reasons why the inherent profit volatility of business with fixed liabilities in a non-profit fund should differ from similar business in a with-profits company? We suggest the appropriate question is Does the volatility of non linked non profit business justify a mechanism to provide smoothing to be applied to the accounting result. We believe that the volatility of non linked non profit business ( NLNP ) does justify a mechanism to provide smoothing to be applied to the IFRS result. Short term volatility arises from the different economic risks of the liabilities and backing assets together with different accounting measurement bases being used. The long term nature of the contracts means that economic variability is smoothed out and policyholder behaviour can be reasonably predicted in aggregate over the lifetime of the products. There are two main products sold by the life industry on a NLNP basis, being annuities and protection products. The profit profile of both of these types of business can be very volatile under IFRS, reflecting the nature of the products sold, although the volatility is particularly acute for annuity business. The risks taken by the insurance company on annuity business are: Assets Liabilities Market risk Credit risk (default & liquidity risk) Market risk Insurance risk If assets are matched to liabilities, market risk should be broadly synchronised for both assets and liabilities. However the insurance company will also be exposed to credit risk on the assets it invests in. This credit risk can be split into default and liquidity risk. Of these credit risks it is possible under the current regime to take an allowance for liquidity risk in valuing liabilities for statutory purposes (FSA return), since annuity liabilities are held for the long term. However this still leaves the insurer exposed to default risk on the assets in which it invests and it is not possible to take an allowance for this in valuing liabilities, since the insurer still has to meet its obligations to the policyholder regardless of the return on the assets in which it has chosen to invest. In 2008 there was a significant widening of credit risk due to market conditions. This resulted in a significant reduction in the value of assets backing annuity business. This adverse outcome in 2008 reversed in

21 It can be seen that if there is no liquidity premium allowed in valuing liabilities under Solvency II, insurers would be exposed to potentially catastrophic movements in profits with huge implications for the solvency of the industry. Such volatility would also be extremely difficult to manage from a tax perspective, particularly if it resulted in trapped losses for which no economic value could be obtained. Even if a liquidity premium is allowed there is likely to be some increased volatility under IFRS 4 Phase II, as the discount rates used to value liabilities will not be directly linked to the yields on the actual assets held to back the annuity liabilities. There will be more volatility than currently as the regulatory liabilities can be smoothed to make them more market consistent. Given the quantum of the assets held to back this business and the long term nature of annuity business we believe there should be an equalisation mechanism which permits tax deductible retention of funds in years of high profits with release in years of loss, combined with increased flexibility in carry back of losses to ensure full economic value for losses over the life cycle of the product. If the current rules with a restriction of carry back to one year remain there is a real risk that life companies, due to the unique nature of their business whereby they hold huge portfolios of assets to finance their annuity liabilities, may have substantial trapped losses for which they are unable to get relief. Volatility General 2.36 (i) Further comment and discussion is invited on: How, and to what extent, tax volatility might increase under an accounts-based tax regime? What the impact of any such increased volatility might be? What measures might be taken to mitigate any adverse impact? What are the factors that make this a particular issue for this industry, given that profit in other sectors, particularly banking, are susceptible to market volatility? We believe that using the accounts for tax purposes is likely to increase volatility for life offices because: (i) (ii) (iii) There is no concept of an investment reserve so the full movement in investments unmatched by liabilities will be brought into account. There is no book value election. There is no concept of admissible assets. 21

22 (iv) (v) (vi) (vii) Movements in intangibles will be brought into account. For annuity business there could be a mismatch between the values of assets used to back liabilities and the valuation of the liabilities themselves. For protection business the discount rates applied to the valuation of liabilities are based on the yields on the assets backing those liabilities, which provide some reduction in market volatility (i.e. asset and liability valuation bases are more closely matched). Under IFRS 4 Phase II for insurance contracts this link will be broken, as the discount rate has to be specific to the characteristics of the liability rather than based on the specific assets held to cover the liability. Hence volatility due to changes in market interest rates and credit spreads may increase. Movements in FFA/UDS may be brought into IFRS profits. The impacts of this increased volatility could include: (i) (ii) (iii) (iv) In terms of shareholder profits there will be occasions of exceptionally higher or lower profits, including periods like 2008 of exceptional losses. The life insurance business model will need to adapt or change to cope with more volatile tax cash flows. In respect of point (i), the life insurance industry profits outcome will begin more to resemble the general insurance industry. In the UK, the tax treatment of profits and losses is not equal tax is payable on profits on a quarterly basis, but (generally) the economic recovery of losses must wait on a loss carry-back claim or be applied against future profits. The UK life tax regime allows the taxation of shareholder trading profits to be included within the overall I-E result, which seeks simultaneously to tax policyholder and shareholder profits. The mechanisms that achieve this could be disrupted by significant swings in trading profits i.e. there is also a risk that profit spikes in any one year could lead to the creation or augmentation of excess expenses generated by section 85A FA The taxation of short term movements flies in the face of a business whose profits on the underlying contracts are expected to arise after many years from the policy initially going in-force. Although this might be manageable in a pure shareholder business, life insurance business has policyholders as stakeholders (whether through participating business or otherwise). Taxing short term value flows against a background of long term business could result in inappropriate amounts of tax being charged to shareholders / policyholders in aggregate. 22

23 Measures that should be taken to mitigate any adverse impact include (this is a non-exhaustive list): (i) (ii) (iii) (iv) The use of an appropriate tax base for life insurers including the non-taxation or allowance of profits or losses accounted for in reserves not available to shareholders. Use of a specific equalisation regime which permits tax deductible retention of funds in years of high profits which would then be released in years of loss. Greater flexibility in carry back of losses. The ability to carry back or group relieve excess expenses generated by section 85A FA The factors that make volatility a particular issue for the insurance industry are: (i) (ii) (iii) Insurance companies as financial services providers and holders of investments are exposed to the same risks as banks but in addition operate under the additional category of insurance risk indeed, this is the very reason for their existence. This additional risk adds to the volatility of insurance company results. Life insurance groups suffer a greater degree of likely volatility on the valuations of assets and liabilities on their balance sheet compared to other UK traders-e.g. banks. Whilst both banks and insurers see asset value volatility causing major changes from year to year as assets are valued on a mark to market basis, in addition the life insurer suffers volatility on the valuation of policyholder liabilities. These can arise from FSA basis changes (e.g. PS 06/14) or from internal rebasing of liabilities in relation to changes in mortality, morbidity, persistency, interest rates etc. Whilst on occasions there is a correlation in the movement of assets and policyholder liabilities, most notably on unit linked business, such correlation has diverged significantly at times, for example the extensive trading losses suffered in The factors that make NLNP business volatility a particular issue for the life insurance industry are: (a) The need for life insurers to mark to market fixed interest securities used to back annuity and protection business to enable them more closely to match the valuation of liabilities which use current market rates as inputs to valuation models. This results in potentially large movements in asset values as a result of credit risk which cannot be fully matched by changes in value of liabilities. In contrast banks wish, and are able, to value their fixed interest securities on an amortised cost basis as their liabilities are also typically measured on an amortised cost basis. For example, a bank will carry out 23