Out-Law Analysis | 04 Mar 2016 | 4:34 pm | 4 min. read
The changes have particular implications for long-term insurance companies, which were taxed based on the figures that appear on their regulatory returns. However, some changes have also been made to the way in which firms carrying on general insurance business are taxed.
The main changes
The biggest changes, which were implemented via part 2 of the 2012 Finance Act, have been switching the basis of taxation of affected firms' shareholder profits from actuarial surplus to accounting profit, and replacing the apportionment of income and gains by reference to policyholder liabilities with a commercial allocation between the categories of long-term business. These changes have effectively decoupled tax computations from regulatory returns and instead use financial statements and basic accounting records as the source material.
The UK Treasury also took the opportunity to change the tax treatment of life protection business where little or no investment return accrued to policyholders from the traditional 'I minus E' basis to a pure trade profit basis. I minus E refers to the firm's investment return minus management expenses.
A number of areas received special attention under the new legislation:
This last area required both an additional schedule, schedule 17 of the 2012 Finance Act; and new regulations, the 2012 Insurance Companies (Transitional Provisions) Regulations.
The reforms were timed to take effect alongside the Solvency II regime, which was originally scheduled for the end of 2012. Although Solvency II ultimately did not come into force until January 2016, the tax changes still took effect from 1 January 2013.
Under the previous regime, the basis of taxation for long-term business was set in financial year 1988/89 by reference to the figures appearing in the regulatory returns. This basis was chosen as the most reliable source of detailed information underpinning the figures on which the surplus, and therefore the reported profit, had been determined.
In 1994, the EU's third Insurance Accounts Directive came into force. Before this, the financial statements of companies writing long-term insurance business would typically report profits as the amount of the surplus of the relevant fund or funds determined in the course of the annual actuarial investigation by the company's appointed actuary. This was also the figure deemed to be realised as profit available for distribution.
The directive was transposed into UK law in schedule 9A to the 1985 Companies Act, and is now found in schedule 3 of the 2008 Large and Medium-Sized Companies and Groups (Accounts and Reports) Regulations. The principal effect of these changes on reported profit was a new requirement to account for deferred acquisition costs, which had to be written off in determining actuarial surplus. There were also differences in the definitions of liabilities to policyholders in the financial statements from those for mathematical reserves in the surplus calculation.
When these changes to the accounting framework took effect, the Inland Revenue was forced to reconsider its position on the basis of taxation. Life assurance taxation continued to be based on the regulatory returns as this approach was so ingrained into the regime that it would require primary legislation to change it. However, the taxation of long-term business other than life assurance business was from then on based on the profit in the financial statements – save for the anomaly that the apportionment of items between life assurance and other long-term business was by reference to liabilities reported in the regulatory returns.
Solvency II has, however, done away with the Solvency I regulatory returns altogether. The approach set out in part 2 of the 2012 Finance Act has been designed to get around this change, while still retaining HMRC's fundamental approach to taxation of policyholder returns.
Regulatory powers were included in the 2012 Finance Act to enable what were in effect corrections to be made to the rules on transfers of business and the transitional provisions, which were the last matters to be agreed before enactment. Both these powers have been used to clarify what was intended by the primary legislation, which the most recent changes being those relating to transfers of business included in the 2015 Insurance Companies (Amendment) Regulations.
However, these regulatory powers are not comprehensive. Clause 34 of the 2016 Finance Bill is intended to amend the primary legislation for a number of anomalies not spotted and addressed when part 2 of the 2012 Finance Act was being drafted.
One final area which is still under discussion is the taxation of reinsurance of life investment business. This will require revisions to the regulations, which are currently still covered by the 1995 Insurance Companies (Taxation of Reinsurance Business) Regulations. At some stage, section 843 of the 2006 Companies Act will also need to be amended to provide a new basis for determining realised profits from long-term business.
Changes for general insurance business
In contrast to long-term business, the taxation of general insurance business was traditionally far less dependent on the regulatory returns. Instead, it is based on the taxation of the trade profits recorded on the financial statements.
The main exception was a relief for equalisation reserves set up in the regulatory returns to smooth changes in capital requirements resulting from claims volatility. These reserves do not exist under Solvency II. The changes here were discussed at the same time as those for life assurance, and the primary legislation withdrawing the relief and setting out transitional provisions for existing equalisation reserves is set out in sections 26 to 30 of the 2012 Finance Act.
The approach to commencement of these sections was different from that of part 2 of the 2012 Finance Act, requiring activation by statutory instrument from an appointed day. That day was later set as 1 January 2016 and the last relief for equalisation reserves for both general insurance companies and corporate vehicles at Lloyd's was at 31 December 2015. Existing equalisation reserves for which there has been relief will be treated as released over a six-year period from 2016, spreading any tax on resulting taxable profits.
Matthew Taylor is an insurance taxation expert at Pinsent Masons, the law firm behind Out-Law.com.