Deductions for Tax in Unit Pricing
14 September 2011
Maxine Phillips
He attacked everything in life with a mix
of extraordinary genius and naive
incompetence, and it was often difficult to
tell which was which.
Douglas Adams
English humorist & science fiction
novelist (1952 - 2001)
FSA Principles for Businesses – PRIN
2.1
4 Financial prudence
A firm must maintain adequate financial resources
6 Customers’ interests
A firm must pay due regard to the interests of its customers and treat them fairly
8 Conflicts of interest
© Zurich Assurance Ltd
A firm must manage conflicts of interest fairly, both between itself and its customers
and between a customer and another client.
3
ABI – A Guide of Good Practice for Unit
Linked Funds – 1 June 2006
“Where the fund is subject to tax the following principles should apply:
•
Policyholders should be treated fairly.
• The firm’s approach to tax should, as far as possible, be consistent with any
information or commitments given in marketing literature or policy documents.
• The basis of taxation chosen should aim to achieve broad equity between
generations of policyholders and fairness between the company and the fund,
supported by appropriate reconciliation to help ensure that a fair outcome has
been achieved.
© Zurich Assurance Ltd
The scope and nature of the taxation of unit linked life funds may be
subject to change over time, but wherever possible announcements of
future changes should be taken into account in any tax calculations.”
4
Implications for tax deductions in unit
pricing
Three principles:
1.
2.
© Zurich Assurance Ltd
3.
Pricing policy must not jeopardise solvency (FSA Principle 4 – Financial
prudence)
Aim for equity between policyholders and shareholders so that tax
deductions from the linked funds share the actual company tax charge
between shareholders and policyholders in a just and reasonable way
(FSA Principle 6 - TCF)
Aim for equity between different generations of policyholders (FSA
Principle 8 – Conflicts of interest)
5
Traditional Pooled Linked Fund Model
“Our approach is to charge tax to each fund that approximates to the tax
that the fund would bear as a standalone taxable entity.”
“The basic principle that is adopted for taxation calculations for each
unitised fund is to assume that the tax legislation applies to that fund as if
it were a single separate company that is not associated with any other
unitised fund or any other [XYZ] company.”
© Zurich Assurance Ltd
“For tax purposes, we generally treat each fund separately as though it
were the entire business of the company. The company’s tax bill will be
different from what we charge to the funds because the company is taxed
on the position of all the funds combined …”
6
Tax deductions from investment income
Generally straightforward
Deductions taken from taxable investment income (interest, rebates, rent)
at full policyholder rate
Problem areas:
Overseas withholding tax recoveries
– Accruals basis or cash basis?
– Administrative costs of recovery?
– Fokus Bank claims?
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Capital allowances
7
Tax deductions from gains
How to calculate gains (1)
Shareholder v Policyholder equity might suggest that fund level calculations should
use the full tax legislative rules for calculating the taxable capital gains of life
assurance companies
BUT
Unacceptable(?) system complexity (eg ten day matching rule – S107(3) TCGA
1992)
Indexation time lag – funds must be priced on a real time basis but RPI not
available until mid-way through the following month
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S212 deemed disposal assets – need to hold sevenths spreading data at fund
level?
Need to mirror S213(3) loss carry back rules?
8
Tax deductions from gains
How to calculate gains (2)
“Fairness” and “equality” are not
synonymous
Simplification and approximation are
acceptable as long as they result in
compensating “swings and
roundabouts”
© Zurich Assurance Ltd
Documentation, documentation,
documentation
How/why do any tax simplifications in the
fund pricing model comply with TCF
considerations?
9
Tax deductions from gains
Different asset types
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Loan relationships
Equities
Collectives
Derivatives
Property
Others
Probably do need to distinguish in fund pricing due to significant
differences in:
• Tax relief for losses;
• Taxation of unrealised gains;
• Indexation allowance.
10
Tax deductions from gains
Mechanics & cash extraction
Tax provision built up over time, so linked
fund unit price equivalent to:
Linked asset value
Less: Tax provision
Need a mechanism to extract cash from the
linked funds so Shareholders have cash to
pay actual tax liabilities to HMRC
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When to extract cash?
On realised gains?
• On realisation?
• Weekly/monthly/annually?
On deemed disposal gains?
• To match sevenths spreading?
• On full deemed disposal gain?
On unrealised gains?
11
Cash extraction (1)
© Zurich Assurance Ltd
“Each quarter there will be payments made either to or from the fund at the
same time as the company pays instalments of tax under the Quarterly
Instalment Payment (QIP) scheme. If the total tax payment due from the
fund at the end of the quarter is greater than the amount of tax already
paid then there will be a deduction from the fund. If the total tax payment
due is less than the amount of tax that has already been paid then there
will be a payment into the fund.”
12
Cash extraction (2)
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“For gains on deemed disposals, in some funds we take tax out over seven
years at the full special corporation tax rate in each of those years. In
others we settle the whole balance in one go after the deemed disposal,
using a tax rate lower than the special corporation tax rate to allow for the
delay until the company would have to pay the tax bill.”
13
Tax deductions from gains
What rate?
TCF considerations imply that tax
provision rate should take account of
time value of money as between
current date and tax payment date(s)
Eg for Loan Relationship assets –
deductions on realised and unrealised
gains generally at full policyholder rate
© Zurich Assurance Ltd
For equity/property unrealised gains and
spread deemed disposal gains –
suitably discounted rates – regular
Actuarial review and sign off essential
Documentation!
14
Discounted tax provision rates
“Net unrealised gains on equities and properties are charged to tax in the current
tax year but we apply a discounted rate to allow for the expected time until the
gains will be realised.
Equities currently have a rate of 18.5% applied to the unrealised gains.
Property currently has a rate of 17% applied to the unrealised gains.
© Zurich Assurance Ltd
When any equities or properties are realised there will be an increase in the tax
provision as the tax rate on realised gains is greater than the discounted rate
used to calculate the provision.
A tax provision is set up for each fund in respect of realised gains, deemed disposal
gains and unrealised gains for the year to date. The tax provision allows for the
deemed disposal gains that will be charged to tax in each of the next six years
and we apply a discount rate of 3% p.a. to allow for the time until these will arise.”
15
An actuarial view
Move away from “snapshot” approach
to
Probabilistic model based on range of possible future market movements up to
predicted date of sale
“Projecting the market value forward using risk-neutral market-consistent scenarios”
Generates much lower tax provision rate due to factoring in possibility that Markets
might fall
© Zurich Assurance Ltd
“Enables more complex [!!!] models to be built that allow for synergies between
assets and appropriate values to be placed on the tax relief available from
realised losses.”
Not aware of any companies actually using this approach???
16
Tax relief for losses (1)
FSA Principle 4, Financial prudence, becomes relevant
Potential solvency/capital issues if policyholders given benefit for tax losses
before those losses have resulted in cash tax repayments/reductions in
cash tax liabilities in the life company
© Zurich Assurance Ltd
In segregated funds, need rules to ensure:
• realised capital losses only set against realised/unrealised capital gains,
not against investment income or LR gains;
• unrealised capital losses only set against unrealised capital gains;
• possibly understates tax provision (ie what happens if gains are realised
before losses?)
17
Tax relief for losses (2)
Need to determine if any immediate benefit to be given for net unrealised
losses:
• On Loan Relationship assets – probably yes
• On equities/property – probably no
• On S212 deemed disposal assets???
© Zurich Assurance Ltd
If no immediate benefit given, then TCF implies that losses should be
carried forward in memorandum form and set against future capital gains,
so that future tax deductions are not taken until the fund returns to a net
gain position.
18
Tax relief for losses (3)
“We allow realised capital losses to be offset against deemed gains that
have been brought forward from previous years and have yet to fall into
the company’s actual tax computation. We also allow realised capital
losses to be offset in the calculation of the tax provision on unrealised
gains.
We do not give credit for realised capital losses in excess of the total of
deemed gains carried forward and unrealised capital gains.
© Zurich Assurance Ltd
We do not give relief for unrealised capital losses in excess of realised
capital gains falling into the current tax computation and deemed gains
carried forward.”
19
Tax relief for losses (4)
“We do not give any immediate credit to policyholders for losses that could
be carried back and offset against gains that were brought into the
company’s actual tax computations in earlier years. This reduces the
complications of allowing for tax in pricing and hence the risk of pricing
errors. Such losses will be carried forward and offset against future tax
liabilities.”
© Zurich Assurance Ltd
“We will consider giving a tax credit to the fund where we think the
company can use the losses to reduce its own overall tax bill.”
20
Tax relief for losses (5)
© Zurich Assurance Ltd
“There are a number of former [XYZ] funds where losses were fully
credited prior to June 2002. The tax provision on these funds was
capped, and no further credit was given for losses in each fund until
future capital gains reduced the cap to zero. This happened in October
2009 and the funds received credit for new losses arising from that point
onwards.”
21
Tax relief for losses (6)
What happens when a policyholder exits from a linked fund that is in an
overall loss position (eg by switching out, maturity or full/part surrender)?
Departing policyholder receives no benefit for contingent tax loss asset
© Zurich Assurance Ltd
What happens to that asset?
• Shared between remaining policyholders?
• Transferred to shareholders?
22
Dilution effects (1)
There is an argument that the traditional pooled linked fund structure can cause
inequities as between generations of policyholders.
For example, consider a linked fund in an overall loss position, ie with capital losses
being carried forward in memorandum form.
The unit linked fund price does not include any value for the contingent tax asset.
Hence when new policyholders enter the fund, they benefit from the tax losses (by
being allowed to realise future gains without any tax deduction) without having
paid anything for those losses.
© Zurich Assurance Ltd
The value of the contingent tax asset to the original policyholders is reduced.
This could be regarded as favouring new policyholders at the expense of existing
policyholders.
23
Dilution effects (2)
BUT
All policyholders started off as “new” and become “new” again if they
switch funds
•
Data on fund level losses is not generally published, reducing the ability
of financially astute policyholders to exploit such dilution effects
•
Investing in funds that have clocked up the highest level of historic losses
might not necessarily be the wisest strategy for wealth accumulation!
© Zurich Assurance Ltd
•
24
Tax relief for expenses
Within the linked funds – generally only for expenses directly attributable to
the relevant fund
– Fund Manager’s fees
– Internal investment department costs
– Property expenses
I-E tax relief for other expenses (sales costs, general overheads) is one of
the factors to be taken into account when setting allocation rates, product
charges etc
© Zurich Assurance Ltd
What if structurally XSE?
25
Accounting treatment
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UK GAAP
• Fund Deductions “hidden” within “Change in
technical provisions”
• Discounting of deferred tax provisions allowed
(FRS19)
IFRS
• Fund Deductions explicitly disclosed – “Other Fee
Income”
• Discounting of deferred tax provisions prohibited
(IAS12)
26
It is obvious that …….
Fund Deductions (ie charges taken from
the linked funds in respect of taxation)
should equal
the Policyholder tax charge …….
© Zurich Assurance Ltd
Oh really???
27
© Zurich Assurance Ltd
Don’t Panic!
28
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"'Don't Panic.' It's the first helpful or
intelligible thing anybody's said to
me all day."
29
Squaring the circle
Fund Deductions:
various percentages x [“I” – Fund “E”]
Policyholder Tax Charge
© Zurich Assurance Ltd
{various percentages x [“I” – BLAGAB “E”]} – {amounts included in Shareholder tax}
30
© Zurich Assurance Ltd
Reconciling items
•
Different measures of “I” – particularly losses attracting relief at the
company level, but no immediate credit in the linked funds
•
Different tax rates on “I” – Fund Deduction rates often discounted, IFRS
tax rates not discounted, UK GAAP deferred tax rates discounted
•
Tax relief for “Non-Fund” expenses (sales costs, overheads etc)
•
Part of overall tax charge within Shareholder tax line
•
Indexation time lag
•
Other “noise” – matching rules, bid/offer spread, accumulations,
equalisation, corporate actions etc, etc, etc
31
ABI – A Guide of Good Practice for Unit
Linked Funds – 1 June 2006
“The basis of taxation chosen should aim
to achieve broad equity between
generations of policyholders and
fairness between the company and
the fund, supported by appropriate
reconciliation to help ensure that a
fair outcome has been achieved.”
© Zurich Assurance Ltd
Easier said than done????
32
© Zurich Assurance Ltd
“I may not have gone where I intended to go, but I think I have
ended up where I needed to be. “
Douglas Adams
33
Thank you
zurich.com