Tax Transparant Funds and Loan Relationships

A curio on the tax transparent fund ("TTF") legislation. (See post of the 9th May for a description of the tax regime for TTFs).  This note covers the co  - ownership structure TTF (described as CTTF below) but not  partnership TTFs.

For a CTTF holding assets subject to chargeable gains tax the position is as follows .  TCGA 1992 section 103 D prevents the assets in the CTTF being subject to CGT but provides that the holding in the CTTF is treated as if it were a unit in an unauthorised unit trust.  I'm not quite sure why the unauthorised unit trust wording is used but the intention is clearly to prevent the CTTF being transparent for capital gains tax purposes.  This will be administratively convenient for life insurance companies investing BLAGAB assets as they will be able to treat the CTTF as a single asset for CGT rather than having to calculate CGT on all the assets held in the CTTF.

But what is not clear is what the tax analysis is for loan relationship assets held in a CTTF.  For authorised unit trusts there is CTA 2010 617 which prevents the income of the trust being taxed in the hands of the trustees ( I think that for these purposes  loan relationship gains and losses are included as income) and instead provides that the authorised unit trust is liable to corporation tax.  (Regulation 10 of SI 2006/964 then takes authorised unit trusts outside of the loan relationship regime in respect of gains and losses on assets).

However, there are no equivalent provisions for CTTFs nor would I expect anything similar as the whole point of the CTTF is that its transparent for income.  It does though seem that there is a risk that loan relationship gains and losses on assets held within a CTTF will be taxed / relieved twice.  That is via the loan relationship regime on a look through basis and under the CGT rules on the deemed holding in an unauthorised unit trust.  What I think comes to the rescue here is CTA 2009 464 that gives the loan relationship priority for corporation tax purposes.  This could be seen as meaning that the look through loan relationship basis trumps taxing the gains under the capital gains tax regime.  This would have the benefit that you would seem to end in a sensible position i.e. taxing loan relationship assets under the loan relationship regime.

But the analysis is not straightforward and it would be good to have some comfort that this is the way that HMRC would expect life insurance companies investing BLAGAB assets in CTTFs to be taxed.  Actually there are quite a number of areas of life assurance legislation where HMRC guidance would be useful.  A good idea might be to make all that advice available in a single place - you could call it the Life Assurance Manual.

   

Tax in with profits funds

Something I've been having a look at recently is tax deductions in with profits funds.  I had a recollection that at one stage the FSA made some statements about tax in with profits funds that caused some consternation amongst life insurers.  But I couldn't track it down.  I think I've found it and so I'm putting it on the blog.

As per usual with these things the tax section is lurking at the back in annex 5 paragraphs 6.43  -  6.45.  I'm pretty sure that the regulator eventually backed away from these proposals but it perhaps gives some guidance on how things could be done.

CP207

Tax in fund of funds

A bit more on TR13/8 (see post of 18 October).

The specific tax issue raised by the FCA was as as follows

"One insurer offered a ‘fund of funds’. The approach to the taxation of this fund was

inconsistent – as the unrealised gains were taxed at the overarching ‘fund of fund’

level (‘top down’) whilst the realised gains were taxed at the underlying component

fund level (‘bottom up’). This meant that losses in one fund may not be offset against

gains in another and may lead to customers paying an overall higher rate of tax."

 

I would have thought that conceptually calculating tax in a fund of funds would work as follows.

•  Value the fund of funds as the sum of the price of each underlying fund multiplied by the holding.

•   Provided each underlying fund is priced net then you have effectively already allowed for tax in the fund of funds via that net price.

•  However, if the underlying funds are priced on a stand alone basis (i.e. each fund is a separate silo when making assumptions about the utilization of capital losses) then there might be a tax synergy at the fund of fund of fund level that should be reflected in the unit price

•  So say underlying fund A has realised capital gains of 10 and tax has been deducted of 2 in the unit price.

• And underlying fund B has a realised loss of 10 but has not reflected in the unit price.

•  Then at the fund of fund levels (assuming that the FOF holds 100% of both underlying) the realised capital gains position is 0 and there should a tax asset of 2 in the prIce.

The devil would be in the detail.  For instance if the gains in the example above were unrealised rather than realised then the correct answer is indeterminate as if fund A was to realise all of its gains in the current accounting period and fund B realised none of its losses in the current period then the future loss could not be set against the current gains. So how should the fund of funds tax asset re unrealised losses be valued?

 

I guess the key is to do something sensible, document the policy and have tests in place that can identify if the sensible assumption is not working out in practice..

 

  

 

 

Tax in unit linked pricing TR 13/8

The FCA has released its report on the thematic review of the governance of internal linked funds.  The report can be found at

Thematic Review

Paragraph 2.3.4 of the report is about tax in unit linked pricing.

A few headlines

• Twelve firms were included in the thematic review and the report states that improvements in the calculation of tax in unit linked prices were required in "just under half of the firms reviewed" (or 5 as its more commonly known).

• The issues identified were consistency across different types of funds and the treatment of losses.

• Seems that fund of funds are a particular concern to the FCA. (There's a specific example of an inconsistent approach to taxation in a fund of funds).

• The ABI has committed to add more detail to its ‘Guide to good practice for unit-linked funds’ in light of the findings of the thematic review.

Double Taxation Relief Life Insurance Companies

I was preparing some notes for a client on how to calculate the restriction on the amount available for double taxation taxation credit relief when the associated foreign income is included in a trading profits computation.  The legislation for this is now in  sections  99 -104  TIAOPA 2010.

For the purposes of credit relief the relevant foreign income has to be reduced by an amount of "total relevant expenses" determined by applying a formula of RI/TI to total relevant expenses where RI is relevant income and TI total income.

Relevant expenses and total income are both defined terms in the legislation and pre FA 2012 were derived from the FSA returns in accordance with TIAOPA 2010 section 102.  So I turned to section 102 to see how this legislation had been updated post 2012.  But section 102 had been repealed - my first thought was this looked like something that had gone astray during the 2012 redraft and the terms relevant expenses and total income had lost their definition.

Fortunately this is not the case(oh me of little faith).  The definitions are in the new legislation and they have been updated so that they now refer to information in statutory accounts rather than FSA returns. However, the definition section has now moved to TIAOPA 2010 section 103.  Might just save you looking for it.

IFRS 4 Phase ii and Solvency 2

EY have issued an update on IFRS 4 phase ii and tax.  Most of the content will be familiar to those who heard the EY presentation on this topic at Oracle but the analysis of how the UK, France and Germany tax life insurance profits is interesting.  (Notably its only the UK that has an any GAAP is OK for tax policy) Also if you like pictures of people staring moodily into the distance whilst wearing outdoor clothing this is the publication for you.

The update is here

EY_IFRS_4_Phase ii

Whilst on things solvency 2 ish there is now a proposal from the EU commission that this will come in to effect from 1 January 2016.

http://www.solvencyiinews.com/tag/delay

And for something completely different the 2013HMRC calculation of the tax gap is below.  It's been around for ages I just stumbled across it on a wet Friday afternoon.  Top fact

"The proportion of SMEs submitting an incorrect return leading to a loss of tax declined from 42 per cent in 2005-06 to 26 per cent by 2009-10, before rising to a provisional estimate of 36 per cent in 2010-11."

The full report is here

http://www.hmrc.gov.uk/statistics/tax-gaps/mtg-2013.pdf 

CGT is rubbish

Perhaps more accurately CGT for life companies is rubbish.  The arguments below will probably be familiar to most people but worthwhile putting them all in one place.

1. The Rates are Wrong

I think it would be generally accepted that an individual should pay an equivalent amount of tax on the disposal of assets subject to capital gains tax regardless of whether the assets are held directly or via an insurance policy.  Currently individuals pay capital gains at either 18% or 28% with no allowance for indexation and with an annual CGT tax free allowance.

For investments in life policies the rules are complicated.  Firstly there is a liability to policyholder tax in the I+G-E tax charge paid by the insurance company but with the availability of indexation so the effective rate can be any where between 0% and 20%. However, there is no relief corresponding to the individuals personal allowance.

Secondly there is a potential liability to higher rate and additional rate tax.  This is, of course, under the chargeable events legislation so neither indexation nor the personal CGT allowance are available.  This results in a tax charge of 20% for a higher rate tax payer and 25% for an additional rate tax payer.

So if we combine the above but ignore (for the moment) personal CGT allowances we get the following;

				Life Policy		Direct investment
Basic Rate				0% / 20%		18%
Higher rate				20% / 40%		28%
Additional Rate				25% / 45%		28%

Given the availability of personal CGT allowances I think you would get a more equitable outcome if you simply abolished CGT for life companies.  If this were done then the equivalent table would like;

				Life Policy		Direct investment
Basic Rate				0%		18%
Higher rate				20%		28%
Additional Rate				25%		28%

Obviously not a perfect solution but I think better than what we have at present.

2. Loss Relief

Accepting that the abolition of CGT for life companies might not be possible then the next best option would be to retain what we have but allow for CGT losses to have the same loss relief rules as apply to loan relationship assets.  

This would move us away from the situation where a policyholder might be invested in a with profits fund that has both loan relationship and CGT assets.  Given market movements in the last few years the loan relationships will probably be standing at a gain but the CGT assets might be at a loss.  If this happens its quite possible that the policyholder will be taxed on the loan relationship gains but get no relief for the CGT losses.  

This is inequitable .  I suppose that there is an argument that allowing CGT losses to be set against other income and gains in a life company is an advantage that is not available to individuals holding assets directly.  However, this could be seen as a rough quid pro quo  for the fact that individual CGT allowances do not apply to gains on life policies.

3. CGT Legislation is Archaic

In my view CGT legislation as a whole is antiquated.  It creates a structure for taxing gains from scratch that is out of keeping with the way that companies account for gains and as a result causes all sorts of unnecessary problems .  The legislation has also been undermined by HMRC taking measures to improve the tax take that reduce the coherence of the CGT legislation and create traps for the unwary and unfortunate.  If it was decided to do something about the loss relief rules then it might be worthwhile revisiting corporate CGT at the same time.

Balanced Funds and Non - resident AIFs

I was having a bit of a think about the issues thrown up by the potential end of corporate streaming.  At the ILAG seminar (see post of 17th September for details) this was mentioned as being particularly problematic for pension business assets invested in balanced funds.  

This slightly surprised me as although there is an issue with balanced funds I'd seen property funds as being the real problem if corporate streaming was abolished (as all the income in a property fund is taxable but only some of a balanced fund's income is taxable).  Perhaps the point is that for property investments there are plenty of alternatives to AIFs.  Firstly there seems to be a rash of conversions to PAIFs (see post of 4th September) and a good proportion of life insurance investment in property funds is in transparent for income vehicles typically Jersey Property Unit Trusts.

This set me thinking about alternatives to UK resident AIFs for balanced investment strategies for pension business assets.  The most straightforward approach would seem to be to disinvest from a UK AIF and invest in an equivalent non  - UK resident fund (Irish OEIC, Lux SICAV).  As these entities are not subject to tax on income in the AIF then there will be no tax leakage for life companies investing pension business assets.  For withholding tax reasons an Irish OEIC might well be preferable to a Lux SICAV (Luxembourg suffers 30% withholding on dividends paid from the USA).

An offshore balanced AIF might also be an attractive option for BLAGAB investments of a UK life insurer but the tax position would need some thinking through.

If an offshore AIF wasn't felt to be suitable for pension business balanced investments then a UK tax Exempt Fund would be another alternative.  Finally the life insurance company could invest directly into the assets concerned.  This would probably minimize tax leakage as direct investment would allow the life company to take advantage of the reduced withholding tax rates available for dividends paid to pension "schemes" in various double taxation treaties.  (See post of 6th May).