ABI Guide of Good Practice for unit linked funds

I'm just starting a piece of work for a client looking at  tax in unit pricing policies and documentation in the light of TR 13/8 and the ABI reissued "A guide of good practice for unit linked funds" ("The Guide").   I've been reading through the Guide to get a feel for what constitutes good practice.  What follows is my summary of what the I think the Guide is saying and a few suggestions on what I think the implications are.

Probably the most important point to note is the Guide's brevity.  It is only 24 pages long (and that includes title pages indexes chapter breaks etc).  It is not telling firms what to do but rather setting out general principles.  Accordingly it is necessary to read through the Guide as a whole rather than just concentrating on the tax sections.

The forward, introduction and status sections of the guide set out how companies operating unit linked funds should apply the principles in the guide.  This includes the following.

The FSA has indicated that it will take account of the standards set out in this Guide in their supervision of unit linked offices (see para 1.1.4) 

The Guide is aspirational: it is something companies should work towards.

But in some cases products sold in the past may not be able to meet the good practice guidelines owing to the materiality of the issues, the disproportionate costs, or contractual constraints. (see paragraph 1.0.02)

However, if a company does not meet the guidelines then it should document the non  - compliance and why this is acceptable. (paragraph 1.0.03)

It is recognized that some of the guidelines may not be appropriate for institutional unit linked companies (1.1.5).

Section 2 of the Guide covers fund governance and policyholder documentation and communication.  

The individual policy conditions should define  the boundaries within which a

company has agreed to operate its unit linked funds.  Tax is specifically mentioned as an area that should be documented in this way. (paragraph 2.1.9).

Where this information has not been set out in individual policy conditions, then firms must ensure that they make such information readily available to their customers. 

Taken together, all the information provided (or made available) to customers should enable them to understand how the firm operates the fund and manages their investments.  (Paragraphs 2.1.10 and 2.1.11)

Comment : Many unit linked firm's include wording in their policy terms that the unit linked fund will be taxed as if it were a stand alone company.  I do not believe this allows customers to understand how the firm operates and manages the fund, (unless the customer has a good working knowledge of I-E tax.)  I think companies should be making a fuller disclosure of how the fund is taxed.

Section 3 of the Guide is on the use of discretion

The Guide requires that where discretion is applied this should be on the basis of  published criteria and standards. (3.1.2).  The calculation of tax including deferred provisions are specifically mentioned as being areas where discretion is applied.  As is the the taking of charges for tax  from (or applying credits to)  the fund. (3.1.6).

Section 4 of the document is about operating standards including pricing issues.

As a general principle wherever possible processes and decisions should be documented by the firm with relevant information made available both to the regulator and to policyholders. (4.01).  I think this confirms the need for information to be provided to policyholders beyond a "we tax the fund as a stand alone company."

4.1.1 of the guide sets out two basic principles to be applied in pricing.

The pricing mechanism should not be used as a deliberate means of extracting value from the fund or from policyholders, and

Cross subsidy among policyholders or individual funds should be minimised as far as reasonably possible.

Its easy to read over the "not be used as a deliberate means of extracting value from the fund or policyholders" but taken at face value it is quite radical.  After all an annual management charge is an explicit extraction from policyholder assets to fund shareholder costs and provide a profit. However, a footnote provides  clarification that this does not prevent the proper application of disclosed management charges and fees.

Comment 1 Notwithstanding the footnote, I still think the reference to extracting value is potentially quite a far reaching statement.  At one time it was common for insurers to operate unit linked funds on the basis that no credit would be given in the unit price for CGT losses when the fund was in a net loss position.  This policy would still be followed when the company as a whole had net CGT gains due to the "taxed as a stand alone company" policy.  However, in these circumstances the stand alone company is effectively lending its CGT losses to the shareholder at a 0% interest rate.   The question is, is that an extraction of value? 

In the absence of a clear statement in the unit pricing policy I  think it is  - if the fund is to be taxed as stand alone company then shouldn't that stand alone company expect a fee for the loan of its tax assets?  Also the failure to pay for the loan of losses would not be disclosed to the policyholder.  I guess the contrary view is that the use of its losses does not make the fund any worse off so is not extracting any value but I know which side of the argument I would like to be on.

Comment 2 Although the need for equity between groups of policyholders is established some companies have unit pricing polices where credit stops being provided for CGT losses when the fund is in a net loss position.  It is hard to reconcile this with equity between groups of policyholders.  A policyholder may leave a fund in a net loss position and not receive  any value for CGT losses that then accrue to future policyholders when the value of the fund increases.  Clearly there is a point at which a fund has so many CGT losses that an additional pound of loss has no value but its hard to see any justification for that point being reached in one fell swoop when the fund moves in to a net loss position. .

Sections 4.5.9 - 4.5.11 are specific tax sections.  As these are quite short I have reproduced them below.

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4.5.9 Where the fund is subject to tax the following principles should apply: 

 

Policyholders should be treated fairly.

 

The firm's approach to tax should be consistent with marketing

literature and policy documentation. The firm, if appropriate,

should amend marketing literature and policy documentation

when changes in tax regimes arise

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The firm should document how its chosen basis of taxation

meets its aims, including if appropriate broad equity between

generations of policyholders and fairness between the company

and the fund.

 

4.5.10 The following factors should be considered when choosing its basis of taxation

 

 The impact of tax balances in the fund as these can distort the

risk profile of the fund (e.g. through gearing).

 

Ensure consistency with current tax rates and tax regime (with

changes being implemented from the effective date of the

change, unless equity demands otherwise).

 

Place an appropriate value on deferred tax assets and liabilities.

 

The firm should ensure that the value of the fund takes account

of any appropriate tax relief attributable to asset classes held in

the fund.

 

The need for procedures that are operationally robust, bearing

in mind that taxation deals with future events whose outcome is uncertain.

 

 4.5.11 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.

 

Comment 1 The Guide is clear that tax deductions in unit pricing should be consistent with policyholder documentation.  Accordingly I think it is saying that except in exceptional cases what is in the documentation trumps any abstract notion of fairness.

 

Comment 2 The gearing point is interesting but I'm not 100% sure what it refers to.  I think it would be a situation where a fund has assets of £100 and  a tax liability of £10.  In these circumstances the unit linked policyholder has an investment of 90 but backed by assets of 100 and a liability of 10.  Therefore the policyholder has, potentially an exposure of more than 100% to market movements.

Comment 3 The need to place an appropriate value on deferred tax assets is quite vague but I think it supports the need to do away with the "cliff edge" where CGT losses go from being valued at 20% to 0%.

 

Section 5 of the document is on fund launches, mergers and closures and at 5.2.2 lists tax as one of the factors that should be taken into consideration when deciding whether to merge or close funds.

 

Final Comment The Code is good at setting out overarching principles for operating and pricing unit linked funds.   However, it offers little in terms of specific guidance for charging tax to unit linked funds.  For companies with robust TCF procedures the lack of rules will allow them to develop policies that take account of their particular circumstances.  Unfortunately for other companies the lack of firm guidance just provides room to wriggle away from policyholder commitments.  

 

Accordingly although I expect there to be continued improvements in tax in unit pricing tax to provide greater  equity between policyholder and shareholder and groups of policyholders I think that there will be a wide range of policies followed and some companies will cling to established but inappropriate polices. 

If there is a single theme running through the document it is the need to articulate, document and communicate unit pricing policies in a way that can be understood by customers and the regulator.

 

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