ABI Guide to Good Practice

A few thoughts on the ABI Guide to Good Practice.  Plus I went to the ILAG forum on tax provisioning in unit linked funds presented by Financial Risk Solutions and I'll try and summarize some of the comments from there. 

Where are we? The ABI last issued its Guide to Good Practice in Unit Linked Funds in 2012.  This guidance can be accessed by following the link in the post of 5th November.  The ABI has now issued a draft guide, updated, following the FCA's thematic review on the governance of unit linked funds.  This draft guidance is part of a consultation process that ends on the 28th March and a link to the draft is below. There is an expectation that by 31 December 2014, firms should have reviewed their operations against the updated guidelines set out in this Guide and begun making progress towards following them.

ABI Good Practice

The revised guidance is of particular relevance for those working in life assurance tax as the fair allocation of tax between customers and shareholders was one area that the FCA identified as requiring improvement.

Is This is a Good Idea? In my opinion, no its not.  If the FCA believed that certain approaches to tax in unit pricing were incorrect then it should have set out what it objected to, and the changes required.  Its effectively trying to outsource its work to the ABI, but the ABI is guided by its members, not vice versa.

What has stayed the same in the draft guidance? Much of the text of the guidance is the same as per the December 2012 guidance.  More importantly the overall emphasis remains on documenting policies, particularly in areas such as tax where judgement is required; disclosing those policies to customers, and, if required, regulators; and applying policies consistently.  The Guide,  generally, does not lay down hard and fast rules.

What are the Tax Changes The specific commentary on tax is at paragraphs 5.58 - 5.64 of the document.  I've set this out below and have attempted to highlight in red the bits that have changed or are added to the December 2012 guidance.

5.58

Under the tax regime applicable to UK life assurance firms, basic rate tax on the policyholders’ investment return from investing in a life product is assessed on the life assurance firm itself. For unit linked business, the firm therefore levies charges in respect of taxation on the unit linked funds.

5.59

The firm's approach to tax will often be outlined in the policy documentation. Making charges in respect of taxation and the tax commentary in its marketing literature and policy documentation should be consistent. The firm should amend such documentation when material changes to tax regimes arise which impact on charges to policyholders’ funds. For funds where tax charging basis varies from the firm’s standard approach, e.g. where the standalone basis is not applied, such variations should be disclosed, if material to the policyholder outcome.

5.60

The calculation of tax - related charges is complex, and there is not necessarily a single right answer to the treatment of tax in unit-pricing. However, the pricing methodology adopted should seek to preserve fairness between different generations of policyholders and between policyholders and shareholders.

5.61

Where the assets in the linked fund back taxable business (e.g. Life Bond business) the following principles should apply to the calculation and deduction of tax charges:

• ·Customers should be treated fairly.

• ·The firm should document how its chosen basis of charging funds in respect of taxation meets its aims, including achieving broad equity between generations of customers and fairness between the firm and the fund.

5.62

The following factors should be considered when choosing the basis of levying

charges in respect of taxation:

• ·The impact of tax balances in the fund as these can distort the risk profile ofthe fund (e.g. through gearing).

• ·Consistency with current tax rates and tax regime (with changes beingimplemented from the effective date of the change, unless equity demands otherwise).

• ·Appropriate value on deferred tax assets and liabilities.

• ·The firm should ensure that the value of the fund takes account of anyappropriate tax relief attributable to asset classes held in the fund.

• ·Appropriate procedures are put into place that are operationally robust,bearing in mind that taxation in pricing deals with future events whose outcome is uncertain.

• ·Appropriate relief for external expenses charged to the fund.

• ·The discounting of tax rates where there is likely to be a prolonged period from the pricing date until the expected date of payment of the tax, for example on deemed and unrealised gains or losses. The approach to discounting should also be consistent with the settlement of tax provisions, or the holding of cash within a fund against the provision, required to avoid accidental or inappropriate gearing of the fund.

5.63

The scope and nature of the taxation of UK life assurance firms, and therefore of unit-linked life funds, may be subject to change over time. Wherever possible, and where appropriate announcements of future changes should be taken into account in fund tax charge calculations.

In addition, firms should:

• ·Ensure that the offsetting of losses against gains before calculating tax liabilities is done fairly and consistently.

• ·Document their processes and procedures for offsetting gains and losses and have in place systems and controls to ensure those processes and procedures are correctly applied.

• ·Aim for consistency of approach in offsetting gains and losses and the rationale for any inconsistency should be documented with a view to ensuring that all policyholders are being treated fairly.

5.64

The investment return on Pension Business is not subject to corporation tax. However, taxes may be suffered on assets held to back Pension Business and the life company may be able to recover an element of such tax.  Allowance for tax recoveries on pension funds should be done on an appropriate and consistent basis.

My comments on the substantive points are as follows:

There is, for the first time, a specific requirement to provide appropriate relief for external expenses charged to the fund.  At the ILAG seminar there was an interesting discussion over the true economic effect of shareholder charges to the fund.  However, I think it is clear that this guidance only covers external fees.  It was suggested that if the shareholder charge to the fund was net then it would not be necessary to provide for tax relief on specific external costs.  I would have thought this might be OK if both the implicit gross management fee and its net equivalent was disclosed to customers.

For the first time there is an explicit requirement to discount the tax on unrealized and deemed gains.  But I have never come across a company that didn't provide a discounted rate for such amounts.

At paragraph 5.63 the guidance makes some additional comments on offsetting gains against losses before calculating tax liabilities. However, the wording here is very vague and I think expanding the guidance possibly provides for more diversity of approach than under the December 2012 guidance.  For instance in the ILAG seminar reference was made by George McCutcheon of FRS to the two year carry back of deemed losses under TCGA 1992 section 213 (3). The 2012 ABI guide included a comment that "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." And I would say that this means that company's do have to apply the two year carry back in providing funds with a value for losses.  The draft guide also includes this wording but now there is this additional guidance refers to the need to apply loss offsets fairly and consistently, which, to me, seems to muddy the waters.  

There was an interesting bit in the FRS presentation at the ILAG forum, on valuing CGT losses.  This looked at the fund value method and the transaction value method depending on whether the fund concerned was expanding and contracting.  Those interested in the mechanics of such an approach can follow the link to the full analysis at:

FRS Paper  

There is, however, a bit of a gulf between these actuarial approaches and how most life insurers value losses in practice.  I suspect an approach along the FRS lines will become the best of the best practice for the more engaged life insurers.

Where the FRS approach was in line with industry practice was that it looked at losses and prospective gains on a stand alone fund basis. There was also a discussion over what should happen when CGT losses in one fund are used against other gains of the company and whether there should be a price for the "sale" of losses from a unit linked fund to the "shareholder".  To my mind there should be such an assumed sale as it is intrinsic to the "stand alone" assumption.  That is if each unit linked fund is to be treated as a stand alone insurance company, then that stand alone company is only going to transfer its losses to another entity for market value.  However, I think my opinion is a minority view and there is certainly nothing in the Guidance as it stands that suggests that such an approach might be required.

For the first time the Guide comments on tax in pension business linked funds referring to tax that is suffered on assets held to back pension business.  This I assume is a reference to foreign withholding tax and, potentially, the deemed income tax deducted from the UFII element of AIF dividends (which effectively recovers tax leakage in an AIF).  The issues here are complicated as the offset of withholding tax is the result of the tax suffered by the pension customer and the insurance company's own corporate tax position. Again the wording in the draft guidance is loose enough to support a variety of treatments. However, I would have thought that, where an insurance company is able to obtain a beneficial rate of withholding tax on pension business under a double taxation treaty, the benefit of that reduced rate should be reflected in the unit price.