Summary
This turned out to be a long note so I thought I'd sum up. To date the focus for life insurers on the new rules for loss relief has been the damaging impact they will have on the SII balance sheet. Working through the proposals in the condoc I think the impact of the rules on SII capital is complicated but may not be disadvantageous for all life assurance companies.
Basics
The reform applies to carried forward trading losses, excess management expenses, non - trading loan relationship deficits, UK property losses and non-trading losses on intangible fixed assets. Capital gains tax loss rules remain unchanged
It would appear that the rules for loss carry backs and group relief will remain unchanged, although no draft legislation has been issued.
The reform is a mixture of good and bad news.
The good news is that where losses arise after 1 April 2017 companies will have the ability to carry the losses forward and set against the taxable profits of different activities and other group members. Current loss relief rules allow brought forward losses to be set only against profits from the same company and sometimes only against profits of the same source source (i.e. a trading loss can only be set against trading profits of the same company.)
But the bad news is that from 1 April 2017 the amount of profit that can be relieved by carried forward losses is restricted to 50% of the total profit. The 50% restriction will only apply where more than £5 million of carried-forward losses are being used across a group of companies in a given year. Accordingly a group of companies can set brought forward losses against £5m of profits without restriction with the 50% restriction applying above that amount.
There is a difference in the timing of the good news and the bad news. The restriction on using losses applies to all losses including those arising before 1 April 2017 but,
The ability to use losses against taxable profits of other activities and the profits of other group members only applies to losses arising after 1 April 2017.
Accordingly companies with losses as at 1 April 2017 will only be able to set those losses against 50% of profits from the same company post 1 April 2017 (and trading losses can only be set against trading profits), but a loss arising after 1 April 2017 can be set against 50% of profits (regardless of source) of the same company plus 50% of other profits in the group.
Life Insurance Company Specific
The reform applies to excess management expenses but excess Basic Life Assurance and General Annuity Business (BLAGAB) expenses are excluded. What is not clear is what will happen to BLAGAB Trading Losses, will BLAGAB trading losses arising post 1 April 2017 be eligible to set against profits from other trades and other group members?
The condoc recognises that the new rules may have an impact on the Solvency II capital of Life Insurance Companies via the impact on both own funds and the capital requirement [A bit more on this below]. The Treasury would " like to understand ways in which the impact on insurers’ regulatory capital could be mitigated through the detailed design of the reforms, while noting the significant policy and legal challenges in making these detailed changes specific to the insurance sector."
Recognition of Deferred Tax Losses
Losses arising Before 1 April 2017
Under IAS 12 where a company has accumulated tax losses it recognises a deferred tax asset in respect of the losses "to the extent that it is probable that future taxable profit will be available against which the unused tax losses can be utilised."
IAS 12 identifies two sources of future taxable profits:
- Taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which the unused tax losses or unused tax credits can be utilised before they expire.
- Other taxable profits arising before the unused tax losses or unused tax credits expire.
Under current (i.e. pre 1 April 2017) loss relief rules, establishing a deferred tax asset for losses against taxable temporary differences (i.e. deferred tax liabilities) is generally quite straightforward. The taxable temporary differences have to relate to taxable amounts against which the losses can be set but as, under existing rules, losses brought forward can be set against all profits arising in the same company (sometimes limited to the same source) in future periods the test is easy to meet. But from 1 April 2017 only 50% of the profits from taxable temporary differences can be relieved by brought forward trading losses and accordingly deferred tax recognition by virtue of taxable temporary differences may be reduced.
Recognition of a deferred tax asset in respect for losses on the basis of future profits arising from sources other than taxable temporary differences is quite difficult under current loss relief rules as senior management and auditors have to be happy that it is probable that such profits will arise. Although in theory it is possible to recognise all expected future profits even those arising many years from now the requirement that these profits will probably be available often means that only profits from a particular period of time are considered (5 years or 10 years perhaps). Again it is possible that the new loss relief rules will see a reduction in deferred tax assets recognised as now it will only be possible to use 50% of the expected future profits arising in a specified time period to support deferred tax asset recognition.
What is important to note is that for losses arising before 1 April 2017 the proposed new rules will either leave a deferred tax asset for losses as it was before the change, or result in a reduction in the amount of deferred tax asset recognised.
Losses arising after 1 April 2017
For post 1 April 2017 losses the impact of the proposed new rules on deferred tax asset recognition is more nuanced. The post April 2017 loss can only be set against 50% of taxable profits, clearly worse than the current rules, but the types of profit that losses can be set against is widened to include profits in other group companies and from other activities. Accordingly, the impact of the new rules on loss recognition for post 1 April 2017 losses will vary depending on each group's tax profile.
Life Insurance Companies Deferred Tax Asset Recognition for Losses in the SII Balance Sheet
Life insurance companies can recognise deferred tax assets for tax losses in two places in the SII return.
- Deferred tax assets can be recognised in own funds (i.e the asset and liabilities included in the SII balance sheet).
- An allowance for the deferred tax impact of the stress event can be included in the companies Solvency Capital Requirement, this is generally known as the loss absorbing capacity of deferred tax (LACDT).
For own funds the above analysis on deferred tax assets should be, broadly, applicable to life insurance companies. However, I think the implications for LACDT are more complex. There are two points that occur to me.
A simplified view of SII is as follows:-
That is the SII balance sheet can be seen as an opening IFRS balance sheet plus SII adjustments (that is SII own funds generally higher than IFRS net assets) less the deferred tax calculated on those adjustments. Sticking to my simplified approach the stresses that make up the pre tax SCR could "hit" either the IFRS base balance sheet or the SII adjustments.
If a stress impacts the SII adjustments then the question is what impact does that have on the deferred tax liability for SII adjustments? Generally the position is that the stress loss represents a tax loss and accordingly the impact of a stress that impacts on the SII adjustment is to reduce the deferred tax liability in the stressed balance sheet by amount equal to the stress loss multiplied by the appropriate tax rate.
In these circumstances the loss absorbing capacity of deferred tax has been demonstrated and the new loss relief rules are not an issue. [Obviously things could be more complicated, particularly if the stresses make SII adjustments negative].
However, the stresses that make up the SCR could hit the IFRS oval in the above diagram. In this case the analysis is more complicated. As the IFRS result is the starting point for the calculation of taxable profits the impact of the stresses may be to create tax losses, the issue to be determined in calculating LACDT is whether those losses can be recognised in the post stress balance sheet. In recognising a deferred tax asset for tax losses arising from the stress event a life insurance company can consider the potential for loss relief from carry backs and group relief.
If group relief and loss carry back is insufficient to use up the tax loss on stress then loss carry forward can be considered. An insurance company can demonstrate the brought forward losses can be utilised either against deferred tax liabilities in the pre - stress balance sheet (but these would be reduced by any amounts already allowed for in establishing LACDT for stresses that hit the SII adjustments "oval") Or expected future profits arising in the insurance company. In both calculations it would seem that, the new rules introducing a 50% restriction on taxable profits that can be relived by brought forward losses need to be considered. This would imply a reduction in LACDT compared to the calculation using the current rules.
However, the assumption in SII is that the stress event happens immediately after the balance sheet date. Accordingly for periods ended on or after 31 March 2017 a tax loss arising from the stress will be eligible to set against 50% of profits arising in other group companies in future periods. This would represent a source of LACDT that is not available under the current loss relief rules. There may be some difficulties in forecasting future profits with sufficient accuracy to demonstrate that it is probable that loss relief will be available. The PRA are sceptical about using group relief as a basis for LACDT recognition and requires that the stress event is modelled for the company receiving the loss as well as the insurance company. Similar points will probably be raised about setting brought forward losses against profits of other group members but are perhaps easier to satisfy given that the brought forward loss can be surrendered in any accounting period whereas group relief can only be surrendered in the year of loss.
On the basis of the above and assuming that the proposals included in the condoc apply to insurance companies then I think the process for calculating LACDT would like something like this.
- Allocate stresses between SII adjustments and IFRS base.
- To the extent stresses impact SII adjustments calculate LACDT via reduction in deferred tax liability for SII adjustments included in base balance sheet.
- Calculate impact of stresses on IFRS profits and calculate tax loss in year of stress.
- Establish LACDT for loss carry backs and group relief.
- Establish LACDT for loss carry forwards arisng from the IFRS stress, from 31 March 2017 this will be on the basis of the new loss relief so possible to look at group as a whole.
This is (probably) more complicated than the LACDT calculation under the present rules where the distinction between stresses that impact SII adjustments and stresses that impact IFRS / tax computations is not significant. However, on the positive side I think that the new rules are not all bad news for LACDT recognition and there may even be companies who are able to recognise more LACDT using the new loss relief rules than they were under the existing rules.
However, the above assumes that the new loss relief rules do apply to insurance companies. As set out in the condoc HMT are prepared to consider changes that will reduce the impact of the new rules on SII capital so we may end up with different rules for insurers.
