Deductions for Tax in Unit Pricing

1. Deductions for Tax in Unit Pricing 14 September 2011 Maxine Phillips

2. 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 AdamsEnglish humorist & science fiction novelist (1952 - 2001)

3. 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 A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client.

4. 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. 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.”

5. Implications for tax deductions in unit pricing Three principles: • 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)

6. 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.” “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 …”

7. 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? Capital allowances

8. Tax deductions from gainsHow 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 S212 deemed disposal assets – need to hold sevenths spreading data at fund level? Need to mirror S213(3) loss carry back rules?

9. Tax deductions from gainsHow 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” Documentation, documentation, documentation How/why do any tax simplifications in the fund pricing model comply with TCF considerations?

10. Tax deductions from gainsDifferent asset types 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.

11. Tax deductions from gainsMechanics & 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 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?

12. Cash extraction (1) “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.”

13. Cash extraction (2) “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.”

14. Tax deductions from gainsWhat 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 For equity/property unrealised gains and spread deemed disposal gains – suitably discounted rates – regular Actuarial review and sign off essential Documentation!

15. 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. 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.”

16. 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 “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???

17. 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 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?)

18. 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??? 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.

19. 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. 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.”

20. 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.” “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.”

21. Tax relief for losses (5) “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.”

22. 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 What happens to that asset? • Shared between remaining policyholders? • Transferred to shareholders?

23. 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. 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.

24. 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!

25. 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 What if structurally XSE?

26. Accounting treatment 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)

27. It is obvious that ……. Fund Deductions (ie charges taken from the linked funds in respect of taxation) should equal the Policyholder tax charge ……. Oh really???

28. Don’t Panic!

29. "'Don't Panic.' It's the first helpful or intelligible thing anybody's said to me all day."

30. Squaring the circle Fund Deductions: various percentages x [“I” – Fund “E”] Policyholder Tax Charge {various percentages x [“I” – BLAGAB “E”]} – {amounts included in Shareholder tax}

31. 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

32. 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.” Easier said than done????

33. “I may not have gone where I intended to go, but I think I have ended up where I needed to be. “ Douglas Adams

34. Thank you zurich.com