It seems that whenever the UK Inland Revenue loses a test case in the courts, it takes countermeasures by introducing new legislation. In certain circumstances these actions are valid, but sometimes the Inland Revenue just does not believe in fair play and, like a spoilt child, seeks revenge in a manner that goes against the grain of common sense. This is exactly what it has done following its defeat recently on the issue of discounting of technical reserves.
The new Finance Act 2000 introduces new legislation dealing with the whole aspect of the tax treatment of technical provisions made by a general insurance company. It also allows the Inland Revenue to issue secondary legislation by way of regulations before the end of the calendar year. These new rules, which will be effective for accounting periods commencing after 1 January 2001 and applicable to all UK general insurance companies and offshore captives of UK owners, will have significant consequences for all concerned.
Although the draft regulations for consultation were expected in September, or at the very latest October, by the beginning of November we were still awaiting the final contents with great anticipation. Given that the regulations will need to be finalised before the end of the year, the delay in the issuance of draft regulations means that there will be insufficient time period for proper consultation. It would seem that this whole consultation process is contrary to the stated intentions of the present Government, which has said it is committed to a new and better form of consultation.
So what can we expect to be included in the draft regulations? Early in April, the Inland Revenue issued a Consultation Paper on Proposals for Regulations in which it outlined how it expected the proposals to operate in practice, and invited comments on certain matters which will eventually be covered in the final regulations.
Broadly, although insurance companies will remain free to decide the right level of technical provisions (including claims handling costs), they will be expected to set their technical provisions as accurately as possible. These will then be compared with the actual out-turn in later years on a discounted basis and if they prove to be excessive, an interest charge will be included in the tax computation. If, however, they prove to be deficient, then a negative interest will be allowed as an expense. Companies will be allowed to elect to have only part of their provisions taken into account for tax purposes. However, it is not as simple as it sounds, particularly when one realises that these calculations will need to be done every year for each accident year for the next ten years.
The Inland Revenue initially proposed a risk-free discount rate linked to the rate of interest on medium/long term gilts. However, after strong representations by Ernst & Young and other interested bodies, the Economic Secretary, Ms Melanie Johnson MP, has accepted that the rate should reflect risk and that the calculation should be done on a commercial basis. I understand, however, that the Inland Revenue is still undecided on the actual risk-based discount rate, hence the delay in the publication of the draft regulations.
The Inland Revenue claims that these rules are necessary because it will broadly align the tax treatment of general insurance companies with that of other companies. It also claims that the regulations will both achieve their intended purposes and at the same time add as little extra compliance burden as possible on companies. When one looks at the facts and analyses the proposals carefully, their intentions and beliefs do not hold true.
The Inland Revenue believes that insurance companies obtain a tax advantage because they do not discount their provisions. It would prefer insurance companies to follow applicable accounting standards, which require a best estimate of the relevant liability, discounted where material. But this ignores one crucial factor, namely the allowance for risk.
Insurance companies were excluded from the provisions of Financial Reporting Standard 12, Provisions and Contingencies, as the inherently risky nature of their business means that often the allowance of risk (as required by the standard for non-insurers) would outweigh the discount for the time value of money, making the standard ineffectual. Instead, the ABI Statement of Recommended Practice provides extensive guidance for insurance companies when setting technical provisions. It allows explicit discounting where the expected average interval between the date of settlement of claims being discounted and the accounting date is at least four years. Generally, non-insurers and insurers alike will be reserving on a similar basis and therefore the latter group will not be obtaining a “tax advantage”.
It is inequitable to use the benefit of hindsight to penalise a company for its inability to set its technical provisions accurately, particularly if it has complied with generally accepted accounting principles and has used all available data to arrive at the best estimate. If the plight of the general insurance company is compared with that of banks for example, the inequity becomes even more apparent; banks do not have to discount their provisions for bad debts.
The press release accompanying the announcement of the proposals said that the change would bring the UK into line with other countries. The main competitors to the UK insurance industry are located in Europe. Most European jurisdictions do not discount and of those few that do, none apply hindsight. The UK proposals, when compared with those in France and Germany, seem to be materially unfair and unwieldy.
In France, tax authorities in practice accept the accounting reserves provided that they can be justified, but discounting is not imposed on French insurance companies. An insurance company will be liable to a specific tax of 0.75% per month on the excess of claims reserves over the amounts of actual claims paid. It only applies to over-provisions and will not be due if the reserves were under-provided.
The new discounting and loss reserving provisions in Germany require all companies, including insurance companies, to discount their reserves for tax purposes provided certain conditions are met. Although the discount rate is 5.5%, the tax authorities have simplified the calculation for certain classes of business such that, after certain exclusions and deductions, the effective discount rate is lower. This method seems to be simpler in comparison to the UK proposals and also much fairer.
The UK Government has stated that it wants the UK to be a competitive jurisdiction. These new proposals are unlikely to maintain the competitiveness of the UK insurance companies, particularly within the EU. What's more, the proposals could have a detrimental effect on the UK insurance industry in that it could encourage foreign insurers to reject the UK as a potential base. Worse still, it could motivate UK insurers to move out of the UK to other favourable jurisdictions within the EU.
The Inland Revenue's claim that the new proposals should not increase the tax compliance burden is not sustainable. Given that companies are expected to pay their tax liability on a quarterly basis, they will need to do the calculations in accordance with the new regulations to determine the potential tax liability for all relevant years. They will also need to keep a memorandum account for each accident year and monitor the claims payments and movement on reserves for at least ten years. This is going to put added pressure on internal resources and possibly cash flow. The resources are already under pressure due the strict requirements of corporate tax self-assessment, and the introduction of these proposals will stretch them even further.
If a UK company owns an offshore captive insurance company, these new proposals will also have an adverse effect on the resources of the captive manager; the latter will have to provide all relevant information to the tax department of the UK parent company to enable it to calculate the net chargeable profits of the captive on a timely basis.
Nevertheless, companies and captive managers must prepare themselves to deal with the increase in compliance burden and potential adverse cash flow. Companies will need to put in procedures to capture all relevant information on a timely basis to calculate their tax liability. They will also need to consider any tax planning opportunities that may be available to them to optimise the group's tax position and the effect of these proposals on the group's effective tax rate.
These regulations, when introduced, will include some extremely complex matters. It is unsatisfactory that they are being issued so late, denying proper consultation before their formal implementation. It will not allow sufficient time for insurance companies to evaluate the impact on their business and potential tax liability. It is disconcerting that such an important tax rule will be introduced without proper review, as poor legislation could have a detrimental effect on the insurance industry. Therefore, the UK Government and the Inland Revenue should defer these proposals, at least for another year, to allow sufficient time for proper consultation. It is generally accepted that tax rules are not always logical, but surely it does not mean that the Inland Revenue must ignore common sense and the opinion of the industry at large when embarking on such a sensitive issue.
Please note that just before going to press, the Inland Revenue published new draft regulations, extending the consultation deadline to
31 January 2001.
Praveen Sharma is a senior tax consultant in the insurance tax department of Ernst & Young, London office and can be contacted on + 44 (0) 20 7951 2065.