TAXATION OF LIFE INSURANCE

Life insurance companies underwrite policy contracts providing benefits to, or in respect of, individuals on death, disablement and critical illness (Risk Policies). They also underwrite policies providing investment returns – either guaranteed or linked to the performance of specified investment funds or through participation in profits– payable on death or survivorship to a specified date including in the form of annuity payments (Investment Policies).

Policy contracts may be written providing both investment and risk benefits in bundled form – e.g. whole of life and endowment assurance (Bundled Policies).

To the extent that investment returns are included, a life policy provides the owner with the opportunity to benefit from collective investment. In the interests of competitive neutrality, and consistent with our previous submissions, we seek taxation of policyholders benchmarked against the basis of taxation of direct investors and those investing in other Collective Investment Vehicles (CIVs).

The RBT paper A Platform for Consultation builds on the framework for taxing life companies as Business Entities under the Business Entity Tax Regime proposed in the Government’s August 1998 paper A New Tax System.

A Platform for Consultation addresses many of the concerns of the industry’s participants, which would be raised as a result of the transition to the proposed regime. The Review recognised that it was necessary to consider technical matters in some depth. The length and complexity of our submission has therefore been necessary in order that we respond appropriately to these matters.

We note that the RBT proposes a number of changes to company taxation.

We accept that, in relation to shareholder profits, life companies should be taxed in a similar way to other corporate bodies and business entities generally.

However, there are many aspects of the Review which we believe, if implemented, would have a seriously detrimental effect on policyholders. There is also every likelihood that the behavioural responses of companies, policyholders and their advisers would cause significant disruption to the industry for no net gain to Revenue. Accordingly Lend Lease/MLC believes there are strong grounds for reasonable transitional rules.

The Review, in A Strong Foundation, commented that:

Thus an objective of the tax reform proposals should be to achieve competitive neutrality for investors regardless of whether they invest directly, or through CIVs such as life policies or unit trusts. Not only is this approach clearly fair and reasonable, but to do otherwise would favour wealthy investors against the less wealthy. Wealthy investors can obtain the risk reducing benefits of diversification of investments by investing directly. However, the high individual minimum amounts often required for each investment can often mean that less wealthy investors can only obtain such diversification through CIVs such as life policies.

For life companies to properly carry out their fiduciary responsibilities to policyholders, implementation of the proposed reforms would require:

• re-education of customer service staff, sales forces and financial planners;
• policyholder communication strategies and programmes; and
• a major overhaul of policyholder administration and accounting systems.

For these reasons Lend Lease/MLC believes that commencement of the new tax system should be deferred by 12 months until 1 July 2001.

In summary:

Taxation Framework for Policyholders

Policyholders should be subject to their personal rates of tax on their investment returns from the policies. This includes trustees of superannuation funds being taxed at 15% on their investment returns under Superannuation policies.

Tax would be levied at the corporate rate (currently 36%, but under review) on investment returns in the hands of the life company. Policyholders would include investment returns from life policies in their tax returns and receive refundable imputation credits against their personal tax assessment. This will depend upon the type of policy involved. In general, for Superannuation business the tax rate would be 15%, and for Ordinary business the individual’s marginal tax rate would apply. Refunds would be available for tax overpaid at the life company level.

Exceptions to this procedure would be Retirement Savings Accounts, Deferred Annuities and Immediate Annuities, where the tax levied in the life company would (continue to) be 15%, 15% and 0% respectively.

In general, the proposals put Ordinary policies on a similar footing with other CIVs, and are supported.

Fees are levied and costs are charged to policyholders in a wide variety of ways – some explicit, some incorporated in the contract through reduction in benefits. Various forms of relief for policyholders are proposed, depending on the type of fee or cost.

We submit that the different approaches proposed add complexity to the system.

We note that it is intended to tax the shareholder on all fee income, from whatever source, and however imposed.

We suggest therefore that all investment related fees and charges, which are included in premiums or deducted from investment income or benefits, be treated as reductions in the investment return to policyholders.

Fees that are paid in addition to the premium should be treated, as proposed, as related to an investment of capital. They should then be deductible in the hands of the policyholder on a consistent basis with investments in other CIVs.

More detailed comment, is included in the section "Treatment of Policy Fees" (Page 14).

No tax would be paid by policyholders on the benefits arising from pure risk insurance policies– whether through death, disablement or critical illness – except where tax relief had been provided for the premiums paid.

Premiums would be deductible from taxable income if they can be justified as expenses incurred in the obtaining of income.

The general approach for Bundled Policies is to ensure that a similar position arises in respect of the part of such policies related to risk benefits and premiums.

The proposals follow current practice and are supported.

The Review is silent on this subject.

Section 67AAA of the Income Tax Assessment Act denies a deduction in respect of interest on borrowing where the amount borrowed has been invested as premiums for life policies.

Interest deductibility has been denied since August 1992 – essentially on the grounds that life policies do not provide an annual assessable income.

We submit that new style policies, where an amount is assessable to the policyholder, either annually or on termination, should now permit financing costs to be immediately deductible. This treatment would then be consistent with the deductibility of financing costs generally and with the taxation treatment available to investors who borrow to invest in other CIVs.

NEW ORDINARY (NON SUPERANNUATION) POLICIES

It is proposed that holders of ordinary policies pay tax at their marginal rates on their investment return under the policies (i.e. bonuses assigned), with allowance for imputation credits reflecting tax paid by the life company on behalf of policyholders.

We support this proposal as this would make the taxation of investment returns to policyholders consistent with the taxation of investment returns to individuals who invest directly or in other CIVs.

Three options for the calculation of the policyholder’s tax are proposed:-

Option 1 – Calculate and pay net tax each year or when bonuses are received;

Option 2 – Calculate the tax shortfall every year and pay net tax at that time or when bonuses are received; and

Option 3 – Calculate and pay net tax when bonuses are assigned.

It is also proposed that, under Options 1 and 2, policyholders may be given the opportunity to choose when they should be assessed for the tax.

We note with interest that the Review has proposed that life companies be given the opportunity to issue two types of policy – one where bonuses are assigned only on termination, and the other where bonuses are assigned annually.

We have recognised that giving policyholders choice is of advantage to them. However, the administration of such arrangements can become difficult – particularly where it is possible for the election to be varied a number of times, and at any time, during the term of the policy.

We therefore submit that the policyholder’s election should be focused simply on the type of policy selected at commencement, rather than under an option within the policy.

On this basis we support the Review’s proposal of allowing two types of policy. For these, we would suggest:-

(1) Bonuses assigned only on termination, with taxation assessed at that time at the policyholder’s then marginal rate (Option 3), but subject to "averaging" (refer Page 11).

(2) Bonuses assigned annually in respect of investment income received including realised capital gains (indexed), and assessed annually (Option 1), together with a bonus assigned on termination with taxation assessed at that time at the policyholder’s then marginal tax rate.

Currently, revenue and capital gains are taxed only on realisation.

A Platform for Consultation suggests in various places that a consequence of particular proposals could be for tax to be levied on unrealised gains.

We strongly object to any situation where a life company, or a policyholder should be subject to tax on gains when no proceeds have been received. To do so would amount to a significant competitive disadvantage relative to other investment alternatives.

We submit therefore that, in the case of the annual assignment of bonuses, taxation should be assessed only on realised gains.

For Ordinary business, no indexation of gains has been allowed - on the basis that the life company holds investments for the purposes of trading.

We submit that the turnover of life companies’ investments is no greater than that of CIVs – where a capital gains component is passed on to the investors.

In any case, the benchmark should be the treatment of gains in the hands of an individual.

The competitive neutrality benchmark demands that, if indexation continues to be available to individuals, then it should also be available where such individuals invest in CIVs – such as life policies as well as unit trusts.

The Review proposes the possibility of changes to the taxation of capital gains in the hands of individuals and superannuation funds. We submit that, for consistency and competitive neutrality, any changes made to the treatment of capital gains, the benefit of which can flow through CIVs to individual investors, should also be available to Ordinary policyholders.

The investment income attributable to policyholders will usually comprise a mix of components with different taxation characteristics. These include interest from fixed interest investments and property rents, with no tax deducted at source, Australian share dividends with imputation credits, foreign investment income net of withholding tax, tax preferred income from property enjoying the benefit of accelerated depreciation allowances, and capital gains, both unrealised and realised, some of which may have the benefit of indexation.

It is important that policyholders are taxed on each of these components in a manner consistent with their taxation as if they were investing directly in similar investments as individuals. This approach applies to the taxation of income for other CIVs.

A life company should be required to identify the separate components of income in policyholder statements. These would also show imputation credits given, and be the basis for the policyholder’s tax assessment on bonuses assigned.

While this would require development of suitable systems by life companies, the technology and software is already available as such information is required for unit trust and other fund management operations.

The income assessed for tax in the policyholder’s hands following termination of a policy will usually have arisen over a period of years.

This corresponds to the realisation of a capital gain which may also have arisen over a long period.

"Averaging" relief is given for capital gains – whereby the individual’s marginal tax rate is determined as that applicable to the average yearly gain.

It is recommended that such "averaging" is applied also to the income assessed on termination of a life policy, averaged over the period since its commencement.

Participating policies include mainly whole of life insurance, endowment insurance, pure endowment and investment account policies. Many of these are Bundled Policies.

In principle, the taxation of participating policies is intended to be no different from that of other policies.

For new policies, policyholders would be assessed for tax at their marginal rates on the excess of the policy proceeds (PP) over the investment component of premiums paid (IP). Imputation credits would be available to the policyholder in respect of tax paid by the life company.

It is noted that the policy proceeds will effectively be those available after charges have been levied or incurred during the life of the policy for the cost of any risk cover – death, disablement or critical illness.

In order for (PP – IP) to reflect purely the investment return allocated to the policy, it is necessary for the deduction from total premiums for the cost of risk cover to equal that cost effectively deducted in arriving at the amount of the policy proceeds.

For participating business, this is determined from the actual experience of the fund. However, allocating this cost of risk cover appropriately to each policy would be a very complex exercise. It is proposed therefore to adopt the best estimate assumptions made by the appointed actuary for the purposes of determining the Policy Liabilities for the Financial Statements for each of the relevant years.

Thus the investment component of the premium payable in any year is equal to:-

Total Premium – Cost of Risk Cover

when the Cost of Risk Cover = q x (sum insured – CTV) where q is the cost per unit of risk for one year and CTV is the Current Termination Value.

This appears to be an elaborate procedure. However, the data should be readily available to enable the calculation to be carried out each year.

Moreover, this approach will be consistent with the method outlined in this submission for calculating the policyholders’ share of taxable investment income (net of fees) in the determination of the life company’s taxable income.

The proposed date of commencement is the beginning of the first financial reporting period ending after 1 July 2000.

The proposed tax changes are significant and complex. The new tax regime demands the following significant upgrading to policy administration and accounting systems to accommodate the new style policies envisaged:

(a) Policyholder franking credit accounts

(b) Annual assignment and advice of bonuses

(c) Imputation credit advices to policyholders – annually for some policies.

In addition to the work required to make the necessary above changes, life companies will be required to carry out:

(1) extensive training of staff, agents and financial planners; and

(2) a carefully constructed communication plan for policyholders.

The proposed changes are the most substantial reform of life insurance taxation since 1 July 1988. Furthermore, the system changes required for implementation are in addition to the systems and other changes which will be required to implement a GST.

We would strongly counsel against introducing both changes at the same time, and instead recommend deferral of the introduction of the income tax proposals for a period of 12 months, i.e. to 1 July 2001.

TREATMENT OF POLICY FEES

The basic structure proposed is:-

(a) Shareholders are taxed on fee income.

(b) Policyholders may receive tax relief on fees paid – either directly by claiming against personal tax, or implicitly as a result of deduction from policy benefits.

The Review proposes that policyholders pay tax when bonuses are assigned to their policy. Options have been suggested as to when this may occur (i.e. either annually or termination) and how the amount would be determined.

In this submission we have recommended that two forms of Ordinary policy be acceptable:-

(1) where bonuses are only assigned on termination of the policy, and

(2) where bonuses are assigned annually in respect of investment income received, including realised capital gains, with a final bonus on termination.

In each case, it is submitted that the policyholder’s taxable income would be calculated after allowing a deduction for all fees included in premiums or deducted from investment income or policy benefits.

In (1), the policyholder taxable income on termination would equal

(a) "total policy proceeds, less

(b) the investment component of premiums paid" (including any fees incorporated in the premiums).

In (2), the annual bonus would be calculated after allowing for annual fees, other than premium based fees. The final bonus on termination would be the same as in (1) above.

The effect of the above proposals will be:-

(a) where bonuses are assigned on termination - to give the policyholder the benefit of tax relief for fees paid over the policy term, at termination, at the policyholder’s then marginal rate of tax,

(b) where bonuses are assigned annually - to give the policyholder annual tax relief on annual fees paid, with tax relief on premiums only available on termination – again at the policyholder’s marginal rate of tax.

The paper proposes that premium based fees should be treated as being capable of offset against "capital gains", i.e. when the life policy investment is terminated. This is consistent with the treatment of fees charged to unit trust investors where the fee forms part of the cost base of the investment.

This will effectively apply in terms of the policyholder’s own assessment for tax under both types of policy envisaged above.

EXISTING POLICIES

The general approach in the paper is to recognise existing policyholder expectations as regards the "10 year" rule. Consideration is then given to a range of possible transitional arrangements.

Three options are suggested for industry comment. These are described as:-

Option 1 – Continue to apply the current taxation treatment to bonuses paid on existing life insurance investment policies;

Option 2 – Apply the redesigned imputation system to bonuses paid on existing life insurance investment policies terminated within 10 years (from their commencement), and the current taxation treatment to bonuses paid on existing policies terminated after 10 years; and

Option 3 – Apply the redesigned imputation system to bonuses paid on all existing life insurance investment policies. The rate of tax on bonuses paid on existing policies terminated after 10 years would be capped at the company tax rate.

In para 35.61, it is suggested that "it would be logical to allow policyholders to elect to treat an existing life insurance investment policy as a new life insurance investment policy. That would mean that policyholders would not face unnecessary transaction costs."

In our view, existing policyholders have entered into their policies on a certain tax basis, and arguably, the policyholders have expectations that their tax treatment will be maintained.

To provide all policyholders with sufficient material to enable them to make a decision, would be an onerous exercise. Even if we adopted a fall back position of "no change" in the event of failure to reply, we would still be inundated with enquires from many people for whom the "treatment as a new policy" would be of no benefit. For such policyholders the process would represent a huge waste of time, and may upset many of our older policyholders.

Moreover, it is proposed that the definition of "bonuses" would change under the proposed system. It would not be the whole of the premiums paid that are deducted from the policy proceeds as at present. It would only be the "investment component" of such premiums.

To "convert" an existing policy to a new policy would involve retrospective identification of the investment component of all premiums paid prior to the introduction of the new tax system.

Attempting to track such components historically would be a very elaborate and costly process and require system support.

It will, of course, be open to any policyholder to surrender an existing policy, or make it paid up, and effect a new one. Companies may, of their own accord, choose to offer favourable terms in such circumstances.

"rollover" deferred annuities

The paper (paragraphs 34.65 to 34.71):-

(i) proposes that existing policyholders should continue to have investment income under rollover deferred annuities taxed at 15% in the same manner as other superannuation business,

(ii) notes that the existing procedures do not appear to fit readily with the proposed taxation of life companies under the Business Entity Tax Regime, and

(iii) suggests various methods under which the principle in (i) above could be achieved - one of those methods being that the deferred annuity business would need to be moved out of the life company.

We see no purpose being served by making any changes to the existing regime. Rollover deferred annuities are simply another form of superannuation investment.

The taxation procedures for these products are well established and controlled. There is a good understanding of the nature of the product in the community.

The calculation of taxable income of the life company in respect of (concessionally taxed) deferred annuity business is accommodated under Option 1 (section 34.22), with the modifications suggested in this submission. This will ensure that shareholders pay tax at the corporate rate on all investment income and profits, other than that which has been allocated to policyholders which would continue to be taxed at 15%.

In the circumstances, we see no need to withdraw the current tax treatment for either new policies or existing policies. In any case the paper’s suggestion that existing business be transferred to RSA’s, complying superannuation funds or ADF’s, is impractical. The policies are contracts owned by individuals who would need to be parties to any changes in the terms of their policies.

Taxation Framework for Shareholders

The aim of the proposals is to levy tax at the corporate rate on the whole of a life company’s:-

(i) investment income, plus

(ii) fee income, less

(iii)deductible expenses, plus

(iv) underwriting profits.

The major part of most companies’ investment income is attributable to policyholders. Policy benefits would be reduced by the tax on such income, which would be effectively retained by the shareholders for inclusion in the total tax assessment for the company.

Accordingly, the shareholders would effectively bear tax on their own account at the corporate rate on:-

(1) total investment income, less income attributed to policyholders, plus

(2) fee income, less

(3) deductible expenses, plus

(4) underwriting profits.

We support this framework.

Currently, the industry wide tax rate effectively paid by shareholders on their part of life companies’ taxable income is, on average, around 20%.

It is submitted that an immediate or single step increase to 36% (or even 30%) would cause significant disruption to the industry. The profitability of many existing policies, written under current rules, will reduce – possibly to a negative position. This may require the injection of additional capital.

The writing of life insurance business involves significant up front costs. Relief for such costs in relation to existing business has been given at an average rate of 20%. The income to repay those costs arises from future margins embedded in the policies. Application of a 30% or 36% tax rate to such income has the effect of imposing additional tax in an arguably retrospective manner.

In some instances life companies will be able to adjust the pricing of their policy contracts and effectively pass on some part of this increased tax cost to policyholders. The "flow-on" to policyholders will occur so as to support shareholders’ return on equity requirements.

In other cases such adjustments will not be possible. That business may well become loss making because:-

• the initial tax advantage has already been, to some extent, priced away to policyholders, and
• the increased tax would not be recoverable from policyholders.

Finally, the tax rate adjustment itself from, on average 20% to either 30% or 36% is significant. In other instances, where significant tax rate changes have been introduced, most notably in the case of credit unions and friendly societies, those changes have been "phased in".

life company Taxable Income

The paper proposes that a life company be taxed an amount which incorporates both the tax on shareholders’ income, and the tax on policyholders’ income (subject to certain exemptions), calculated at the corporate rate.

Three options for the determination of taxable income are proposed. These are referred to in the paper as:-

Option 1 – "Include Premiums in Assessable Income"

Option 2 – "Identify Components of Taxable Income"

Option 3 – "A combination of Option 1 and Option 2 under which:

(a) Risk Business taxable income would be calculated using Option 1, and

(b) Investment Business taxable income would be calculated using Option 2".

All three options are intended to produce similar results, and include the liability for policyholder tax. The choice to be made is essentially based on administrative ease of calculation, the monitoring of the calculation, its robustness and minimising opportunities for manipulation.

The paper recognises the need to make special allowance for types of business where policyholders should be taxed at a lower rate than the corporate rate. These include immediate annuities and deferred annuities, and by implication, RSA’s.

In this submission, we have recommended that policyholder benefits under Superannuation policies also be excluded from the Business Entity Tax Regime.

The modifications suggested below are those necessary to ensure that it is distributable profits which are taxed, to recognise where policyholders’ tax is applied at a different rate from that for the shareholders, and to ensure consistent taxation principles apply as between the shareholders of life companies and those of other business entities.

Some advantages of Option 1 are set out in the paper. To these can be added:

Option 1 may be expressed as requiring the taxable income of the company (TI) to equal Premiums (P) + Management Fees (F) + Investment Income and other income (I) – Expenses (E) – Policy Claims (C) – [Increase in the value of Policy Liabilities (D L) - Policyholders Taxable Income (PTI)], i.e.

TI = P + F + I – E – C - D L + PTI

To determine these items in a robust manner, it is desirable to utilise numbers from statutory returns as far as possible. These amounts are subject to independent audit as well as actuarial certification under the Life Insurance Act 1995.

For this purpose, it would be usual for the fees described as Management Fees in the paper to be deducted from the Policyholder "account balances" – whether under an investment linked policy or an investment account policy. Thus the increase in the policy liabilities, (D L) in the formula, is an amount determined after the deduction of these Management Fees.

This is illustrated in the following example which examines the revenue accounts of the separate Policyholders’ and Shareholders’ Interest in the Statutory Fund for investment linked business:-

(Please note that, for simplicity, we have assumed (and are recommending) that all fees taxable in the shareholders’ hands should be deductible in determining the policyholders’ taxable income within the life company.)

In the above example this is 550 – 80 = 470,

made up of (100 + 50 – 80) = 70 for Shareholders,

and (500 – 100) = 400 for Policyholders.

Now the Increase in Policy Liabilities D L = Premium (P) + Policyholders Income (PI) – Fees (F) – Claims (C)

i.e. D L = P + PI – F - C

Substituting for D L in the formula for TI at the top of the previous page, we have

TI = P + F + I – E – C – [P + PI – F – C] + PTI

= 2F + I – PI – E + (PI – F)

This compares with the intended total of I – E, which has already counted "F" as taxable in the shareholders’ hands and deductible for policyholders.

This illustration also serves to show that, under the existing I – E tax base, shareholder profits are effectively already being taxed, albeit at the rate of tax applicable to the statutory fund. For Superannuation business that is at 15%, for Annuity business that is at 0% and for Ordinary business at 39%. We understand that the "blended rate" for the industry as a whole is, on average, about 20%.

It is noted that the increase in Policyholders Liabilities (D L) will have been reduced by the amount of current taxation attributable to policyholders (PT). This will need to be added back for the purpose of determining the increase in policy liabilities deduction in the formula.

Accordingly, taking account of the above two adjustments, we suggest that the formula be restated:-

TI = P + I – E – C – (D L + PT) + PTI

where "I" is investment income plus all other income which does not correspond with amounts which have been debited to policyholders’ accounts.

The above formula may be said to equal the sum of:-

(i) Shareholders’ Taxable Income (STI) = P + I – E – C – (D L + PT), and

(ii) Policyholders’ Taxable Income (PTI) = Policyholders Investment Income (PI) less Fees (F)

The Shareholders’ Taxable Income will be subject to tax at the corporate rate, and the Policyholders’ Taxable Income will be subject to the appropriate rate depending on the class of business.

This is equivalent to the basis which currently applies to the determination of taxable income for RSA’s.

Under Risk Business there is no policyholder tax. Accordingly, PT and PTI are zero. The effect is for all investment income to be taxed in the hands of the shareholders.

Option 1 then corresponds with the regime currently applicable to the Accident and Disability business of Life Insurers, and all the business of General Insurers.

The paper drew attention to the possible disadvantage of Option 1 arising from the need to rely on the calculation of actuarial liabilities, and the need to make suitable assumptions for that calculation. Some limitations of the statutory "Margin on Services" calculation of policy liabilities were identified.

We submit that adoption of the Solvency Requirement for the policies (SRP) should eliminate these concerns.

The Solvency Requirement is the amount of assets required to meet the statutory Solvency Standard. The basis of calculation is prescribed by the Life Insurance Actuarial Standards Board in its standard AS2.01. This leaves negligible room for uncertainty with regard to the calculation, or for manipulation.

One component of the Solvency Requirement is the value placed on non policy liabilities. Accordingly, this should be deducted to arrive at the Solvency Requirement for the policies (SRP) for tax purposes.

SRP effectively represents the current termination values of the policies together with prudential margins. As such, it corresponds with the value of liabilities adopted in the determination of tax for General Insurers, and, for Life Insurers, it reflects the current approach adopted for the taxation of Accident and Disability Business.

We submit therefore, that the use of the Solvency Requirement for the policies, as calculated for statutory purposes, as the "actuarial liabilities", is particularly suitable for the purpose of determining a life company’s taxable income.

The prudential margins in SRP will be represented by Shareholders’ Capital and Shareholders’ Retained Profits, (and for some types of business, Policyholders’ Retained Profits – mainly participating business).

However, the Option 1 formula, modified as suggested, will still levy shareholder tax at the corporate rate on all the income from all the assets of the fund or subfund, excluding the income which has been allocated to policyholders.

The existence of the prudential margins in the "Actuarial Liabilities" only serves to defer taxation until the policies are terminated. Relief is effectively given on the prudential margins when business is written; tax is payable on the release of the prudential margins when policies go off the books. In our view this treatment is justified since such amounts are neither earned nor distributable until that time.

This is demonstrated in the following simplified example of a portfolio of two year term risk insurance policies. Investment income will be small, and will be the same under each scenario (assuming Retained Profits at the start of the policies of at least 20 to cover the Year 1 "loss" after providing the prudential margins).

* Release of Liabilities as policies go off the books.

There will be a further minor, but important issue, to be addressed. As policies go off the books after the new tax regime has commenced, the prudential margins related to those policies will be released and fall into taxable income. This implies relief would have been given when the prudential margins were established. This would not have been the case prior to the commencement of the new tax system (except perhaps in the case of Accident and Disability business where prudential margins have been included under the current tax regime).

Accordingly, at the start date of the new tax regime (proposed 1 July 2000, but recommended 1 July 2001) it will be necessary for life companies to be given tax relief in respect of the prudential margins existing at that date.

Other disadvantages noted in the paper comprise essentially:-

(i) the need to exclude (policyholders’) investment income from the change in actuarial liabilities, and

(ii) identifying adjustments to avoid duplication of income or deductions in the calculation of taxable income may be difficult.

With regard to (i), the suggested adjustment to the formula indicates that policyholder income must be calculated as it forms the basis of the calculation for taxation attributable to policyholders, and so will be readily available.

With regard to (ii), some modifications are suggested in the following paragraphs to the Option 1 formula and calculation procedure. These, together with the recommended alignment of assessibility and deductibility of fees, reduce the difficulty in identifying adjustments to avoid duplication of income or deductions in the calculation of taxable income.

Under the proposals in the paper, the business of RSAs and Immediate Annuities would be "quarantined" in such a way as to ensure that the investment income attributable to the policyholders was taxed only at 15% and 0% respectively. We are proposing that this approach also applies to Superannuation business, including Deferred Annuities.

The Option 1 formula, adjusted as suggested, in conjunction with the use of the Solvency Requirement for the policies as the actuarial liabilities, operates appropriately for the purpose of determination of taxable income for this business.

The paper (paragraphs 34.43 to 34.57) recommends that the interest component in an annuity, or credited to an allocated annuitant’s account, should be a deduction in determining taxable income. Effectively, this means that the income attributed to the Policyholders would be exempt from tax in the life company’s hands. This is supported as being consistent with the current arrangements for such policies. It is also an integral part of the existing superannuation and retirement income framework.

Life company accounting demands a "mark to market" approach in the valuation of assets. Actuarial liability standards demand a corresponding adjustment to the value of policy liabilities.

Consequently investment income for annuity business will include gains or losses from the revaluation of assets.

The Option 1 approach to the determination of taxable income (with the modifications suggested) reproduces the basis of taxation set out in the paper for annuities. It also makes the necessary adjustments for the appropriate inclusion of gains in the determination of the investment income attributable to the annuitants to be deducted.

Under the current tax regime, investment gains are only taxed on realisation. This is consistent with the well established principle of levying tax when the benefit is received. It also recognises that, until an investment is realised, cash is not available to pay tax on any gains.

The investment income (I) and the Policyholders income (PI) in the Option 1 formula cannot therefore be obtained directly from accounting entries for Financial Statements as these include (by virtue of statutory requirements) unrealised gains.

Suitable adjustment will therefore be required to these items to exclude unrealised gains arising during the financial year, i.e. D UGS and D UGP, for amounts attributable shareholders to policyholders respectively.

The Policy Liability will have been reduced by the increase in the deferred tax reserve attributable to policyholders, i.e. D DTRP. This should be added back for the purpose of determining the increase in Policy Liability deduction in the formula.

Allowing for the above adjustments, the Option 1 formula becomes:-

Under the current superannuation tax regime indexation applies in the calculation of the tax on capital gains. To the extent that this continues, it should also continue to apply to the Superannuation business of life companies.

Although capital gains tax does not currently apply in the determination of tax for Ordinary business, we submit that it should be adopted under the new regime for life companies for two reasons:

(1) Only one tax calculation would be required for all types of life company business. This addresses the complexities raised by the Review at paragraph 34.2 of the discussion paper. (At present, two tax calculations are required for some assets adding significant complexity to the life company tax basis); and

(2) It is consistent with the tax basis applied by most competitor CIVs which recognise realised capital gains as a distinct component in distribution statements. If changes are made to the treatment of capital gains more broadly, the benefit of which can flow through CIVs to individual investors, then those benefits, in the interests of competitive neutrality should similarly be available to Ordinary policyholders.

This enables individual and superannuation investors to continue to obtain the same treatment as they would have had they invested directly, via CIVs or life policies.

Income received from investments in many foreign countries is subject to withholding tax. Under double taxation agreements between such countries and Australia, withholding taxes can be offset against Australian tax.

Investments in property in Australia can generate building and depreciation allowances, some of which are "accelerated" (i.e. the depreciation is written off over a shorter period than the expected lifetime of the investment).

To the extent that these preferences continue to be available to reduce the tax payable on income by individuals or stand alone superannuation funds, they should also be available to reduce the tax payable by policyholders. This should apply both in the determination of the tax payable by the life company on behalf of the policyholders, and in the policyholder’s own tax assessment on bonuses assigned to the policy.

The application of a Deferred Company Tax ("DCT") or a Resident Dividend Withholding Tax ("RDWT") to life company bonuses would effectively undo the benefit of these tax preferences for policyholders.

Policyholders’ income will be that income which is allocated to the policyholders in terms of their policy contracts.

This income will be made up of interest, dividends and rents, and will include realised and unrealised gains and other components which are treated in different ways for tax purposes.

In order to assess tax in the life company on income attributable to policyholders correctly, it will be important to ensure that the components of such income and the assets giving rise to it are identified appropriately.

In some cases, assets relating to a particular class of business will be directly identifiable with that class of business. In addition, some assets may be specifically identified as shareholder assets. Sub-funds within a statutory fund may be established to enable this identification to be maintained on a robust, continuing and audited basis.

However, the nature of life insurance statutory funds is such that shareholders and policyholders will "share" the assets of a sub-fund.

We propose therefore that, for each sub-fund, all of the following be considered as divided between policyholders and shareholders in proportion to total income allocated during a period:-

(i) each of the amounts of interest, dividends and rents receivable during that period,

(ii) the amounts of gains realised during that period,

(iii) the amounts of unrealised gains arising during that period.

For this purpose,

(a) in the case of investment linked business, each fund established for an investment option will be considered as a sub-fund,

(b) a sub-fund is only recognised as such if clear rules for determining payments into and out of the sub-fund have been established, and audited accounts have been prepared.

This approach should provide a robust basis for allocation of the various components of investment income between shareholders and policyholders.

There will be occasions when transfers of assets between statutory funds and sub-funds will be made. In some cases, the transfer will be from or to a fund or sub-fund where the policyholders’ income is taxed at a different rate from the corporate rate.

An issue arises as to the rate/amount of tax on the gain or loss when an asset, which has been the subject of earlier transfer, is sold.

To avoid any opportunity for manipulation, it is proposed that transfer of an asset between statutory funds or sub-funds be treated as a taxable event.

Life company rules demand that such transfers be carried out on an arms-length basis.

Accordingly, tax would be assessed on the gain (or loss) on transfer at the "old" (sub) fund tax rate. The amount paid on transfer will then be the base price for assessment of future gains or losses in the new (sub) fund.

Income which is allocated to "Smoothing Reserves" should be considered as allocated to policyholders, provided that it is clear that such income will only ever be reallocated to specific policyholders’ accounts at a future date.

The paper envisages the establishment of two franking accounts – one for shareholders and one for policyholders.

The shareholders’ franking account will operate for shareholder tax paid in respect of all the business of the life company. However, there should be a number of adjustments to the policyholders’ franking account.

For superannuation business, including deferred annuity business and retirement savings accounts, Lend Lease/MLC has recommended that these be conducted on the same "tax paid" basis as currently applies. For these businesses, therefore, no franking account is required for policyholders. Accordingly, franking credits from policyholder tax attributable to this business should not arise.

In the case of immediate annuity business no tax is payable in the life company in respect of the investment return attributable to policyholders. Again, therefore, no franking account is required for policyholders.

Thus, policyholder franking credits will only arise for new Ordinary business. For existing business, which is to be "grandfathered" for policyholder tax purposes, no franking credits should arise.

As suggested by the RBT in paragraph 34.75, we accept that franking credits in respect of tax paid should be allocated between new Ordinary investment policies and shareholders in proportion to the allocation of tax for regulatory purposes. Similarly, franking credits attributable to dividends required should be allocated in proportion to the allocation of those dividends.

In a life company, expenses are required by law to be apportioned on an equitable basis between (a) funds (i.e. shareholder and each statutory), (b) sub-funds, and (c) classes of business. Under the Life Insurance Act 1995, the apportionments must be approved by both the appointed actuary and the external auditor.

Under the proposed tax regime, all expenses for non participating business will be attributable to the shareholders, and those allowable as deductions will be deductible at the corporate rate regardless of the type of business.

The only issue with apportionment of expenses arises as between the non participating business and participating business where the policyholders effectively incur a (major) share. However, this is also the most important apportionment from the point of view of the regulator, who is concerned that life companies act in the best interests of their policyholders. With such a strong regulatory control, the opportunity for manipulation is negligible.

Accordingly, we submit that the Treasury should incorporate the use of the statutory apportionment for tax purposes.

Examples of the operation of Option 1, modified as suggested, are attached. These cover Investment Linked Business, Risk Business, Ordinary Participating Business and Immediate Annuity Business.

These show a split of statutory fund accounting items separately into those attributable to policyholders and shareholders.

They also demonstrate that the tax calculation using the Option 1 formula, modified as suggested, will result in total tax payable equal to tax at the corporate rate on shareholders’ (distributable) profits, together with the taxation attributable to policyholders.

LIFE INSURANCE TAXATION – EXAMPLES:

Notes:-

(1) Shareholder Investment Income includes both:-

(i) investment income on assets in excess of the Solvency Requirement for policies (SRP), and

(ii) all investment income from SRP assets, other than that which has been allocated to policyholders.

(2) The split of unrealised gains at the start of the period (UG) is between those allocated to policyholders (UGP) and the balance, i.e. allocated to shareholders (UGS).

* This will not be recognised as income to policyholders on claim, so no tax has been deducted from the policyholders’ "accounts". Income from the investments supporting the Solvency Requirement simply increases the "fee" (including profit) payable to the shareholders.

Notes:-

This example is of a declining fund, with decreasing policyholder liabilities.

Being a participating fund, the major part of the prudential margins in the Solvency Requirement are supported by Policyholders’ Retained Profits. Hence the decrease in the shareholders’ commitment to meet the Solvency Requirement is relatively small, but still contributes to shareholders’ taxable income. This is identified in the breakdown on the previous page, and is included automatically in the modified Option 1 calculation above.

Notes:-

(1) Investment Income allocated to policyholders is:-

(i) the amount expected to be earned under the policy contracts, plus

(ii) the policyholders’ share of the balance of the income earned in the fund, on the basis that the total allocated to Policyholders = total fund income x current termination values/total net assets.

(2) The split of unrealised gains at the start of the period (UG) is between those allocated to policyholders (UGP) and the balance, i.e. allocated to shareholders (UGS).