THE IMPACT OF INCOME TAX ON LIFE ASSURANCE AND ANNUITY BUSINESS BY C. E. PUCKRIDGE, F.I.A. INTRODUCTION

Transcription

1 166 THE IMPACT OF INCOME TAX ON LIFE ASSURANCE AND ANNUITY BUSINESS BY C. E. PUCKRIDGE, F.I.A. Assistant Secretary, Prudential Assurance Company Limited [Submitted to the Institute, 24 February 1958] INTRODUCTION THE original intention of this paper was to discuss the impact of income tax on annuity business only. In practice it was found impossible to discuss the impact on annuity business without at the same time discussing the impact on Life assurance business. A company transacting Ordinary life assurance, Pension annuity and General annuity business is not assessable in respect of three separate businesses; for the purpose of income tax the company conducts only one business, i.e. Life Assurance and Annuity business. Attention is drawn to this point at the outset because it is considered most important. A student coming freshly to the subject should not be misled into thinking that separate taxable units are involved because in the Income Tax Act, 1952 and the Finance Act, 1956 such terms as annuity fund and profits arising to an assurance company from pension annuity business are used. It may be noted that in this paper the term fund has been avoided wherever possible, because, without precise definition on each occasion that it is used, it is liable to be misleading. It would be impracticable to discuss in one paper all the problems of a composite company which writes all classes of insurance business both at home and overseas. It is, therefore, proposed to consider only the position of a proprietary company which writes Ordinary life assurance and annuity business in the United Kingdom, values its liabilities annually and is taxed on an interest less expenses basis. For taxation purposes such a company would classify its business under the following headings: (i) Ordinary Life Assurance Business. (ii) Pension Annuity Business, i.e. business written in respect of retirement arrangements approved by the Inland Revenue under Section 379 of Income Tax Act, 1952 or Section 22 of Finance Act, (iii) General Annuity Business, i.e. all life annuity business which is not Pension annuity business. No apology is offered for devoting a disproportionate amount of space in this paper to discussing General annuity business because the problems arising in respect of this class of business are of far greater complexity. BROAD BASIS OF TAXATION 1. The company is taxable in the first place on interest income either by deduction at source or otherwise. 2. The company can claim relief of tax on total allowable management expenses. Note. The fact that management expenses are dealt with in total in itself provides a strong indication that life assurance and annuity business is being treated as one business for taxation purposes.

2 Income Tax: Life Assurance and Annuity Business The company can claim relief on interest apportionable on a net liability basis to Pension annuity business. 4. The company can claim relief on interest apportionable on a net liability basis to General annuity business up to but not exceeding the gross General annuity payments during the year of account. (In practice tax deducted when paying annuities is retained by the company and is set off against the tax relief claimed.) 5. The company is taxable on profits from Pension annuity business not reserved for pension annuitants. Taxable profits for this purpose are generally assessed as follows : plus plus plus minus minus minus minus minus Actuarial liability at 1 January premiums and considerations received gross interest gross profits on realization of investments gross losses on realization gross annuity payments payments on death and withdrawal actuarial liability at 31 December any taxation loss arising from a similar computation previous year } in the V0 C I R A W V 1 Note. Expenses having already been relieved are excluded from the computation. For a company which has not yet reached a position where taxable profits are emerging, the taxation loss (TL)1 carried forward to the following year is computed as follows : As and when a company reaches the position where taxable profits are emerging the taxable profit (TP)1 is computed as follows: and at this stage the company will have been taxed on gross profit since inception less the loss carried forward, if any, apportioned to Pension annuity business in the first year in which this business was separately assessed. 6. The company is taxable on profits from General annuity business not reserved for general annuitants. Taxable profits for this purpose are generally assessed as follows : Actuarial liability at 1 January Vo plus plus plus minus minus minus minus minus minus premiums and considerations received gross interest gross profit on realization of investments gross losses on realization } gross annuity payments payments on death and withdrawal unrelieved interest, i.e. gross interest less gross annuity payments (if this item is negative it is ignored) actuarial liability at 31 December any taxation loss arising from a similar computation in the previous year C I R A W I A V1 (TL)o

3 168 Income Tax: Life Assurance and Annuity Business For a company which has not yet reached a position where taxable profits are emerging, the taxation loss (TL) 1 carried forward to the following year is computed as follows: (i) If I>A (ii) If I<A As and when a company reaches the position where taxable profits are emerging the taxable profits (TP) 1 are computed as follows: (i) If I>A (ii) If I<A 7. The company can claim relief so as to reduce the rate of income tax to 7s. 6d. in the on the excess of taxable income over its Case I, Schedule D liability of the previous year calculated as follows: plus plus plus plus plus Shareholders dividends net of income tax deductible at source allocations to, less transfers from, shareholders reserves capital expenses less capital allowances in respect of plant and machinery any other expenses disallowed as a business expense profits tax charged to revenue income tax at the current standard rate on the Case I, Schedule D liability computation made one year earlier. PRINCIPLES UNDERLYING METHOD OF LEVYING INCOME TAX 8. M. E. Ogborn (J.I.A. 74, 36) says: The method of taxation appears to have been devised with the purpose of taxing on interest income those funds whose business is substantially the provision of lump sums and taxing on profits those funds whose business is mainly the provision of annuities. It may be that since the passing of the Finance Act, 1956 it would be nearer the mark to say that the broad intention is to tax the build-up when benefits will not be taxed, and to permit a gross build-up when benefits will be taxed. It may also be broadly true to say that, for taxation purposes, assurance companies are regarded as primarily investment companies which accept the savings of the public, and return them later together with a share of the interest earnings. On this approach profits or losses from sources other than from interest and capital profits or losses on investments do not have to be considered, the conception being that amounts received from investors have to be supplemented year by year from interest in order to meet payments to investors, and to provide the necessary reserves to meet future liabilities to them. The balance of interest earnings can then be used to pay expenses, provide additional benefits to investors (bonuses) and profits to shareholders.

4 Income Tax: Life Assurance and Annuity Business 169 The whole of the interest following purposes : income is thus assumed to be used for one of the (a) For meeting expenses of management. (b) For provision of benefits to life assurance policyholders. (c) For provision of benefits to Pension annuitants. (d) For provision of benefits to General annuitants. (e) For provision of benefits to shareholders. 9. The broad bases of income tax as set out in 1 7 of this paper then fall effectively into an understandable pattern: (1) All interest is taxed. (2) Relief is granted on interest which is used to meet expenses. Note. The remote possibility that shareholders may take out of the business more than the interest earnings less management expenses, is provided for by limiting the claim for relief on expenses should a Case 1, Schedule D liability computation exceed interest less expenses. (3) Interest allocated to Pension annuity business is relieved of tax. (4) A correction is made to (3) by levying tax: (i) On interest which, having been relieved of tax because it was allocated Pension annuity business, is subsequently released as no longer required to meet the liabilities of Pension annuity business, and (ii) On interest equal to the expenses of Pension annuity business because relief has been allowed on such interest twice, i.e. under both (2) and (3). (5) Interest allocated to General annuity business, up to but not exceeding the amount of the annuity payments, is relieved of tax. (6) A correction is made to (5) by levying tax on interest equal to the expenses of General annuity business plus interest released as no longer required to meet the liabilities of General annuity business to the extent that the sum of these two items exceeds the interest not relieved under (5) above. (7) If the standard rate of income tax is in excess of 7s. 6d. in the relief can be claimed to reduce the rate to 7s. 6d. on the balance of interest not otherwise relieved, except in so far as such interest is deemed to have been used to provide benefits for shareholders. METHOD OF ALLOCATING INTEREST FOR TAXATION PURPOSES 10. For taxation purposes total interest from investments is allocated in proportion to net liabilities without regard to the date of purchase or current value of the investments. Profits or losses on realization of investments are similarly apportioned without regard to the date of purchase. 11. During certain periods in a company s history it may be thought inappropriate to apportion interest and profits or losses on realization in this way when analysing the aggregate net surplus from life assurance and annuity business. If, for example, the proportion of annuity business to the total business of the company has been increasing rapidly during a period when

5 170 Income Tax: Life Assurance and Annuity Business interest rates obtainable on new investments have been below the average rates earned on total investments taken at book values, the interest allocations to annuity business for taxation purposes may exceed the interest reasonably apportionable when analysing surplus; the latter should ideally pay some regard to the interest earned on investments purchased at times when money has become available because income from annuity business has exceeded outgo. Conversely, a rapid expansion of annuity business, during a period when rates of interest obtainable on new investments are above the rates being earned on total investments taken at book values, could lead to interest allocations to annuity business less than the interest reasonably apportionable when analysing surplus. In subsequent sections of this paper the term earned interest will be employed for interest reasonably apportionable when analysing surplus and the term allocated interest for interest allocated for taxation returns. Similarly, the term true surplus will be used for surplus emerging after apportioning earned interest as defined above and the term apparent surplus for surplus emerging after crediting allocated interest. HOW TAXATION WORKS IN PRACTICE Life assurance business 12. Life assurance business is effectively taxed on interest less management expenses at a rate not exceeding 7s. 6d. in the subject to the proviso that gross profits paid to or reserved for shareholders attract tax at the standard rate. Pension annuity business 13. Pension annuity business is taxed only on gross surplus released as no longer required to meet the liabilities of Pension annuity business. In practice relief on gross management expenses is received first and gross surplus plus gross management expenses are taxed later; gross losses up to but not exceeding gross management expenses are thus effectively relieved immediately but gross losses in excess of gross management expenses are carried forward to be set against future gross surpluses. General annuity business 14. The impact of income tax on the General annuity business is not so clear and varies materially from company to company. G. V. Bayley (J.I.A. 76,237) has approached the problem by attempting to establish a relationship between gross trading profits and net surplus released as no longer required to meet the liabilities of General annuity business. Following the notation used by Rowland and Wales (J.I.A. 68, 447) he has considered a Type A position which is defined as one where annuity payments exceed the annual interest income and a Type B/C position where interest income exceeds annuity payments. 15. Dismissing a taxation loss carried forward as an intangible credit which is available to protect future profits from being charged to tax when a Type A position is reached and taxable profits then emerge, Bayley establishes

6 Income Tax: Life Assurance and Annuity Business 171 the following relationship between net surplus (s ) from annuity business, after providing for bonuses, if any, to annuitants and trading profit (P E): For a company in a Type A position For a company in a Type B/C position Assuming that earned interest is I and allocated interest is I these formulae can be restated as follows: For a Type A position For a Type B/C position 16. In practice a loss carried forward cannot be dismissed as an intangible credit. It is intangible only to the extent that the basis of taxation and the rate of tax may change by the time that it can be realized. In all other respects it is a real asset of the company. This is demonstrated in Appendix I ( 46-49) to this paper where Bayley s algebra has been pursued a stage further to see what would be the position over a period of years of a company at present in a Type B/C position and expected if it were to issue no more new business (i) to reach a Type A position in n years time, and (ii) to exhaust its loss carried forward and start paying tax on profits in (n+m) years time. 17. It is felt that the impact of taxation on General annuity business can more easily be understood from an arithmetical demonstration. The position has therefore been examined in Appendix II ( 50 64) for a life company which has not previously undertaken General annuity business and decides to enter this field. The progress of the company in respect of this new venture is set out in three separate tables which are similar in all respects except for the bases of valuation adopted and the interest apportionments. Distortions arising from realized capital profits and losses have been avoided by assuming that these will approximately balance and can therefore be ignored. In Tables I and II earned interest is credited and the valuation bases adopted in the early years are not so stringent as to need financing from profits earned elsewhere. In Table III allocated interest is credited and the target valuation basis as defined in 51 (2) is adopted from the outset. The differences in apparent progress are then analysed, and it is demonstrated that over a long period the impact of taxation varies very little. 18. The conclusions drawn are (a That apparent net surplus from General annuity business can vary materially from true net surplus because allocated interest differs from earned interest. (b) That the valuation bases adopted and the methods of allocating interest can alter the incidence of taxation but there is no possibility of true net surplus from annuity business being released as no longer required to meet the liabilities of General annuity business unless income tax has been paid on an equivalent amount of gross surplus.

7 172 Income Tax: Life Assurance and Annuity Business (c) That a temporary deferment of tax payments can result from the adoption of a stringent valuation basis during a period when either (i) taxable profits would be emerging if a less stringent valuation basis were used, or (ii) interest would be less than annuity payments and the company would be carrying forward a loss if a less stringent valuation basis were used. (d) That the benefit resulting from a deferment of the date when tax is payable will, in the long run, be relatively small. Note. This is demonstrated in Table IV where comparisons are made between Table I and Table III. Despite the fact that this is considered to be a very exaggerated example of what might occur, the extra net surplus re sulting from deferment accumulated over a period of 50 years is only about ¾d. in the on gross interest earnings during the period. (e) It is most desirable that true net surplus should be calculated regularly to make sure that real trading losses are not being obscured by the apparent net surpluses which are emerging. CONSIDERATIONS WHEN DECIDING BASES FOR CALCULATING PREMIUMS Life assurance business 19. Interest must be regarded as taxable at a rate not exceeding 7s. 6d. in the. Provision for management expenses can then be made net of tax also at a rate not exceeding 7s. 6d. in the. Pension annuity business 20. Credit can be taken for interest gross and allowance must be made for annuity payments and management expenses to be paid gross. Although management expenses of Pension annuity business are relieved of tax in the first place, they are left out of account when assessing profits, and it is only reasonable to assume that in the long run the gross assessable profit from Pension annuity business will be at least equal to the management expenses relieved at an earlier stage. General annuity business 21. Prior to the passing of the Finance Act, 1956, the purchaser of an im mediate annuity out of capital or net income was taxable on the whole of the annuity payments, and there was a strong argument for adopting a basis for calculating premiums which relieved him to the maximum possible extent of the unfair burden of taxation. There was, therefore, some justification for charging, for both immediate and deferred annuity business, rates of premium which a company calculated it could afford to accept having regard to its current taxation position (after estimating the dates when it could expect, if it issued no more new business, to be in a Type A position and to exhaust its loss carried forward), because this basis when used by a company in a Type B/C position results in rates which are very favourable to purchasers of immediate annuities. 22. Since the passing of the Finance Act, 1956, a purchaser of an annuity out of capital or net income is taxable on the average on only the income content of annuity payments, and the most that he can now expect is that the consideration

8 Income Tax: Life Assurance and Annuity Business 173 money will be calculated on the assumption that the insurance company has to pay annuities gross but can invest to earn gross interest. In practice it is of course impossible for a company not firmly in a Type A position to use gross interest for all General annuity premium calculations, and a less generous basis has to be adopted for at least some contracts. If it be assumed that full gross accumulations of interest are not allowed on General annuity business because under certain circumstances non-taxable lump-sum benefits are permitted, a reasonable approach would be to allow for annuity payments, interest and management expenses gross, whenever the circumstances are such that there can no longer be a possibility of non-taxable lump-sum benefits being payable (i.e. when annuities are in possession), and to allow for interest and management expenses at a rate somewhere between net and gross during the period when there is still a possibility of a lump sum being payable (i.e. before annuities come into possession). Each company must make its own decision on the rate to be used during the period of deferment, bearing in mind its current taxation position and also the basis on which it proposes to grant cash options and surrender values (see 23). A student coming freshly to the problem of the calculation of premiums for General deferred annuity business might well be excused if he came to the conclusion that it was impossible, in view of taxation uncertainties, to issue General deferred annuity contracts on a non-participating basis which would at the same time give a fair deal to the purchasers of such contracts and to holders of participating contracts. It is perhaps surprising that participating contracts for General annuity business are not traditional. CONSIDERATIONS WHEN FIXING SURRENDER VALUES (INCLUDING CASH OPTIONS) 23. When fixing surrender values to be granted, many practical considerations arise quite apart from taxation. It is no part of the purpose of this paper to deal with these, the sole intention being to indicate, on a retrospective approach, what are the maximum surrender values which can be granted if all business which is ultimately to be surrendered is regarded as abortive business, which should not be permitted to impose a strain on the life assurance and annuity business of a company. If it is the intention of a company to grant more generous surrender values the expected strain on surrender should be taken into account when calculating premiums. Life assurance business 24. The maximum surrender values which can be granted without imposing a strain on life assurance business are premiums less net expenses and the cost of the death cover provided accumulated at a net rate of interest. Pension annuity business 25. The maximum surrender values which can be granted without imposing a strain on Pension annuity business are premiums less gross expenses and the cost of the death cover provided (if any) accumulated at a gross rate of interest. Although relief of tax will be claimed on management expenses, such expenses cannot be deducted when the company is assessed on profits. 12 AJ

9 174 Income Tax: Life Assurance and Annuity Business General annuity business 26. A company which would be in a Type B/C position and be carrying forward a loss even if no abortive business had been written, is in effect required to pay tax on gross interest accruing on business ultimately to be surrendered, and is permitted to increase its loss carried forward by an amount equal to the difference between the valuation reserve however determined and the premiums received. When the contracts are surrendered it will be deemed to have earned taxation profits equal to the difference between the valuation reserves and the surrender values paid, and the loss carried forward will be reduced by a corresponding amount. The profits of a company in a Type B/C position offering surrender values calculated by accumulating premiums less net expenses and the cost of the death cover, (if any), at a net rate of interest should therefore be unaffected in the short run. Its loss carried forward would, however, have been increased by the amounts paid on surrender less the premiums received (see 6). The amounts paid on surrender calculated as above may be expected to be less than premiums received for surrenders at the early durations and greater at the later durations. 27. A company in a Type A position with a substantial loss carried forward is in a more favourable situation, since it will not be taxable on interest as received. The only effect on its taxation position will be that after the contracts have been surrendered, its loss carried forward will have been reduced by the difference between premiums plus gross interest in respect of such business and the surrender values paid. It could, therefore, be contended that a company firmly in a Type A position could afford to grant surrender values and cash options calculated by accumulating premiums, less gross expenses and the cost of death cover (if any), at a gross rate of interest. It is suggested, however, that this would not be a desirable course to adopt, because the benefit of a favourable taxation position should in equity be passed on in the form of an improvement of taxable benefits rather than of untaxable benefits; those who receive the taxable benefits are the persons who suffer when the taxation basis is less favourable. 28. When fixing guaranteed surrender values for General annuity business a company must approach the problem on the basis of what it can afford to pay when in a Type B/C position, and therefore it could not contemplate guaranteeing more than premiums, less net expenses and the cost of death cover (if any), accumulated at a net rate of interest. In practice, guaranteed surrender values should, of course, be fixed at a lower level than this, to avoid an option against the company at times such as the present when interest rates are high and the market values of long-term investments are low. CONSIDERATIONS WHEN DETERMINING BASES OF VALUATION 29. If a company undertakes only life assurance business the bases of valuation adopted have no effect on its taxation position. This is also broadly true in the case of a company transacting only life assurance business and General annuity business, provided that it would remain Type B/C and be carrying forward a loss for taxation purposes whatever reasonable bases of valuation were adopted. The taxation position of a company which transacts

10 Income Tax: Life Assurance and Annuity Business 175 Pension annuity business, or is approaching the stage where it will be Type A for General annuity business and has only a small or no loss carried forward is, however, directly affected by variations in the bases of valuation. 30. If the provisions for adverse contingencies implicit in the valuation reserves maintained for annuity business were relatively weak, as compared with the corresponding provisions in the reserves maintained for life assurance business, the result could be that interest would be under-allocated to annuity business; it would then be possible for a company to find itself in the position where, having prematurely paid tax on taxable profits disclosed in the early years, it was unable to claim immediate relief on taxation losses disclosed later. If on the other hand, the provisions for adverse contingencies in the valuation reserves for annuity business were relatively strong as compared with those in the reserves for life assurance business, interest could be overallocated to annuity business during a period when taxation losses were being carried forward; part of the interest over-allocated at such periods could temporarily escape tax. 31. In the long run the valuation bases adopted, provided they are reasonable, should have little effect on total taxation, because any extra interest allocations to annuity business will either be taxed immediately or emerge as profit at some later date and be taxable. It may be noted that a company with a rapidly expanding annuity business cannot adopt unreasonably strong valuation bases for such business without unfairly restricting distributions to holders of participating contracts and shareholders; negative net surpluses from annuity business obviously have to be financed from profits from other classes of business. 32. On taxation considerations alone, it would appear superficially that a reasonable method of valuation for non-participating annuity business taxable on profit, is a gross premium less expense-loading method, with allowance for mortality and interest at the rates used for calculating premiums, or the rates currently being used for calculating premiums on new contracts if the bases have been strengthened. By this method significant changes, such as an improvement in pensioners mortality or a fall in the market rate of interest, would be allowed for automatically, and losses which it appeared must inevitably emerge would be accepted as soon as they were known to exist. Despite its superficial attractiveness this method cannot be recommended as a practical solution. Quite apart from the fact that valuation bases should not be fixed by reference to taxation considerations alone, it is doubtful if its adoption would in fact result in a fair allocation of interest. A company which valued its Life assurance business by a strong net-premium method without modification for initial expenses might find itself in the position referred to earlier, where provisions for adverse contingencies implicit in the reserves for business taxable on profits were relatively weak, as compared with the corresponding provisions in the reserves for life assurance business, with the result that too little interest would be allocated to the former. Total taxation might not in the long run be affected if taxable profits were emerging despite the under-allocation of interest, since the extra interest allocated to life assurance business and in consequence taxed, would alternatively have increased the taxable profit from annuity business. If, however, a taxable loss is carried forward after an under-allocation of interest to annuity business, interest 12-2

11 176 Income Tax: Life Assurance and Annuity Business which should, for the time being, have accrued gross will have been wrongly allocated to life assurance business and thus have prematurely attracted tax. 33. The problem could become of real importance to companies transacting with-profit Pension annuity business. If the major part of the distributable profits from this class of business is to be distributed as bonuses to annuitants holding with-profit contracts, and the distributable profits are arrived at after apportioning earned interest', under-allocations of interest for the purpose of arriving at taxable profits could result in losses being carried forward indefinitely. In other words, interest over-allocated to life assurance business and consequently taxed will subsequently have to be used to make good the shortfall of surplus from annuity business, but relief of tax will not be claimable. CONSIDERATIONS WHEN SELECTING INVESTMENTS 34. When comparing the relative merits of various investments, a company must determine a method of taking into account the expected impact of taxation. It has been demonstrated by H. G. Clarke (J.I.A.80, , ) that a marginal approach should be adopted. Any company with common investments for life assurance, Pension annuity and General annuity business has therefore to determine the probable impact of each investment on marginal interest and capital profits or losses, bearing in mind that they will be arbitrarily apportioned when they accrue. 35. It is not proposed to go over again the ground covered in the discussion on Clarke s paper, but three points not then raised may be worthy of mention: (i) If marginal interest or capital profits are allocated in respect of nonparticipating Pension annuity business during a period when a loss is being carried forward, they will increase liability to tax not in the year in which they are allocated, but in the year in which the loss carried forward is exhausted. Deferred liability to tax may also occur in respect of marginal interest allocated to non-participating General annuity business of a company in a Type A position and carrying forward a loss, and in respect of capital profits on General annuity business if a loss is being carried forward irrespective of whether the company be in a Type A or a Type B/C position. (ii) A company, which issues participating Pension annuity business and does not allocate a constant proportion of the surplus from Pension annuity business to participating Pension annuitants, may find it difficult to determine the extent, if any, to which bonuses to annuitants are likely to be affected by marginal interest and capital profits. A similar problem has to be faced by a company which issues participating General annuity contracts. (iii) Special consideration must be given to investments which are subject to either double taxation relief, or have a net United Kingdom rate of tax below the standard rate. Double taxation relief can be claimed on the portion of the interest from overseas investments which is allocated to life assurance business. Similarly, no special difficulties arise in regard to interest from investments which have a net United Kingdom rate of tax below 8s. 6d. in the, in so far as such interest is allocated to life assurance business, apart from the restriction when the net rate is less than 1s. in the. At the time of writing this paper the position, in regard to the portion of interest on these

12 Income Tax: Life Assurance and Annuity Business special types of investments, allocated to Pension annuity business, is a little uncertain, but it would appear likely that refunds of tax will be limited to the tax paid in the United Kingdom. The refunds claimable in respect of interest allocated to the General annuity business of a company in a Type A position, or in a Type B/C position with a loss carried forward are likely to be similarly restricted. Interest allocated to General annuity business of a company in a Type B/C position with no loss carried forward is likely to be divided into two parts. In so far as the interest is deemed to have been set off against annuity payments, refunds will be restricted to the net tax paid in the United Kingdom, while the remainder will rank for refunds on the same basis as the portion of interest allocated to life assurance business. I77 CONCLUSION 36. The main purpose of this paper is to analyse the impact of existing taxation legislation on a life assurance company. It may, however, be of interest briefly to discuss the legislation itself from the point of view of its reasonableness to the man or woman who enters into a contract with an assurance company with the object of making provision for old age. 37. If it had been possible to make a fresh start without consideration of existing legislation, it is suggested that the Committee on the Taxation Treatment of Provisions for Retirement, which reported in 1954, would almost certainly have recommended that provision for old age should be permitted on one or both of the following bases. Basis 1. Full relief on cost and build-up and all benefits taxable. Basis 2. Cost provided from capital or net income, build-up taxed and benefits not taxable. 38. Prior to the passing of the Finance Act, 1956, the only method of provision for old age which broadly conformed with Basis I, was a privately administered scheme approved under s. 379 of the Income Tax Act, Similar schemes administered by an assurance company were under the disadvantage that unless the assurance company was in a Type A position for annuity business some part of the interest build-up attracted tax. 39. Contributions made by employers to a scheme approved under s. 388 of the Income Tax Act, 1952, enjoyed full relief. The contributions deducted from the employee s pay-packet ranked as taxable income and, if the scheme was assured with a life office, were entitled to assurance premium relief in accordance with the provisions of s If, however, such a scheme was privately administered, the contributions deducted still ranked as taxable income, but relief was not available under s If such a scheme was privately administered any interest accruing in a year in excess of annuity payments during that year was taxable but, if the scheme was administered by an assurance company, the taxation position of the interest build-up was the same as for a similarly administered scheme approved under s The major obstacle to the adoption of Basis I for schemes approved under s. 388, was the limited lump-sum tax-free payments on retirement which have been customary in recent years, notwithstanding that full relief on cost may have

13 178 Income Tax: Life Assurance and Annuity Business been granted. One recommendation made to the Committee for dealing with this problem was that when a gross build-up is permitted either: (i) no exemption from taxation of benefits should be permitted in future (except for a saving clause permitting prospective rights to continue for existing employees), or (ii) the concession permitting a limited lump-sum payment free of tax should be extended to apply generally. 40. The most heavily penalized persons were those who were not contributors to any scheme and who, therefore, could provide for their retirement only out of capital or net income and should have been taxed on Basis 2. A purchaser of an immediate annuity out of capital (or accumulated net income) was fully taxable on annuity payments as received. The purchaser of a deferred annuity was also penalized but not so heavily, because the method of taxing annuity business permitted the assurance company to claim relief of tax on interest accruing on the reserves for deferred annuity business by setting against it the tax on the excess of annuity payments over interest accruing on the reserve for annuities in possession. It could, therefore, be said that some part of the interest content of his annuity was allowed to accrue gross. This concession created an obstacle to the rationalization of taxation in accordance with Basis 2, because large liabilities had been accepted by assurance companies on the basis of existing taxation law and the corresponding tax recoveries were essential. The Life offices, therefore, recommended to the Committee on the Taxation Treatment of Provisions for Retirement that purchasers of deferred annuities out of net income should be allowed a gross build-up, but should be taxed on the income content of the annuity payments. 41. If the recommendations referred to in the final sentences of 39 and 40 had been accepted, annuity business could have been taxed as a single unit on profit brought out by a Case I computation. All investment income of annuity business could have been freed from liability to income tax as such, and all income tax deducted from benefits would have become a debt due to the Revenue. 42. In the event the legislators were unwilling either to extend the concession permitting a limited lump-sum payment free of tax to apply generally, or to create a privileged group of persons who were admitted, prior to the rationalization of taxation, to membership of a scheme approved under s Self-employed were offered benefits comparable with those available to contributors under s. 379 of the Income Tax Act, 1952; the principle that, where annuities are purchased out of capital or net income, only the income content should be taxable was accepted, but no change was made in the method of taxing the interest build-up of General annuity business; legislation in regard to schemes approved under s. 388 was not disturbed. In view of these decisions it is difficult to see how the grouping of annuity business under two headings could have been avoided. 43. The taxation basis of Pension annuity business is now broadly on Basis I, and a scheme approved under s. 379, administered by an assurance company, ranks pari pussu with a similar privately administered scheme, except that separate assets cannot normally be kept.

14 Income Tax: Life Assurance and Annuity Business The business included in General annuity business is still a hotchpotch including mainly: (i) Non-contributory schemes approved under s. 388 where contributions are exempted from tax. (ii) Contributory schemes approved under s. 388 where contributions are partly exempted from tax. (iii) Deferred and immediate annuity contracts where premiums and consideration money are paid from capital or net income. The benefits from (i) and (ii) apart from lump-sum payments on retirement, death or surrender, are fully taxable as income, whereas annuity payments under (iii) are taxable only on the estimated income content of the amounts payable. There is perhaps little wonder that the taxation basis applied to General annuity business was left almost undisturbed in the Finance Act, The author wishes to record his thanks for the help given by his office colleagues and in particular by Mr R. H. Blunt who has undertaken responsibility for the numerical calculations. APPENDIX 46. For a company which is at present in a Type B/C position for General annuity business and which would be expected if it issued no more new business (i) to reach a Type A position in n years time, and (ii) to exhaust its loss carried forward and start paying tax on profits in (n+m) years time, net surplus (S') plus profits less losses on realization (R) should over a long period be positive for if not the business will be running at a loss. It is, therefore, proposed to examine the progress of (s'+ R). As in Bayley s paper, P is used for trading profit plus expenses, which can be either positive or negative. The relationship of P to the symbols used in this paper is I which can alternatively if I>A be expressed or and ifi<a or During the first n years while the company is in a Type B/C position At the end of n years the company equal to (TL)n, where will be carrying forward a taxation loss

15 180 Income Tax: Life Assurance and Annuity Business Thereafter, until the whole of (TL)n has been set off against taxable profits 47. By the end of the (n+ m)th year the whole of ( TL)n will have been set off against taxable profits and thereafter At the end of (n + m 1) years the company will be carrying forward a taxation loss to the (n+m)th year At the end of (n + m) years which can alternatively be expressed 48. The company will at this stage (i) have paid tax on trading profits during the whole of the (n+ m) years; (ii) have been relieved of tax on the loss carried forward at the beginning of the period. If in subsequent years interest I exceeds I the taxation position of the company will be unaffected, provided that net surpluses are emerging after crediting annuity business with I. If the excess interest I I is relieved of tax at the first stage it will be caught in the assessment of taxable profit. 49. It is clear that the ultimate prospects of profit can be worsened by issuing business on the assumption that interest, annuities and expenses can be brought into account net after deduction of tax during a period when a company is expected to be in a Type B/C position unless the period (n + m) years, after which it is to be expected that its loss carried forward will be used up and the company will become taxable on profits, is infinite. The taxation advantage or disadvantage accruing to a company in a Type B/C position on the issue of new business, is that it brings forward or postpones the time when it is able to claim relief on the loss carried forward that has been built up, or is likely to be incurred in the future in respect of existing business. The extent to which a company which has a large loss carried forward, can afford to offer better terms to a proposer for an immediate annuity than a company which is in a position where it is paying tax on profits, must depend on the number of years which it would take to exhaust its loss carried forward if no more new business was written,

16 Income Tax: Life Assurance and Annuity Business 181 APPENDIX 50. The intention in this appendix is to give a practical demonstration of the way in which General annuity business is effectively taxed. The bases adopted for calculating premiums and valuing liabilities have no special significance. They were chosen quite arbitrarily and without regard to past or expected future experience. It has been assumed: (1) That during the whole of the company s operations it writes only nonparticipating immediate annuities on female lives aged 65 next birthday and non-participating deferred annuities by annual premiums on female lives aged 50 next birthday to be entered upon at age 65 next birthday. (2) That new business is written in the proportion of approximately 1 of immediate annuities to 11 of deferred annuities. (The actual amounts used in the first year were 10 3l[64½]a(55) to 10 2l[49½] A ) (3) That new business increases by 5% annually in geometric progression. (4) That the company quotes rates of premium calculated on the following bases II During deferment Deferred Annuities After deferment Immediate annuities Interest 3½% Mortality No allowance Loading for 4 % of gross expenses and premiums contingencies 4 % a (55) Ultimate 1½ % of annuity payments 4 % a (55) Select 4 % of consideration and 1½ % of annuity payments (5) That the mortality experience of deferred annuities follows exactly the A Ultimate table during deferment and the a(55) Ultimate table in possession, and that of immediate annuities the a(55) Select table. (6) That the expenses incurred are 4% of gross premiums or considerations and 1½% of annuity payments. (7) That 25l56½out of every l49½ deferred annuities issued are surrendered at age 57 next birthday, but that otherwise all contracts remain in force until death. (8) That income tax is payable at 7s. 6d. in and does not vary. (9) That the benefit on death or surrender of a deferred annuity contract is the return of 95% of contributions with compound interest at 2% per annum. (10) That profits and losses on realization of investments approximately balance and can therefore be ignored. 51. In Tables I and II progress is traced over a period of years on the assumption that the company decides: (1) To operate General annuity business as an entirely separate business, and, in consequence, is permitted by the Inland Revenue to invest in separate assets.

17 182 Income Tax: Life Assurance and Annuity Business (2) Not to release surplus for distribution to life assurance policyholders or shareholders until such time as it is possible to set up valuation reserves calculated on 3¼% interest with no allowance for mortality during deferment and a (55) Ultimate mortality in possession, valuing the gross premium less 32¾% for expenses and loading for the cost of paying annuities at 1½%; this basis is hereafter referred to as the target reserve basis. (3) To make, in the early years, such modifications to the target reserve basis as will produce reserves exactly equal to the amount in hand after meeting all claims, expenses and taxation. 52. Both Table I and Table II can be regarded as self-contained units which are being credited with earned interest. The only difference between them is that in Table I it has been assumed that earned interest is at the rate of 4% per annum, whereas in Table II earned interest has been credited at 4½% per annum. 53. In Table III the progress of the fund is traced on the assumption that the company decides (1) to operate life assurance and General annuity business as one business with common assets; (2) to set up from the outset full valuation reserves calculated on the target reserve basis. Interest has been allocated at 4¼% on the mean liabilities. 54. An examination of Table I shows that it passes through the following stages. Stage 1. For the first five years interest is less than the total of annuity payments plus expenses, and taxable profits equal to the deficiency emerge. Stage 2. From the 6th to the 22nd year interest exceeds the total of annuity payments plus expenses, and a loss carried forward is steadily built up reaching a peak of 77,290 at the end of the 22nd year. Stage 3. From the 23rd to the 25th year annuity payments plus expenses exceed interest, and taxation losses carried forward start to decrease. Stage 4. From the 26th to the 33rd year although the company is now in a Type A position, i.e. annuity payments exceed interest, taxable profits emerging can still be set off against the loss carried forward accumulated between the 6th and 22nd year, and the company is able to claim relief on expenses without suffering tax on either interest or profits. Stage 5. In the 34th year losses carried forward are exhausted and from the 35th to the 45th year the company pays tax on taxable profits exactly equal to the tax relief on expenses. Stage 6. From the 46th year onwards it is possible to set up reserves on the target reserve basis and to release net surpluses. Taxable profits are, at this stage, equal to expenses plus gross surplus; tax relief having been claimed on expenses and tax paid on taxable profits, the net effect is that tax has been paid on gross surplus. 55. The progress of Table II where excess of income over outgo is assumed to be invested to earn a rate of interest of 4½% per annum can be similarly analysed as follows : Stage 1 lasts only for the first 4 years. Stage 2 is in operation from the 5th to the 27th year, the loss carried forward at the end of the 27th year amounting to 145,390.

18 Income Tax: Life Assurance and Annuity Business 183 Stage 3 is in operation from the 28th to the 30th year. Stages 4 and 5 do not operate. In the 31st year it is possible to set up reserves on the target reserve basis and to release net surpluses. From the 31st to the 33rd year the company is relieved of tax on the excess of annuity payments plus expenses over interest, and emerging taxable profits are set off against losses carried forward. In the 34th year the balance of the loss carried forward is used up and tax is payable on the balance of taxable profits. Stage 6 so far as the tax position is concerned is reached in the 35th year. 56. The progress in Table III is complicated by the fact that General annuity business is financed in the early years from profits from other classes of business, and comparisons with Tables I and II reveal some interesting features. Comparison with Table II has been discussed first because this is less involved than the comparison with Table I. Comparison of Table III with Table I and Table II 57. Although allocated interest is less than the total of annuity payments plus expenses in Table III in the first two years, no taxable profits emerge. The maintenance of more stringent reserves financed from profits from other classes of business, has produced a position where losses are being carried forward and net surpluses are negative. 58. In Table III the loss carried forward at the end of the 17th year is 198,289 which exceeds the loss carried forward in Table II by 116,623. This figure can be analysed as follows: Excess reserves in Table III 118,482 Less taxable profits disclosed in the first four years in Table II 1, ,623 Since none of the extra interest which has been credited after the 4th year, instead of being credited elsewhere, has escaped tax in the year in which it is earned, the sole advantage gained in Table III is that the company is still deferring the payment of tax on 1859 and as a result has earned net interest. 59. In the 20th year in Table III it becomes possible, after setting up reserves on the target reserve basis, to release net surplus to offset some of the negative net surpluses in earlier years. It should be noticed that despite this change in the position losses carried forward continue to increase until the 23rd year. 60. From the 24th year onwards the losses carried forward begin to decrease rapidly, and by the 31st year have reduced in Table III to 116,338 which compares with 118,197 in Table II. Since Table II has by this time reached the stage where reserves on the target reserve basis can be set up and is releasing net surpluses, the difference is exactly 1859 the sum disclosed as profits in Table II in the first 4 years. 61. From the 32nd year Table III is in a Type A position, whereas Table II does not reach this position until the 35th year. As a result there is a tax disadvantage to Table III in the 32nd, 33rd and 34th years as compared with Table II, because in Table III annuity payments are exceeding interest during a period when emerging profits can be set off against losses carried forward.

19 184 Income Tax: Life Assurance and Annuity Business

20 Income Tax: Life Assurance and Annuity Business 185