11 - Taxation of Insurance Activities

1. 11 - Taxation of Insurance Activities Taxation of Financial Markets Vienna, 7-9 December 2009

2. Financial Institutions • Banks • Insurance companies • Other financial intermediaries – e.g. leasing companies • Share brokers • Investment/securities companies • Pension funds • Mutual funds and other collective investment institutions

3. General Tax Policy Objectives • Neutrality between different forms of institutions • Consistency with broad government policies • Not undermine the regulatory regime • Appropriate tax treatment for owners and investors/policyholders • Administrative feasibility • Consistency with accepted international trend • Avoid double taxation of income and capital

4. Relationship between Regulation and Tax • Tax and regulatory regime shares a similar objective – measure health of institution • Regulations include accounting requirements that may be useful for determining taxable income • But, objectives of regulation and tax are not entirely the same • Regulation focuses on capital and not income • Regulatory rules are more conservative • Should tax rules rely on regulatory accounting rules • Factors to consider: not all regulatory rules are relevant, regulatory agencies may have more expertise and compliance burden

5. Taxation of Insurance Activities

6. What is Insurance? “A social service providing financial compensation for the effects of misfortune, the payments being made from the accumulated contributions of all parties participating in the scheme.”

7. Insurers Insurers are important financial intermediaries that play a significant role in the financial system by providing: • Savings vehicles • Risk pooling arrangements

8. Organisational Form • mutual • proprietary

9. Taxation of Life Insurance

10. Life Insurance • insurance contingent on human life • includes insurance paid on death of the life insured and annuities which cease on the death of a person • tend to have a high proportion of savings element but depends on policy type • longer term

11. Many Types of Life Insurance Policy • term • whole of life • endowment • unbundled • annuities Life policies may also be participating or non-participating

12. Difficulties in Taxation of Life Insurance • long term nature of life insurance – difficulties in matching income and expenses • mix of savings and risk in most life policies • split of profits in most life offices between policyholders and proprietors

13. Taxation of Income of Life Insurers • underwriting income • savings/investment income

14. Underwriting Income • business income of life office • generated by the life office’s risk-pooling or pure insurance activity • may be attributable to proprietors or policyholders depending on the nature of the policies and whether the office is mutual or not • If taxed under normal company rules would mean • Premium taxable • Net investment income taxable • Claims deductible • Not totally accurate

15. Underwriting Income Formula (I + P) – (C + E) - V • V = change in actuarial reserves (note: excluded from underwriting income as it represents the savings element) • actuarial difficulties – many judgments and uncertainties involved in reserve figures

16. Matching Revenue and Expenses • Special features in insurance taxation rules: • Actuarial reserve – to reflect the accrual of claims over time (income aspect) • Accrual adjustment to reflect the fact that underwriting expenses are front loaded (expense aspect)

17. Calculation of Reserves • Reserve is a measure of the life insurer’s future liabilities with respect to its life insurance policies at the end of year • equals PV of future liabilities less PV of future premium receipts • Estimates required to include mortality rates, returns on investments that the insurer will earn on the savings component, probability that a policyholder will lapse/surrender prior to death/maturity • also affected by treatment of acquisition costs (i.e. whether and how to spread across the term against future premiums) • Many types of reserves with different assumptions, all affect calculation of taxes

18. Factors That Determine Reserve Levels • method for spreading underwriting expenses • discount rate to be used in valuing expenses and investment earnings • level of future earnings backing policies • appropriate mortality rates to be used

19. Choice of Reserves • choice of reserves affect profits of life insurers • many countries: France, Germany, Portugal use regulatory reserves for tax purposes • Canada allows the lessor of a reasonable amount and the reserves for the regulator • USA has explicit rules for tax purposes • case that tax reserves should be less than the regulatory reserves – given prudential concerns of regulator

20. Savings Income • Derived by life office in its role as a savings intermediary • Potential to escape tax net if claims are deductible to the insurer and non-assessable to the insured, that is only underwriting income is taxed • Savings Income = Investment income less investment expenses (excluded from underwriting income)

21. General Income Tax Treatment on Savings • Under an income tax system all income is assessable as it is derived • Taxes can be applied to flows of funds in savings activities of life insurers • Contributions to savings accounts e.g. wages and salary • Income accruing on savings e.g. interest • Withdrawals from the account • Two common models for taxation of savings income of life insurers are TTE and ETT

22. The TTE Regime • contributions made from income which is subject to tax (taxed) • income accruing is taxable (taxed) • withdrawals represent the conversion of an asset in the form of a positive savings account balance to an asset in the form of cash, therefore withdrawals are not income and are not taxed (exempt)

23. Methods of Taxing Savings Income • Taxation at the life office level • to tax net income of the life office as it accrues to the policyholder • problematic in the attribution to proprietor and policyholders • appropriate tax rate for policyholders – problematic • Taxation at the policyholder level • to tax income as it is distributed or applied for the benefit of policyholders • Different ways attribution (and thus taxation) could occur, see next slide

24. Attribution of Savings Income to Policyholders • increase cash surrender value • policy dividends • increases in coverage • policy loans on favourable terms • cash payments on surrender or maturity

25. Problems with Taxing Attributions to Policyholders • deferral • complex • cash resources of policyholder

26. International Approaches on Taxing Investment/Savings Income • UK Model – life office taxed on net investment income as proxy for policyholder tax on savings income • US Model • Savings Concession Model • New Zealand Model

27. Taxation of General Insurance

28. General Insurance • Also known as catastrophe and property insurance • insurer assumes/underwrites any loss from an event not contingent on human life • greater risk pooling/lower savings than life insurance • shorter term

29. General Insurance Policies Types of policies include: • motor: third party liability and other classes • third party liability • fire (industrial, commercial, residential) • theft and other damages to property • marine, aviation and transport • professional indemnity (medical, legal, engineering) • workers compensation • credit and surety

30. Income of General Insurers • two components to the profits of a general insurer • underwriting income • net investment income

31. Underwriting Income Underwriting Income = Premia less Underwriting Costs less Claims

32. Taxation of Premia • Premia are reported on an accrual basis once a policy is written • Premium income is spread according to risks or evenly throughout the contractual period

33. Reserve and Provision Adjustments • Deductible provisions and reserves • Unearned premium reserve • Outstanding claim reserves • loss reserve, an actuarial estimate of losses reported but not yet paid out • incurred but not reported reserve (IBNR), an actuarial estimate of losses that have arisen but have not yet been reported

34. Other Deductions to General Insurers • Prepaid expenses – acquisition expenses (e.g. agents commissions) • Equalisation reserves • Catastrophe reserves

35. Net Investment Income • Taxation issues in calculating this are the same as for life offices • Income derived in its role as a saving intermediary • Investment income less investment expenses

36. International Tax Issues

37. Application of Tax Treaties • The purpose of tax treaty is to prevent double taxation • but also to ensure that profits are taxed somewhere • Potential problems in the international context • taxation of life insurance takes many forms, not all of which are recognised as “taxes” under tax treaties • some countries exempt life insurance or taxed under the mutuality principle (at the level of policyholders) • the ability for source country to tax cross-border insurance activities would depend on “presence” in the country (i.e. whether there is a permanent establishment) but this could be difficult to establish for insurance activities

38. Establishing the Rights to Tax International Insurance Businesses • Rights to tax international insurance activities can be affected by bilateral tax treaties, mostly based on the OECD Model Tax Convention • Substantial insurance activities could be carried out without a permanent establishment • So, source country may have limited taxing rights • Possible options: • Extend taxation at source; or • Clarify scope of treaty provisions

39. Determining Profits • Insurance activities of foreign offices carried out through permanent establishments or subsidiaries • How to determine the correct amount of taxable income? • Mainly issue of applying the arm’s length principle in the OECD Transfer Pricing Guidelines • But insurance businesses are unique • More careful considerations needed • Part IV OECD Report on Attribution of Profits to Pes contains useful information on insurance

40. Consistency with Domestic Treatment • If domestic policyholders are taxed on savings income, then need to tax earnings accumulated in foreign life offices • Resident domestic life offices are taxed on domestic policies, then needs to ensure that policies written off shores are also subject to tax.

41. Captive Insurance • Companies can not establish reserves that are deductible for tax purposes • set up special purpose insurance subsidiary to insure parent and pass on the economic risks by reinsuring with third party • offshore subsidiary avoid domestic regulation • can establish special reserves as insurance companies • Also used to transfer assets, capital and income to captives and shift profits offshore • May need specific anti-avoidance rules for captives to prevent profits from being shifted out of the tax base

42. Reinsurance • Transaction between two insurers where one insurer purchases insurance from another insurer to cover part or all of the risks that the first insurer does not wish to carry • Tends to be mainly “risk pooling” risks

43. Reinsurance • Reinsurance contracts allow insurance companies to spread risks amongst themselves, across border • Reinsurance treated in the same way as insurance for accounting purposes – premiums paid are deductible • May not be appropriate for tax • shift profits to low tax jurisdictions or tax haven by overstating reinsurance premiums • Three options • treat reinsurance as financing • apply premium tax on reinsurance • restrict deduction of reinsurance premiums