The Government has dealt with one of the most pressing problems relating to the new tax regime for life insurance by recommending a later application date. But other issues remain.
The sheer complexity of the new rules may give rise to distortions of the kind the changes are intended to remedy, and they will require a level of calculation and administration that will make PIEs seem straightforward.
This Brief Counsel traces the history of life insurance taxation (as it is difficult to understand the changes without this historical context) and summarises the main features of the new framework.
Reason for change
The Government regards the current life insurance rules as under-taxing life insurers and over-taxing policyholders: over-taxing because people who choose to save through life insurance products do not qualify for the PIE tax benefits; under-taxing because the profit assumptions in the premium loading formula are increasingly inaccurate, particularly for pure life insurance policies (with no savings component), which have become far more prevalent since the present regime was introduced in 1990.
The Taxation (International Taxation, Life Insurance, and Remedial Matters) Bill, as originally drafted, provided that the new rules were to apply retrospectively from 1 April 2009. But Revenue Minister Peter Dunne announced in March that the implementation dates of a number of the tax changes contained within the Bill should be deferred.
The Minister said in explanation that he had been approached by many business people and their tax advisers who, as 1 April approached, were becoming “increasingly concerned about the problems of working in accordance with complex tax reforms that have still to be enacted”.
Subsequently discussions have been held with the life insurance industry and the feedback from these will be considered in the Select Committee’s deliberations on the Bill. Expectations are that when the Bill is reported back to the House, a new application date will be proposed by way of an amendment. The report back is scheduled for the end of this month.
History of life insurance taxation
Prior to 1982, life insurance companies were taxed in respect of their life insurance business only on the reversionary bonuses allotted to policyholders from surplus funds and at a special rate of tax.
This changed in 1982 with the introduction of section 204 of the Income Tax Act 1976 which treated the life insurer as a conduit through which policyholders invested and, accordingly, taxed the life insurer’s investment income as a proxy for the policyholders. The tax rate was not the corporate rate but 33% – representing the average marginal rate of the natural person policyholders. The risk component of the life insurer’s business was not taxed at all and no deductions were claimable for any related expenses. Any gains from the sale of property were assessable to the life insurer (with no capital exemption).
Further reform occurred in 1990, as part of the Government’s policy of treating savings and investment income consistently across products and vehicles. This resulted in the current life insurance regime. Life insurers became taxable on their income from the risk business in addition to the policyholder’s investment income. This was achieved through the establishment of two tax bases for life insurers: the policy holder base and the life office base.
The life insurer base includes "underwriting profit" (as defined) plus investment income plus income from other sources (such as the sale of property). Significantly, the life insurer is not simply assessable on premiums received with a deduction for claims paid. Instead the risk income is calculated under specific formulas for premium loading, mortality profit and discontinuance profit. These formulas incorporate various assumptions about costs and profit ratios. In particular, the premium loading formula deems a life insurer to derive taxable profit from its premiums equal to 20% x percentage chance of expected death x (payout – actuarial reserves). Profits from annuities are roughly 1% of the amount.
The policyholder base essentially comprises the difference between:
Claims paid to policyholders (plus movements in reserves), and
Premiums paid by policyholders (excluding the life insurer profit component), with this amount grossed up for tax to give the amount of income.
Tax paid on the life insurer base gives rise to imputation credits, which can then be used to satisfy the tax liability of the policyholder base or attached to dividends paid to the life insurer’s shareholders.
Shareholder base and policyholder base
Under the proposed new regime, life insurers will be taxed on two bases: a shareholder base (representing income derived for the benefit of the shareholders of the life insurer) and a policyholder base (representing income derived for the benefit of the policyholders). This approach involves a number of complicated apportionments and allocations, which are governed by complex formulas. The shareholder base consists of:
Profits from the risk component of life insurance (which is to be taxed in full)
The life insurer’s share of any investment income earned
Fees from investment management and other services
Income from annuities, and
Income from other sources.
The policyholder base comprises the net investment income of the life insurer that is attributable to the policyholders. Policyholders will continue to receive claims tax free.
It will no longer be possible to credit the tax payable by one base against the tax payable by the other.
To calculate the life insurer’s risk profit, premiums and claims must be apportioned into savings components and risk components. The savings component of a premium is regarded as an investment by the policyholder (like a bank deposit) and the savings component of a claim is regarded as a return on that investment. These amounts are not taken into account in determining the life insurer’s risk profit.
Instead, the life insurer is taxed (by inclusion in the shareholder base) on the difference between the risk component of the premiums and the risk component of the claims paid, plus or minus movements in risk reserves. Qualifying reinsurance premiums and claims are deductible from policyholder premiums and claims. However the reinsurance contract must be offered or entered into in New Zealand for the premium to be deductible.
This approach is intended to tax the full profit from the risk business. However there seems to be some risk that the complexity of the apportionment and allocation formulas will result in distortions similar to those resulting from the current formulaic approach to risk income calculation. The life insurer can claim a deduction for movements in risk reserves. This can be calculated using either a new premium-smoothing reserve (which apportions the premium to each income year for which the policy runs by reference to the risk of the insured event occurring in that year) or by unearned premium reserving (which spreads the premium evenly over the term of the policy).
Investment income, expenses and credits must be apportioned between shareholders and policyholders. There are further complicated formulas to determine this. Tax is paid separately by the life insurer in respect of the shareholder portion and the policyholder portion of the investment income. Tax paid on one portion cannot be offset against tax payable on another. Tax paid on shareholder base income generates imputation credits, while tax paid on policyholder base income does not.
Policyholder income is eligible for the PIE tax exemptions. The life insurer pays tax on policy holder income at 30%. Alternately, the life insurer can attribute income to each investor and pay tax at their prescribed investor rates. Accordingly, a life insurer is essentially taxed as a PIE in respect of investment income attributable to policyholders.
The life insurer must pay the tax on both the shareholder and policyholder bases by way of provisional tax instalments. The life insurer may hold assets on capital account now.
On entry into the new regime:
policyholder assets are deemed to be sold and reacquired
life office base losses can be carried forward. Any excess in a year can be offset against the shareholder base income, with a limited amount also available for offset against the policyholder base, and
the life insurer’s policyholder credit account is terminated, with the balance transferred to the imputation credit account.
Although the deferment of the implementation date is welcome and provides much-needed recognition of the compliance costs in servicing these new tax-reporting requirements, the new rules are still extremely complex and will require expert advice.
Please contact a member of the Chapman Tripp tax team if you have any questions or would like to discuss any aspect of the new life insurance regime.