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Credit crunching

Last week, I looked at the fundamentals of the new provisions for taxing investment life insurance policies. When you study the detail of the new provisions, it becomes evident that the basis of accounting adopted by a company is very relevant in determining the way in which the rules will apply.

I would not profess to be an expert in the wonders of accounting standards in the UK (or anywhere else for that matter) but it seems that two commonly adopted bases are fair value and historic cost. I would like to look at these in connection with the loan relationship rules and their application to investment life insurance policies. This week, I will look at the fair value basis.

For companies which adopt a fair value basis of accounting, the increase in policy value that arises over an accounting period will be taxed as a non-trading credit under the loan relationship rules. This increase will effectively be the difference between the surrender value of the policy at the beginning of the accounting year and surrender value at the end.

Where a company owned a policy at the start of the first accounting period beginning on or after April 1, 2008, the value of the policy will be established at that date to determine the chargeable event gain that has arisen until the policy enters the loan relationship rules. That gain will not, however, be taxed until the policy is finally encashed when it will effectively inflate the NTC at that point. This is covered in more detail below.

Where a company invests in a UK life policy or a life policy issued by an EEA company suffering a UK-equivalent rate of tax, the year-by-year amount on which the company will be taxed under the loan relationship rules will reflect the net profit arising under the policy after internal life company tax of 20 per cent. This means that there could be an element of double taxation. To deal with this problem, the Finance Bill 2008 provides for the amount subject to tax under the loan relationship rules to be grossed up to reflect the tax suffered at UK life company level at 20 per cent. However, contrary to what was originally thought, this grossing up will not happen each year.

In this respect, the Finance Bill introduces a special rule to ensure that on final encashment of the policy, a 20 per cent tax credit is given for the NTC s (deemed gains) chargeable under the loan relationship rules over the whole period of ownership (or the period of ownership from the start of the first accounting period starting after March 31, 2008 if the policy was owned at that time) and not simply the gain for the accounting period in which the policy terminates.

It is probably best to consider how this operates by looking at an example.

Marriot Ltd effects an investment life insurance contract for £100,000 with Bigface Insurance Company on July 1, 2008 at the beginning of its accounting period. Fair value is therefore £100,000. Marriot Ltd pays corporation tax at 28 per cent.

i: At June 30, 2009, fair value is £105,000, so the NTC = £5,000.

ii: At June 30, 2010, fair value is £112,000, so the NTC = £7,000.

iii: At June 30, 2011, fair value is £120,000, so the NTC = £8,000.

iv: At December 30, 2011, the policy is fully surrendered for £125,000Corporation tax payable by Marriot is as follows:

i: £5,000 @ 28 per cent = £1,400 (financial year 2009).

ii: £7,000 @ 28 per cent = £1,960 (financial year 2010)

iii: £8,000 @ 28 per cent = £2,240 (financial year 2011).

iv: The final surrender of the policy is a related transaction, so the rules in Schedule 13 Finance Bill 2008 apply. First, it must be noted that on final surrender, there is an NTC of £5,000 for that accounting year.

As the company adopts a fair value basis of accounting, the tax treated as paid must be calculated in accordance with para 4 Sch 13 Finance Bill 2008.

To do this, it is necessary to ascertain PC, which is the profit from the contract. This is the total of all NTCs to date and in this case amounts to £25,000 (£5,000 + £7,000 + £8,000 + the final £5,000). The relevant amount is 25 per cent of PC (that is, PC grossed up by 20 per cent) which amounts to £6,250.

The NTC in the last accounting year is therefore treated as increased to £11,250 (£5,000 plus £6,250). Corporation tax is 28 per cent x £11,250 = £3,150 and tax treated as paid of £6,250 is available to be offset against this and any other corporation tax assessable on the company for the period.

When a policy is owned at the start of a company’s first accounting period which begins after March 31, 2008, deemed full surrender is treated as having taken place immediately before the start of that accounting period. No tax charge arises then on the deemed chargeable event gain but it is brought into charge to tax and taxed as an NTC when the policy terminates.

In calculating the deemed chargeable event gain, the carrying value in the accounts is used for a company adopting a fair value basis of accounting. There is no credit for basic-rate tax suffered within the life fund for the NTC derived from the deemed full surrender.

Next week, I will look at the historic cost basis.

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