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Rate expectations

Well, another Budget has come and gone. The early night we were expecting turned into a late night, with some relatively complex detail in the Budget notes and press releases on subject matter of (I suspect) very little interest to the world at large but of greater interest to the financial services industry in general and technical and marketing people specifically.

One particular change that raised a few eyebrows was that notified in paragraph 11 of Rev BN 25: Life Insurance Companies. There it was stated that:-

“The Government is also making changes to the rate of corporation tax on the policyholders&#39 share of a life company&#39s profits. The rate of tax on all policyholders&#39 income and gains will be equal to the lower rate of income tax and no profits will be charged at a rate equal to the basic rate (the rate applying in particular to chargeable gains). This will apply for the financial year 2003 and later. As a consequence, in determining the amount of any additional tax payable on a gain on a UK life policy or annuity contract, policyholders will be treated as having paid tax at the lower rather than the basic rate of tax. This change will take effect on April 6, 2004.”

The first thing to note (and it is easy to miss this) is that the lower rate for this purpose is 20 per cent. The 10 per cent rate is known as the starting rate – so now you know. It is also important to note that this lower rate applies to the policyholders&#39 share of income and gains (as opposed to the proprietors&#39 share, relevant for proprietary companies) for the 2003 financial year, that is, the year commencing April 1, 2003.

Before we move on to consider what this will mean for the taxation of chargeable event gains under life policies arising after April 5, 2004, it is worth spending just a little time on what this rate reduction means for life company taxation and its possible impact on the growth in value of policyholders&#39 funds.

Even the Inland Revenue notes that the basic rate of tax (the rate that applied before this change was made) would in practice only have applied to capital gains. It would also, although the Revenue did not mention this, also have applied to a relatively small proportion of income, too. I do not profess to have any expertise in the arcane area of life company taxation – few people can – but I hope what follows will be of help.

Dividend income received by life insurance companies is franked and no further tax was, or is, payable. Savings income will (even if tax is not deducted at source) have borne tax at 20 per cent anyway. So that would have left, primarily, rental income subject to the 22 per cent charge.

Capital gains made by the life fund, on the other hand, would all have been subject to tax at 22 per cent. The life fund, of course, cannot avail itself of taper relief. This relief is not available to companies. Companies also have no right to any annual exemption in the way that individuals or even trustees have. Companies are, however, entitled to indexation allowance. In a way, then, investors in a life fund get the benefit of the indexation allowance.

How this works is that the life fund, in determining what reserve to make for its liability to corporation tax on capital gains, will take account of the impact of the indexation allowance and the timing issues. This latter point can be quite important. For example, a big fund with good inflow may not need to realise investments to enable it to fund outflow, that is, encashments. This should be reflected in a lower rate of reserved-for tax on capital gains when pricing units in the fund.

The reduced rate of corporation tax from 22 to 20 per cent on indexed gains should also operate to diminish the necessary reserve for tax on capital gains and thus have a beneficial effect (all other things being equal) on unit prices.

Before leaving this issue, it is worth remembering that where, at the end of an accounting period (subject to an exception in respect of assets linked solely to pension business, life reinsurance business or offshore life insurance business), the assets of an insurance company&#39s long-term insurance fund include rights under an authorised unit trust or relevant interests in an offshore fund, the company is deemed to have disposed of and immediately reacquired the assets concerned at market value.

Where any gains or losses arise under the deeming provisions, they will, broadly speaking, be apportioned equally between the accounting period in question and the six succeeding accounting periods.

In considering the overall impact of this change to the rate of tax borne by policyholders&#39 share of the life fund, it is essential to take fully into account the consequential change that will result in respect of policyholder taxation.

Broadly speaking, where a chargeable event gain arises and the policyholder is a higher-rate taxpayer, the reduction of the life company rate to 20 per cent will mean that the tax credit to which the policyholder is entitled will reduce from 22 to 20 per cent. This means the rate payable by higher-rate taxpayers will be 20 per cent rather than 18 per cent.

Next week, I will look at what impact this has, planning strategies ahead of April 6, 2004 – the date when this new rate comes into force, the position for basic-rate taxpayers, non-taxpayers and trustees, the impact on the comparison of UK and offshore bonds (and collectives) and other consequential issues.

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