Although the framework directive has been agreed and there is now much greater certainty over many of the principles which will apply, there remain many areas of uncertainty.
The taxation of life insurance under Solvency II is one of the bigger black holes and resolving the issue will have a major impact on the UK insurance market. It is still unclear how tax will feature as an element of risk and how it will be valued as an asset.
Although many insurance companies have begun to identify areas of concern, it is clear that, with just over three years until implementation, more needs to be done to understand how tax will feature in a Solvency II-regulated world.
At present, UK life insurance companies are taxed by reference to the level of surplus in their regulatory returns to the FSA, as opposed to their profit before tax in the company’s statutory accounts. But the move to Solvency II will mean that the format of the regulatory return will change, probably rendering it incapable of supporting the current life tax regime.
However, a move away from a life tax regime based on the FSA return is not wholly unknown to the industry. Most recently, insurance special purpose vehicles (ISPVs) have been taxed on an accounts basis as they are not required to submit FSA returns.
Also, overseas life insurance companies with branches in the UK are not regulated by the FSA and so are also taxed on their accounting profit.
These precedents suggest it is possible to continue the current income minus expenses tax regime, even with something other than the current FSA return.
But a change in the life tax regime may be necessary in the coming years anyway. The Conservatives’ Shadow Chancellor recently reiterated an intention to free savings from tax at the basic rate. With this being a major part of how a life insurance company is taxed, a major change in regime may become inevitable.
There are more than just tax compliance issues involved in the adoption of Solvency II.
The framework directive has had some major changes made to it since its original drafting, with one of the major casualties being the group support rules, which would have allowed capital held in group companies to cover the requirements of other group companies.
This exclusion, set to be revisited three years after the adoption date, may lead to a number of companies changing their group structure. With individual companies each having to have their own minimum and solvency capital requirements, the most capital-efficient structures may take advantage of the freedom of establishment, using branch structures as opposed to a multitude of subsidiaries.
However, this would require business to be moved between companies and the beneficial ownership of assets would need to be changed. The insurance business transfer rules within the UK are tried and tested but, even for transfers within the UK there are tax rules to be addressed and that could lead to tax being unexpectedly charged. Also, with the transfer in the own-ership or beneficial of assets, stamp duty charges arise.
There may also be issues with regard to intra-group arrangements, such as internal reinsurance and contingent loans. With business being moved, companies becoming dormant and some potentially being dissolved, it is possible that some unexp-ected tax charges could arise in addition to any arising from business transfers. It will be important for companies to consider a wide range of potential issues when looking at restructuring their group.
Although the tax aspect of Solvency II is only now coming into focus, other areas, particularly the actuarial and financial reporting functions, have been preparing for some time.
Whether through participating in the quantitative impact studies, which have been sent out by the FSA, or through actively planning and building capital and reporting models to calculate minimum capital requirement and solvency capital requirement levels, companies have made some headway into the introduction of Solvency II.
With companies’ internal models needing to be review-ed by the FSA within a year, development needs to have already started. But, whether through uncertainty of treatment or relevance, tax has generally been ignored.
It is important that the tax aspect is reviewed now, before it is too late to implement into the model and before it is too late to influence the FSA/committee of European insurance and occupational pensions supervisors on how tax should feature in Solvency II.
The starting point for this will be to decide on how each company sees the life insurance tax regime developing in the coming years. Currently, there is an element of legislative fatigue in the industry due to the extensive changes in tax rules since 2006.
But it is important for companies to give their views again on how insurance companies should be taxed so that it fits the political and regulatory environment that is leading to a new age in capital risk management.
We have an opportunity now, as an industry, to make the life insurance tax regime in the UK not only reasonable and survivable but also world-leading, just as Solvency II will be as a regulatory regime.
The UK is the home of the insurance industry. It has its history here. It has its legacy here. But without an effort in the next 24 months to evolve the way in which these companies will be taxed, we will see more companies move outside our boundaries into countries that are more cost-effective, tax-effective and capital-efficient to carry out this business.