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The devil you don’t know

Last week, I started to look at corporate investment in the wake of the extension of the loan relationship rules to companies which invest in investment-based life insurance policies – another fundamental change introduced in the name of simplification.

The simplification in question here is the abolition of the chargeable event provisions in respect of chargeable event gains made by companies on investments in life policies that generate gains, largely UK and offshore bonds.

Considered on its own, that sounds like a simplification worth having but you cannot consider it alone as it comes as a package and the other part of the package is the application of the complicated and hitherto relatively unconsidered – by financial advisers at least – loan relationship rules. These were applied to capital redemption plans from February 2005 as a measure to counter tax avoidance through the creation of capital losses. They also apply to collectives that are more than 60 per cent invested in debt-based instruments. This means that the loan relationship rules can also apply to funds qualifying for interest distribution treatment.

It is interesting that, in applying the loan relationship rules to collectives, there is a need to consider the nature of the underlying investments to see if the rules apply. When the rules are applied to capital redemption plans and as they will apply to investment-based life policies, they apply regardless of the nature of the underlying investments.

For accounting periods starting on or after April 1, 2008, the loan relationship provisions will apply, as currently proposed, to all investment-based life policies, whenever they were effected. Let us now consider the rules in a bit more detail.

From April 1, 2008, investment-based life policies owned by a company will be taxed under the loan relationship rules. Protection-type policies, which cannot acquire any surrender value, will continue to be taxed under the chargeable event rules.

(i) Policies in force before the commencement of the investing company’s first accounting period beginning on or after April 1, 2008Where a company has an existing investment-based life policy, it will be treated as surrendering that policy on the first day of the first accounting period of the company to begin on or after April 1, 2008.

Any chargeable event gain arising on such a policy will not, however, be taxed at that time but will be brought into account as non-trading income to be taxed in the accounting period in which the company actually disposes of its interest in the policy, for example, on full surrender. Growth accruing after this period will be taxed as described in (ii) below.

(ii) The new provisions. Subject to what is said in (i) above, for investment policies effected on or after the first day of the first accounting period of the company to begin on or after April 1, 2008, a company will be taxed on realised and unrealised gains. Such gains, which are technically called non-trading credits, will be subject to corporation tax as non-trading income under Case III Schedule D.

Gains and losses under loan relationships are calculated either on an “amortised cost basis of accounting” (broadly an accruals basis) or “fair value basis of accounting” (broadly on a mark to market basis) under which values are based on arm’s length prices.

Under a life policy, income earned on the underlying life fund, such as dividends and interest, is not paid to the policyholder but rather the capital value of the policy is increased to reflect the income earned by the underlying fund.

For this reason, it would seem reasonable to use the fair value basis of accounting, in which case the arm’s length price (the market value) would reflect what a willing buyer would pay and a willing buyer would probably pay no more than its encashment value, that is, the surrender value.

Gains and losses will be calculated over the period from the start of the accounting year, or when the policy started if later, to the end of the accounting year or when the policy was fully surrendered if earlier.

Where a policy forms part of the basic life insurance and general annuity business of an insurer taxed in the UK, a 20 per cent tax credit is available by way of relief against corporation tax otherwise payable. The relief is based on the grossed-up gain.

Under a policy issued by a company which is not taxed in the UK, there will be no tax credit for the company unless fund tax is at a rate of 20 per cent or more for an insurer that is resident in an EEA country.

A realised or unrealised loss on a policy, which is technically known as a non-trading deficit, can be set against profits, which includes capital gains, of the accounting period in which the non-trading deficit arises, set against earlier profits from non-trading loan relationships (that is, against non-trading credits) or carried forward against non-trading profits (that is, profits exclusive of trading income).

It is for the investing company to determine which of the two methods of accounting it will need to adopt.

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