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Submission No. 228 Back to full list of submissions
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Institute of Actuaries of Australia

Submission to the Review of Business Taxation

April 1999

 

21 April 1999

 

The Secretary
Review of Business Taxation
Department of the Treasury
Parkes Place
CANBERRA ACT 2600

 

Dear Sir

Review of Business Taxationp

The Institute is pleased to send you the attached submission for the Review of Business Taxation.

Many of the issues involve complex and practical applications. We would be pleased to meet with relevant staff of the Review to expand upon our submission and to further the processes of consultation.

Yours sincerely

 

Richard Mitchell
President

 

Part I Executive Summary

Part II Submission

1 About the Institute of Actuaries
2 Introductory Remarks
3 Collective Investment Vehicles
4 Pooled Superannuation Trusts
5 Superannuation Funds
6 Taxation of Life Insurers and their Policyholders
7 Administration and Implementation

Part III Appendices

A Attachment I – Structure of Wholesale Collective Investment Vehicles
B Attachment II – Detailed Life Insurance Comments and Responses

 

Part I Executive Summary

As a profession, actuaries have a capacity and an obligation to contribute to public policy in their areas of practice and expertise. Two of the key principles that we believe should apply are:

l Tax reform should encourage saving for medium and long term goals and encourage the accumulation of patient capital for investment in wealth and job creating ventures.

l Taxation regimes should not disadvantage individuals utilising collective savings vehicles (broadly defined to include widely held unit trusts and life insurance superannuation and other saving products) relative to individuals investing directly.

1.1 Collective Investment Vehicles

We support the proposal that an intermediate category of taxation be applied to collective investment vehicles (CIV’s) to allow flow-through taxation, provided a "look through" approach applies to wholesale unit trusts and master trusts.

We recommend that a trust that fails the "distributing" criteria simply loses its flow through status and therefore be subject to taxation under the entity system.

The Institute would support a definition of widely held trusts, based on existing legislation such as the public unit trust definition suggested in paragraph 16.16 of A Platform for Consultation. That is, a trust must either be quoted on a stock exchange, or offered to the public, or units must be held by 50 or more persons.

We also recommend that there be some discretion in the treatment of such trusts, to allow for normal trading activity in trust units and changes in the status or relationships of unit holders. Similar discretion should apply to new "widely held" trusts.

As we believe that the appropriate benchmark for CIV’s is the tax treatment of individual investors, any deductions and rebates associated with tax preferred income available to individuals should also be available to trusts.

To avoid penalising existing unit holders and members of superannuation funds, we recommend that rollover relief from capital gains tax and stamp duty should be provided, where trusts need to restructure in order to comply with the new system. We recommend similar rollover provisions for individuals that need to redeem and reinvest units as a result of the changes.

1.2 Superannuation issues

In the case of Pooled Superannuation Trusts (PST’s), which are restricted to one single class of investor, namely complying superannuation funds, we recommend no departure from the current efficient payment of tax through the investment vehicle.

We believe that superannuation funds should continue to be permitted to transfer taxable contributions to life insurers or to PST’s. Any concern with existing or potential problems should be dealt with directly by correcting the problems, not by replacing a more efficient system with a less efficient system. Elimination of transfers of taxable contributions will only add to administration and compliance costs.

The Institute does not support the proposal to tax current pension business of superannuation funds (net of interest credited) at 15%.

1.3 Taxation of life insurers and their policyholders

The Institute has grave concerns that the Government’s original proposals and the options presented in A Platform for Consultation run the risk of radically transforming the life insurance industry to the detriment of existing and future policyholders and to the detriment of the broader community.

The Institute does not believe that it will be possible to achieve a reasonable outcome for life insurers or for their policyholders by operating within the proposed framework of entity taxation. The inequities are too great; the complexities are too great and the possible impact on economic growth is too risky.

The fundamental problem is that life insurance has far more in common with collective investments like unit trusts and superannuation funds than it has with trading companies and trusts.

The actual business of life insurers is not well understood outside the industry. Over 80% of the business is superannuation, around 10% is other investment and less than 10% is risk insurance, depending upon how these categories are defined and measured.

We would be pleased to work closely with the Review over the next few months to endeavour to identify the best way forward within the Review’s timeframe and policy constraints. The first task would be to identify an agreed set of principles and objectives to guide such consultation. We suggest that the following principles and objectives should be included:

  • Life insurance superannuation business and deferred annuities should be taxed consistently with all other forms of superannuation, including RSAs;
  • Other life insurance savings and investment business should be taxed consistently (e.g. no taxation of unrealised capital gains and full indexation of realised capital gains) with widely held collective investment vehicles (excluding the requirement for annual distributions) ;
  • Risk insurance should be taxed on consistent principles with general insurance;
  • Only shareholders of life insurers should be taxed on an entity taxation basis, while customers should be taxed on a similar basis to customers of other financial institutions, such as banks, CIV’s, etc;
  • Grandfathering rules for existing policyholders should be subject to the provisions of existing contracts (ie life insurers should not be obliged to vary existing contracts but may choose to do so); and
  • Transitional rules should apply to the calculation of taxable income to ensure that shareholders are not unfairly disadvantaged due to the imposition of a new tax system on long term contracts (eg it would be unfair if shareholders were fully taxed on annual management fees or premiums on risk products that are used to recoup acquisition expenses that were not deductible because they were incurred prior to the start of the new system); and
  • Solutions should deal with fluctuating returns on insurance products that do not occur with equity distributions.

Nevertheless, we respect that the Review is working to a very tight deadline and that it might not be possible to resolve all these issues and complexities within that timeframe. Accordingly, we have compiled our detailed responses to the issues raised in A Platform for Consultation and these are recorded in Attachment II. The detailed responses relate to the existing proposals and options for reform and may need to be changed if the overall framework for reform is changed.

1.4 Administration and implementation

An implementation date as early as 1 January 2000 could significantly compound the risks associated with Y2K compliance. The Australian Prudential Regulation Authority (APRA) is already closely monitoring these risks for Australian institutions and, in the light of these additional risks, may regard the aggregation of risk as unacceptable for some organisations.

The Institute recommends that the start date be deferred for all organisations for a period of 12 months, ie to the relevant financial years in 2001. However, any financially significant changes affecting profitability (such as changes to life insurance taxation), should commence from a single date (ie 1 July 2001) to avoid competitive advantage, depending on accounting periods. Significant changes affecting policyholder taxation should apply from the same single date.

Part II Submission

1 About the Institute of Actuaries

The Institute of Actuaries of Australia (‘Institute’) represents over 1,000 Fellows and 800 other members. The profession specialises in applying mathematical, statistical, economic and financial analyses, which involve risk assessment to longer-term financial contracts, in a wide range of practical business problems.

As a profession, actuaries have a capacity and an obligation to contribute to public policy in their areas of practice and expertise.

In any reform of the tax system, our members can add value in the public interest by:

  • analysing the financial long-term impact of structural change;
  • assisting in the implementation of programs involving long-term financial risks;
  • providing informed commentary and expert analysis on matters within the profession’s broad areas of expertise, particularly the financial services industry and the health and social security systems;
  • evaluating the impact of demographic changes ( including the ageing of the population); and
  • assisting with the complex transitional problems associated with any structural changes.

Any major reform will lead to behavioural changes and some outcomes might be unclear. Given the training and experience of our members, they are in a unique position to advise on the effect of reforms in the fields in which we specialise.

2 Introductory Remarks

This submission deals with broad aspects of tax reform initially and then turns to issues of most relevance to the Institute:

  • collective investment vehicles;
  • superannuation; and
  • life insurance.

Detailed responses to the specific proposals affecting life insurance are contained in Attachment II. Please note that we will send a separate submission dealing with pensions and annuities in the near future.

The Institute is of the view that business tax reform proposals must be evaluated in two ways. Such evaluation will determine whether a proposal is genuine reform, or merely change, and consequently whether it should proceed or not.

Firstly, business tax reform proposals should be formulated with a desired outcome in mind. Secondly, such proposals should be measured against widely accepted benchmarks or principles.

2.1 Outcomes

Taxation is the method by which government obtains the revenue it requires to govern the country and provide the services required by the citizens. The amount of taxation imposed by the government can be arbitrary and can vary according to how a government perceives its or its citizens' demands.

It can also vary within the mix of taxation, depending on which section of the community the government determines should bear which proportion of the tax burden. Taxation of business is but one avenue for revenue raising.

Other avenues include taxation of income earned through personal exertion, taxation of investments and taxation of savings and other forms of taxation.

If one taxation regime is altered and the others are not, it is almost certain to alter the behaviour of citizens. For example, if personal income tax rates are lowered but taxation of savings is not and such rates become relatively disadvantageous, saving is likely to became less attractive for people than consumption. The extra disposable income created by the personal tax reform is more likely to be consumed than saved.

This may or may not be desirable, depending on what the aspirations of the people and the government are.

Within the business taxation regime it is possible to treat sectors differently, and therefore have an influence on how successful one sector is vis a vis another within the same national economy, and also how competitive sectors are internationally.

The Institute submits that business tax reform should be designed to produce a net financial and social benefit to both business and society.

For example, tax reform should enhance the wealth creating capacity of business by not excessively taxing profits, or imposing high collection costs on business.

Tax reform should also promote business or, at the very least, would not be an impediment to efficiency, competition and growth. It should create a climate in which investment in wealth creating businesses is encouraged. This is in fact what happens with dividend imputation, a clear policy to reward investment in Australian companies.

2.2 Benchmarks

As well as fostering desired outcomes, tax reform should be subject to effective quality control. It should be measured against accepted benchmarks in its implementation.

It should be simple and easy to administer (and should not of itself require high costs of administration and compliance).

It should be transparent so that all can see its intent and its effect.

It should be equitable, in that it does not impose an uneven burden on those paying and those in similar circumstances should be treated in a similar manner.

It should promote efficient allocation of resources and hence increased economic growth.

The reform process should improve matters for all concerned, including promoting market diversity and competitiveness.

2.3 Issues

It has been stated that the Government wishes to move to a 30% corporate tax rate, possibly financed by reduction or elimination of accelerated depreciation. The Government has proposed a uniform tax regime (ie entity taxation with deferred company taxation applying to all unfranked distributions) across companies, life offices and unit trusts. However, significant exceptions will apply to individuals, banks, RSA's, stand alone superannuation schemes and cash management trusts.

There is also the view that the life insurance tax system is very complex and presents opportunities for tax arbitrage.

There is a push to lower the corporate tax rate, remove what are regarded as undesirable opportunities for avoidance from the system, and have a uniform regime for investors which taxes their investment returns at their marginal rate.

2.4 Key principles

The Institute set out certain principles in its earlier submission and we believe that a number of these should be reiterated to establish the context upon which this submission has been developed. These principles are:

  • Tax reform should encourage saving for medium and long term goals and encourage the accumulation of patient capital for investment in wealth and job creating ventures.
  • To the extent that it exists, taxation of savings vehicles should be simple, transparent, efficient and equitable.
  • Taxation regimes should encourage behaviour that adds to the nation’s savings.
  • Taxation regimes should not disadvantage individuals utilising collective savings vehicles (often to obtain a spread of risks) relative to individuals investing directly.

We believe that A Platform for Consultation provides a sound basis to progress the business taxation reform debate, by identifying various options that should lead to improved outcomes compared to the original proposals announced by the Government last year. One of the dangers recognised by the Institute and others last year was that a conceptual model of entity taxation might be inappropriate across the full range of entities to which it was proposed to apply.

In particular the benchmark of taxing all other entities as companies might be inappropriate for those entities that exist primarily or exclusively to provide individuals with a facility to pool their savings to achieve more efficient and productive investment returns than if they invested directly into the financial markets. The more appropriate benchmark in these cases is the taxation treatment of individuals.

It is pleasing that this issue has been given appropriate recognition by the Review and by the Government in relation to cash managed trusts and other collective investment vehicles. The unresolved issues relating to the boundaries of such vehicles, the treatment of tax preferred income and the need for consistency with life insurance companies, which are another form of collective investment, are dealt with in this submission.

3 Collective Investment Vehicles

We support the proposal in Chapter 16 of A Platform for Consultation that an intermediate category of taxation be applied to collective investment vehicles (CIV’s) to allow flow-through taxation. This is more appropriate than entity taxation as it aligns CIV’s with the treatment of direct individual taxation. It is pleasing that the Government recognised the need for this intermediate category when A Platform for Consultation was published.

Trusts play an important role in meeting the investment needs of individuals, including a growing number of retirees, some of whom rely significantly on trusts for their income needs. In addition to providing the benefits of economies and diversification, trusts also provide access to a range of investments that would otherwise be available only to wealthier individual investors and larger superannuation funds.

The imposition of a system of tax prepayments at the company rate, albeit refundable where the company tax rate results in overpayment, would be especially inequitable for lower marginal rate payers and retirees. This would be made worse with the flow on of costs of implementation including the costs of systems upgrades. The Government has already acknowledged the need for special recognition of the impact on end investors in the case of cash management trusts and bank deposits. We believe that the same imperatives should also guide the approach taken for unit trusts.

For these reasons we believe that the benchmark for competitive neutrality in relation to trusts should be the individual investor and not corporate entities. We further believe that an approach that penalises collective as against individual investments could only be harmful to the efficient flow of capital and therefore the economic wellbeing of the country.

Further, the systems for reporting separate categories of income to unit holders are already well established, avoiding the need for costly and extensive changes at a time when systems resources across the industry are stretched by issues such as Year 2000 compliance and GST.

3.1 How would collective investment vehicles and ‘widely held’ be defined?

We support the proposed definitions, provided a "look through" approach is applied to wholesale unit trusts and master trusts.

The efficient administration of CIV’s often involves utilising wholesale trusts. Smaller trusts and superannuation funds will themselves invest in master trusts or larger wholesale trusts in order to gain cost savings of further aggregation. Smaller funds also benefit from the specialisation of larger wholesale trusts, which are likely to concentrate on particular asset sectors or investment styles. Australian domestic equity trusts and share index trusts are good examples of these. The diagrams in Attachment I show the types of master trust and wholesale trust arrangements currently used.

3.2 Investment criteria and full distributions

Restrictions to the investment activities of trusts, if considered necessary, could be based on the current Tax Act definition for trading trusts.

In A Platform for Consultation, it is suggested that all income should be distributed. Otherwise, severe penalties, taxation at the company rate with no subsequent imputation credits, would be applied to undistributed income. We believe that this treatment is unnecessarily harsh on unit holders.

Firstly, in a normal operational environment, a small amount of income may remain undistributed in a year due to timing differences and other incidentals. For this reason, we recommend discretion on the part of the regulator or auditor to treat a fund as complying, providing any amount undistributed is small as a proportion of the fund and that such amounts are justifiable on practical grounds.

Secondly, the stated purpose of the penalty taxation is to prevent the use of trusts in tax deferral for higher marginal rate payers. This seems needless given that the same deferral benefits could be achieved through a non-trust entity. Further, a similar arrangement, allowing deferral of payment of the tax difference between the investor’s marginal rate and the company rate is being considered for life office investments.

For these reasons we recommend that a trust that fails the "distributing" criteria simply lose its flow through status and therefore be subject to taxation under the entity system.

3.3 Recommended definition

The Institute would support a definition of widely held trusts, based on existing legislation such as the public unit trust definition suggested in paragraph16.16 of A Platform for Consultation. That is, a trust must either be quoted on a stock exchange, or offered to the public, or units must be held by 50 or more persons. The definition should include groups of individuals in a position to act in collaboration, such as relatives, as a single individual.

‘Widely held’ definition

The Institute supports a "widely held" definition that will not disadvantage the efficient use of wholesale and master trusts or cause disruption to capital markets by imposing unnecessary restructuring. Therefore we recommend a "look through" approach that considers the nature of individual unit holders, in determining concentration of ownership, where unit holders are either superannuation funds, life office statutory funds, wholesale trusts or widely held distributing trusts. This approach would count the end investors, in determining whether a trust was widely held, these being the unit holders, policyholders complying superannuation ADF or PST fund members etc.

3.4 Regulation of flow through status

In order to qualify, a trust should be able to demonstrate ongoing adherence to the various criteria for flow through tax status. This could be achieved by having the relevant regulator or external auditor vet adherence on a regular basis. This process would allow the regulator or auditor to determine whether a trust had met the relevant requirements for a distributing, widely held or wholesale trust. The tax status of the trust would then flow from the determination of the regulator. The process would facilitate some level of practical discretion by the regulator or auditor in the case of say new trusts, or trusts with small amounts of incidental, undistributed income. These issues are discussed further in the sections below.

3.5 New trusts and changes in status during the year

It needs to be recognised that due to trading activity in trust units and changes in the status or relationships of unit holders that some funds may inadvertently be in breach of the definition of "widely held" at some time during a year. We therefore recommend, in order to avoid unnecessary penalisation of members or trust managers, that there be some discretion in the treatment such trusts. This would allow a trust that finds itself in breach and immediately moves to rectify the situation, to be treated as if it were compliant for the whole year.

This could be achieved by having the relevant regulator or external auditor vet adherence on a regular basis, to the criteria for flow through tax treatment. The same process would also apply in assessing whether a trust has distributed all income that could practically be distributed for the year. If a trust no longer qualifies for flow through status, then, after a reasonable notification period to members, all distributions from that point onwards should be subject to the entity tax arrangements.

We recommend the use of a notification period of say three months in order to avoid penalising members twice for events over which they are unlikely to have had any influence. Members would already be disadvantaged by having to redeem units and meet acquisition costs on finding a suitable alternative investment. It therefore seems unfair to penalise them further through the punitive treatment of trust income, without providing a reasonable interim period.

To encourage a dynamic and competitive industry, we recommend that the regulator or auditor also be allowed to apply discretion in the case of new trusts. New trusts that do not comply with the criteria for widely held, should be treated as complying provided that they were created within the last 12 months and that they are intended to comply by the end of the interim 12 month period.

3.6 How would tax preferences be treated?

These occur mainly in relation to the tax free and tax preferred income of property trusts. The two tax mechanisms which give rise to these classes of income are building allowances and depreciation allowances. As trusts are an aggregation of individuals any deductions and rebates associated with these tax mechanisms available to individuals should also be available to trusts. Therefore, if there are problems, it is the applicability of these mechanisms in general which should be examined, not their use by trusts.

As stated above the Institute believes that the benchmark for competitive neutrality in relation to pooled investments should be based on the treatment of individual investors and not other entities.

Listed property trusts provide liquidity benefits to investors wishing to access property as an asset class. The removal of the flow through of tax preferences would push investors back to direct holdings. Many smaller and medium size investors would not seek to hold property in this circumstance. This could affect capital formation and general economic activity in the building sector. If the trusts were to become unattractive to retirees then there would be one less vehicle available to meet the income needs of retirees. Property trusts have been very influential in providing good yield based investments to retirees.

The aim of tax preferences is to bias the flow of capital in a positive way. The flow through of preferences could only further improve their efficiency in achieving this aim.

3.7 Rollover relief

To avoid penalising existing unit holders and members of superannuation funds, we recommend that rollover relief be provided, in appropriate circumstances. Trusts that need to restructure in order to comply with the new criteria for flow through tax treatment, should be granted relief from capital gains tax and stamp duties that would otherwise be applied on realisation and subsequent reinvestment of trust assets. Such assets should be treated for tax purposes, as if the sale had not taken place.

We recommend similar rollover provisions for individuals that need to redeem and reinvest units as a result of the changes.

Non resident Investors

Under the entity tax approach, interest on directly held debt type investments within trusts would be taxed at the company rate. For overseas investors this would represent an increase in Australian tax paid. Offsets may be provided in their country of residence depending on the operation of any tax treaties in place. The result would likely be a preference by non resident investors to use non-Australian vehicles for debt investment thereby eroding our competitiveness in attracting investments.

4 Pooled Superannuation Trusts

In the case of Pooled Superannuation Trusts (PST’s), which are restricted to one single class of investor, namely complying superannuation funds, there seems little reason to depart from the current efficient payment of tax through the investment vehicle. The Government has acknowledged this principle in its consideration of the treatment of Retirement Savings Accounts. In the case of PST’s, all end investors have a uniform marginal tax rate of 15%. The current restrictions in terms of membership and funding that already apply to complying superannuation funds operate effectively in preventing their misuse for tax planning purposes. Therefore we do not see the same need, in the case of PST’s, for restrictions on trust activity, distributions or the diversity of unit holdings.

5 Superannuation Funds

5.1 Transfers of taxable contributions

The transfer of tax collection for superannuation funds, including that on taxable contributions was originally introduced to simplify the annual tax return process for these funds, providing cost savings that would especially benefit smaller to medium sized funds. The reversal of this arrangement would seem to be a retrograde step. The industry has invested extensively in systems to support complex aspects of superannuation fund taxation and administration, such as the recent surcharge legislation. The cost to superannuation funds and their taxation advisers of reproducing this functionality would be considerable.

We believe that superannuation funds should continue to be permitted to transfer taxable contributions to life insurers or to PST’s. Any concern with existing or potential problems should be dealt with directly by correcting the problems, not by replacing a more efficient system with a less efficient one. Elimination of transfers of taxable contributions will only add to administration and compliance costs.

5.2 Taxation of current pension business

The Institute does not support the proposal to tax current pension business of superannuation funds (net of interest credited) at 15%. The original taxation basis measure was introduced in 1988, to encourage greater use of income streams in retirement. It is inappropriate to make ad hoc changes to this aspect of superannuation taxation, in light of the need to better prepare our community for the impending pressures of an ageing population. It would be more appropriate to consider any such option in the light of an overall review of the superannuation taxation system, as proposed in the Institute’s previous submission. Some of the administrative problems identified for life insurers will also apply to superannuation funds.

The Institute is investigating a standard approach for pensions and annuities that could apply to superannuation funds and life insurers. The results of this investigation will be forwarded to the Review as soon as possible.

6 Taxation of Life Insurers and their Policyholders

6.1 Detrimental impacts of life insurance reforms

The Institute has grave concerns that the Government’s original proposals and the options presented in A Platform for Consultation run the risk of radically transforming the life insurance industry to the detriment of existing and future policyholders and to the detriment of the broader community.

The proposed changes could cause many negative impacts on the industry and its policyholders, including:

  • Taxation disadvantage in competing for new and existing superannuation business (which represents around $125 billion of the industry’s total assets of around $160 billion) and hence potential major transfers (at significant cost in capital gains tax and stamp duty) of assets outside of life insurers;
  • Taxation disadvantage in competing against both direct individual investment and collective investment via unit trusts, due to the loss of tax preferred income and withholding tax;
  • Reduced security for policyholders as shareholders are encouraged to reduce the level of capital support they provide as security against the various risks that are insured;
  • Price increases for products such as risk insurance and annuities which provide external benefits to the whole community, via the reduction in demand for social welfare through the existence of greater financial security;
  • Confusion of existing and new policyholders due to a much more complex taxation environment for life insurance policies;
  • Increased compliance costs for the ATO and for millions of policyholders who will now need to interact much more frequently on average, possibly annually, compared to the current position (ie only those who terminate policies within the first ten years of policy ownership require tax adjustments); and
  • Unfair impact on shareholders who may be subject to higher levels of taxation than can be justified by traditional principles of taxation due to the interaction during the transition period of a new taxation system with existing long term contracts providing various policyholder guarantees.

6.2 Alignment with national objectives

The Institute is very pleased that the Review has invited wide input, via A Platform for Consultation and via other aspects of the consultative process, to avoid any of these consequences that run counter to the national objectives of:

  • Optimising economic growth;
  • Ensuring equity; and
  • Facilitating simplification.

The life insurance industry has been a major contributor to financing economic growth in Australia for many years, via its role in accumulating savings and enabling capital formation, especially in relation to patient long-term capital. If tax reform prevents the life insurance industry from continuing to fulfil this role, it should not be assumed that other aspects of the financial sector would automatically undertake that role. It may take some time for the structural changes to occur effectively. During that period, there could be a significant leakage of savings to consumption that might further exacerbate Australia’s balance of payment difficulties.

The vast majority of life insurance policies are voluntary contracts entered into by policyholders, because it suited their circumstances at the time of purchase. The taxation treatment of life insurance has evolved steadily over recent decades and alternative products with alternative tax treatment could have been purchased. We believe that to achieve equity in practice requires a level of understanding by customers and advisers that is best developed over a reasonable period of time with gradual changes, rather than major unexpected changes that create confusing complexity and uncertainty.

Simplification does not seem to be have given as much weight as it deserves in the area of proposed reforms to life insurance taxation. The existing tax paid system has simplicity as one of its hallmarks. It would be unfortunate if the replacement system was so complex that customers could not comprehend the products.

We hope to provide sufficient input to enable the Review to assess the likely consequences of the various options it has under consideration. Of course, we would also be pleased to provide further detail where required or further input on additional options that the Review may wish to consider to avoid the most damaging of the impacts mentioned above.

The Institute does not believe that it will be possible to achieve a reasonable outcome for life insurers or for their policyholders by operating within the proposed framework of entity taxation. The inequities are too great, the complexities are too great and the possible impact on economic growth is too risky.

6.3 Benchmark selection

The fundamental problem is that life insurance has far more in common with collective investments like unit trusts and superannuation funds than it has with trading companies and trusts.

The actual business of life insurers is not well understood outside the industry. Over 80% of the business is superannuation, around 10% is other investment and less than 10% is risk insurance, depending upon how these categories are defined and measured.

Until recent years, most of the industry in Australia was mutual. This meant that there was an unavoidable blending of the interests of the owners and customers. Transparency of financial operation was almost non-existent to those outside the actuarial profession. This has now changed.

Life insurers now have clearly defined customers (ie policyholders) and clearly defined owners (ie shareholders). Policyholder interests and shareholder interests are clearly defined in financial statements. Actuarial and accounting standards provide clear definitions and transparency that is superior to most other countries. The 1995 Life Insurance Act is a model of policyholder protection and regulation that is rightfully regarded as world’s best practice.

Unfortunately, some of the proposals and options that we have been asked to respond to, seem to be based on outdated paradigms. They do not seem to reflect the restructured and improved basis upon which the industry operates and can be managed. If there are problems, they should be clearly identified and corrected. There is a significant risk of unintended consequences if 150 years of evolution and development of an industry is replaced, with untried theoretical concepts. Such concepts may or may not work in the real world of trying to educate people to put away some part of today’s income to provide for retirement, other savings goals or risks that might occur along the way. If the theoretical concepts don’t work, it could take a long time to rebuild what is lost.

6.4 New taxation paradigm for life insurance

We believe that a new taxation paradigm is required for life insurers and we don’t believe that the Review has yet identified it. The first task would be to identify an agreed set of principles and objectives to guide such consultation. We suggest that the following principles and objectives should be included:

  • Life insurance superannuation business and deferred annuities should be taxed consistently with all other forms of superannuation, including RSAs;
  • Other life insurance savings and investment business should be taxed consistently (eg no taxation of unrealised capital gains and full indexation of realised capital gains) with widely held collective investment vehicles (excluding the requirement for annual distributions) ;
  • Risk insurance should be taxed on consistent principles with general insurance;
  • Only shareholders of life insurers should be taxed on an entity taxation basis, while customers should be taxed on a similar basis to customers of other financial institutions, such as banks, CIV’s, etc;
  • Grandfathering rules for existing policyholders should be subject to the provisions of existing contracts (ie life insurers should not be obliged to vary existing contracts but may choose to do so) and the underlying economic cost of implementation should be considered;
  • Transitional rules should apply to the calculation of taxable income to ensure that shareholders are not unfairly disadvantaged due to the imposition of a new tax system on long term contracts (eg it would be unfair if shareholders were fully taxed on annual management fees or premiums on risk products that are used to recoup acquisition expenses that were not deductible because they were incurred prior to the start of the new system); and
  • Solutions should deal with fluctuating returns on insurance products that do not occur with equity distributions.

We would be pleased to work closely with the Review over the next few months to endeavour to identify the best way forward within the Review’s timeframe and policy constraints.

Nevertheless, we respect that the Review is working to a very tight deadline and that it might not be possible to resolve all these issues and complexities within that timeframe. Accordingly, we have compiled our detailed responses to the issues raised in A Platform for Consultation and these are recorded in Attachment II. We submit these detailed responses and suggest that they will provide part of the input for the consultative discussions that we have suggested above.

The detailed responses relate to the existing proposals and options for reform and may need to be changed if the overall framework for reform is changed.

7 Administration and Implementation

At present it is proposed that the revised business tax system arising from the Review will take effect, subject to passage of legislation, as from 1 July 2000 for most organisations. However for those entities with substituted accounting periods, the implementation date can be as early as December 1999.

This will create a variety of practical problems, which will make it difficult if not impossible for those organisations to comply with the new requirements. If the legislation is not presented and passed until effectively the third or forth quarters of 1999, there is very little time to make the required system adjustments. Concerns about Year 2000 (Y2K) risks have caused many local and foreign institutions to impose embargoes (some self imposed, some imposed by regulators in various countries) on new system implementations, generally from the third quarter 1999 till the end of first quarter 2000. This will make it impossible for most organisations to comply, possibly even by 30 June 2000.

An implementation date as early as 1 January 2000 could significantly compound the risks associated with Y2K compliance. The Australian Prudential Regulation Authority (APRA) is already closely monitoring these risks for Australian institutions and, in the light of these additional risks, may regard the aggregation of risk as unacceptable for some organisations.

The Institute recommends that the start date be deferred for all organisations for a period of 12 months, ie to the relevant financial years in 2001. However, any financially significant changes affecting profitability (such as changes to life insurance taxation), should commence from a single date (ie 1 July 2001) to avoid competitive advantage, depending on accounting periods. Significant changes affecting policyholder taxation should apply from the same single date.

Part III Appendices

A Attachment I – Structure of Wholesale Collective Investment Vehicles

A.1 Collective Investment Vehicles – Wholesale trust models

Simple Masterfund

 

 

 

 

 

 

 

 

 

A.2 Collective Investment Vehicles – Wholesale trust models

More Complex Arrangement

 

 

 

 

 

 

 

 

 

 

B Attachment II – Detailed Life Insurance Comments and Responses

As explained in Section 6 above, this Attachment is included to facilitate the preferred consultative approach that the Institute of Actuaries has proposed. It contains detailed responses to most of the questions raised in Chapter 34 and to key questions in Chapter 35, within the framework established for A Platform for Consultation.

If the overall framework adopted for taxing life insurers differs from that proposed, the detailed responses may need to be varied to reflect the amended framework.

B.1 What are the tax rate implications of the proposals on the superannuation business of life insurers?

We are concerned that applying an imputation credit regime to superannuation business could result in unnecessary administration and a delay in the refund of excess imputation credits to superannuation trustees. This issue has been recognised by the Review in Section 15.79 of A Platform for Consultation.

In addition, we are also concerned that the deferred corporation tax regime may result in unrealised gains and tax-preferred income being taxed when these gains are credited to policyholder accounts.

Superannuation trustees, who invest directly, and industry funds would not be affected by these issues. If the option of taxing Public Superannuation Trusts ("PST") at a rate of 15% is accepted then PST’s would also be in an advantaged position. The result would be a decline in the amount of new superannuation funds invested through life companies and it is likely that most trustees would withdraw funds from life companies and re-invest these funds in alternative arrangements.

We have outlined two possible solutions to this issue. The first solution is analogous to that applied to Retirement Savings Accounts ("the RSA approach"). The second approach proposes a fixed pool of assets in line with Pooled Superannuation Trusts ("the PST approach").

The RSA Approach

We would like to suggest a solution to these problems, which is similar to that currently applied to Retirement Savings Accounts. The solution would operate as follows:

  • The amount of taxable policyholder investment income (excluding amounts of unrealised gains) credited to superannuation funds would be identified. We suggest that this investment income is taxed at the superannuation rate of 15%.
  • The policyholder investment income would include both amounts credited to individual policies and amounts credited to smoothing reserves held solely for policyholders’ benefit.
  • The amount of management fees paid by policyholders would receive tax relief at the rate of 15%. This would avoid the need for the policyholder to separately claim for this relief.
  • The shareholder assessable income would be determined as proposed in A Platform for Consultation but the amount taxed as policyholder investment income (net of management fees) would be excluded. The shareholder assessable income would be taxed at the corporate rate.

The advantages of this solution are as follows:

  • The net investment income on superannuation policies would be taxed at 15% and no refund mechanisms would need to be applied. This would ease the administration for superannuation trustees as a life insurance policies would be "tax paid" and not included in a tax return. This would mean that life companies would not be disadvantaged compared to alternative investment approaches.
  • Franking accounts would not need to be maintained for superannuation policyholders, thus removing significant administration problems.
  • Shareholder assessable income would be taxed at corporate rates and would include the excess of management fees over expenses as well as any underwriting profits.
  • The approach can be extended to all classes of business and is suitable for a fund with mixed classes of business.
  • This approach is line with the approach suggested for Allocated Annuities in Sections 34.50 and 34.51 of the Review, except for the application of a 15% tax rate rather than zero.

We would be happy to provide you with further details on the workings of this solution.

The PST Approach

We would like to suggest a solution to these problems, which is similar to that outlined in Sections 15.81 to 15.88 of A Platform for Consultation. The solution would operate as follows:

  • Superannuation funds within a life company are currently accounted for as a separate "Class" of business. This is a requirement of the Life Insurance Act 1995 (cf Sections 12, 75, 79 and others of this Act). We suggest that investment income earned by the Superannuation Class of business should be taxed at the superannuation rate of 15%.
  • The amount of management fees paid by policyholders would receive tax relief at the rate of 15%. This would avoid the need for the policyholder to separately claim for this relief.
  • We understand that the Australian Taxation Office ("ATO") is concerned about internal dealings within life companies (cf Sections 34.3 and 34.4 of A Platform for Consultation). These problems could be avoided by requiring that each Class of business has separately identified assets. Further the transfer of an asset from one Class of business to another would be considered to be a realisation of the asset and capital gains tax would become payable at the time of such a transfer.
  • To ensure that only policyholder funds are taxed at the superannuation rate of 15%, we suggest that the maximum amount of funds invested in the Superannuation Class be set at the current termination values of the superannuation policies plus any amounts of smoothing reserves that are being held for the benefit of policyholders. At the end of each financial year, the life company would transfer surplus assets to the Ordinary Class of business and tax would be levied at the corporate rate on the assessable amount of such transfers. Additional provisions would be required for participating funds where prudential regulations restrict the amount of such transfers.

The advantages of this solution are as follows:

  • The investment income (net of management fees) on superannuation policies would be taxed at 15% and no refund mechanisms would need to be applied. This would ease the administration for superannuation trustees as life insurance policies would be "tax paid" and not included in a tax return. This would mean that life companies would not be disadvantaged compared to alternative investment approaches.
  • Franking accounts would not need to be maintained for superannuation policyholders, thus removing significant administration problems.
  • Capital gains tax would be payable on the movement of assets between Classes of business thus removing the opportunity for "tax planning".
  • Shareholder profits would be transferred out of the Superannuation Class in a prudent manner and taxed on transfer at the corporate rate (with an appropriate allowance for any tax already paid at the superannuation rate).

We would be happy to provide you with further details on the workings of this solution.

B.2 How should the taxable income of a life insurer be calculated?

Superannuation Policies – RSA Approach

The RSA approach for superannuation policies would result in the investment income of superannuation policies being taxed at 15%. The shareholder assessable income would be taxed at 36%. This income would consist of the following components:

  • The total investment income less that credited to policies and policyholders’ reserves; plus
  • Underwriting profit; plus
  • Management fees; less
  • Expenses; less
  • The increase in any prudential margins included in the policy liability for taxation purposes.

We suggest that this would be an appropriate base for the taxable income of the shareholders of a life insurer.

The total tax paid on superannuation policies would be 15% of policyholder investment income plus 36% of the annual shareholder profits.

The policy liability for taxation purposes should be determined for each Related Product Group in accordance with Actuarial Standard 3.01 (the capital adequacy standard) but excluding any components for resilience reserves, inadmissible assets and new business reserves.

Superannuation Policies – PST Approach

The PST approach for superannuation polices would result in the investment income of superannuation policies being taxed at 15%. The annual transfer to shareholders would be taxed at 36%. This approach would ensure that shareholders would be taxed on:

  • Investment income on assets held outside the Superannuation Class; plus
  • Underwriting profit; plus
  • Management fees; less
  • Expenses; plus
  • Investment income credited to shareholders as part of the profit transfer (an allowance would need to be made for the 15% tax already paid on this item);

We suggest that this would be an appropriate base for the taxable income of the shareholders of a life insurer.

The total tax paid on superannuation policies would be 15% of policyholder investment income plus 36% of the annual shareholder transfers.

Unbundled Ordinary Investment Policies

In A Platform for Consultation, two options are outlined for the taxation of life insurance companies (Sections 34.22 to 34.35). We consider that either option would be appropriate for unbundled ordinary investment policies.

Policyholder and shareholder investment returns would both be taxed at the corporate tax rate (36%). The policyholder net return is investment income less management fees. The shareholder assessable income is management fees less expenses. When these items are grouped the tax basis simplifies to investment income less expenses.

The alternative suggested in A Platform for Consultation achieves the same aim but is more complicated as the rebate on fees is provided to the policyholder in their personal tax returns rather than being grouped with the investment returns.

We would be happy to provide worked examples demonstrating that both approaches achieve the same result (after allowing for a re-balancing of fee amounts). We regard the former method as simpler to apply from a policyholder perspective. Management fees would need to be identified for either method to ensure that the correct franking credits are determined for shareholders.

Some companies may find it administratively difficult to identify management fees on older policies where the fee is expressed in terms of foundation or capital units. Other companies may not record sufficient detail on their accounting systems. For these companies Option 1 would be preferable. Management fees would be determined as:

  • Premiums; less
  • Policy claims; less
  • Increase in the value of liabilities attributed to policies; plus
  • Net investment income credited to policies.

Other companies mainly sell unbundled investment policies and account for these policies in a similar manner to their unit trust business. These companies are likely to prefer Option 2 as it is more aligned with their unit trust operation.

We propose that companies are given a once only choice as to which tax basis should apply. This will ensure that the new tax calculations will result in the minimum level of administration for all companies.

We suggest that the liability calculation for Option 1 should be based on the policy liability for taxation purposes (as defined above), which is subject to a minimum of the current termination value. Other measures of liability are likely to either tax profits before they are earned or to unduly delay taxation.

One problem with using current termination values is that exit fees would be taxed before their realisation on the actual exit of a policy. This is a difference to the way unit trust exit fees are taxed in the management company. However, it should be noted that unit trusts need to hold assets equal to the full face value of units, while life companies only hold assets equal to current termination values. This capital advantage could compensate for any early taxation that results.

Bundled Investment and Risk Policies

In this section, we consider the treatment of bundled investment products (ie where the policy offers both risk and investment benefits) and risk products.

We consider that Option 2 of A Platform for Consultation would present significant measurement and other practical problems to the life insurance industry. It is difficult to define or determine a management fee on most traditional policies. Although a formula could be applied for underwriting profit, it would result in the tax paid by a life company not being related to the actual profit earned. In addition, it would be difficult to determine parameters for a formula that truly represents the amount of profit earned.

As a result, we would recommend Option 1 for bundled investment products and risk products.

In the case of bundled investment products, we suggest that policyholders should be given tax relief within the life insurance company on any implicit management fees. This is the same principle as discussed for unbundled investment policies and would simplify policyholders’ subsequent tax treatment.

In the case of risk only business, we would suggest that the change in liability be determined using the same principles as for the existing tax basis on accident and disability contracts. This would also be in line with the recommendation for unbundled investment policies and superannuation policies.

For bundled investment policies, an appropriate measure of the change in liability would again be the policy liability for taxation purposes but should also include a deduction for the net investment return credited to policyholders. This latter adjustment could be determined as the net actual investment return for the period multiplied by the average amount of the policy liability for taxation purposes over the period.

B.3 Can accounting principles be used by life insurers for taxation purposes?

We consider that accounting principles would not be appropriate for the following reasons:

  • Unrealised gains would be taxed immediately placing life insurance investment policies at a disadvantage to all other investment methods.
  • Policy liabilities are determined using active assumptions and may result in much volatility of tax payments from period to period.
  • Some elements of the calculation are subjective resulting in potentially different amounts of tax being paid as a consequence of individual judgements – however, it should be noted that the calculation is derived as part of an audited process.
  • When policy liabilities were introduced, there was considerable discretion as to how starting amounts would be set. Life insurers should not have to pay different amounts of tax based on such past accounting decisions.
  • As well as unrealised gains, the use of policy liabilities may bring forward the taxation of profits before these are realised with certainty.
  • When a related product group is in loss recognition (ie capitalisation of anticipated losses) the use of accounting principles will result in tax relief being provided prior to the loss being incurred.

B.4 How would life reinsurance be taxed?

We support the proposal that life reinsurance should be taxed on the same principles that apply to life insurers.

We note that reinsurance should be allowed for appropriately within a life insurer. Reinsurance premiums should be deductions, reinsurance commissions and claims would be assessable and the change in liability should be net of reinsurance.

B.5 What are the tax rate implications of the proposals on the deferred annuity business of life insurers?

We suggest that the deferred annuity business of a life insurer should be treated (during the deferment period) in the same way as superannuation policies (ie investment earnings taxed at 15%, while transfers out of the Superannuation Class are taxed at the corporate rate). This is not dissimilar to the proposal contained in Section 34.71 of A Platform for Consultation.

B.6 How would franking credits be allocated between shareholders and policyholders?

The approach we have suggested for the taxation of policies would imply that franking accounts should only be maintained for the shareholder. The franking accounts would be credited with the following amounts:

  • On superannuation policies, the amount of corporation tax paid on shareholder profits;
  • On annuity and risk policies, the whole amount of the tax paid as this represents the tax paid on shareholder returns;
  • On ordinary investment policies, the tax paid would need to be split between policyholder and shareholder amounts. An allocation would only be required for investment income as the tax paid on the other items of assessable income represents tax on shareholder profits only (ie the excess of management fees over expenses and underwriting profits). We would suggest that the tax on investment income could be apportioned in line with the apportionment of the investment income itself; and
  • Similarly only imputation credits received on equity dividends that relate to shareholder investments would be credited to franking accounts.

If a policyholder imputation account is required for ordinary investment policies, then this should be credited with the policyholder’s allocation of corporation tax on investment income and of imputation credits received on equity dividends.

B.7 Some grand-fathering issues for the taxation of existing life insurance policies

The Review proposals will include elements of shareholder profit in assessable income for the first time. After the first year of the policy, the taxable shareholder profit would consist of the following items:

  • The underlying profit of the contract;
  • The release of some prudential margins on the contract;
  • An amount to recover initial expenses.

For a new policy issued under the new taxation basis, it is reasonable for all of these items to be taxed, as tax relief is received in the first year of the contract on both the initial expenses and the cost of establishing prudential margins. For a policy issued before the new taxation basis was put in place, inequities would arise in the following areas:

  • With the exception of accident and disability business, the cost of establishing prudential margins was not given any tax relief under the old system;
  • For life risk and annuity business, initial expenses were not provided any tax relief;
  • For superannuation business, initial expenses were only provided relief at the rate of 15% not the corporate rate.

To ensure that the tax on in force policies is calculated equitably, we suggest that on a transitional basis additional tax relief should be provided as follows:

  • For all risk contracts issued before the tax regime comes into place, a proportion of the assessable premium should be tax deductible. This proportion would be determined, at the transition point, as the ratio of the following two amounts:
    • The sum of the value of remaining unrecouped deferred acquisition costs and the prudential margins contained in the policy liability for taxation purposes; and
    • The present value of future expected premiums.

All of these items can generally be derived from audited accounts.

  • For superannuation policies, the deduction would be determined in a similar way as for risk business, but the proportion deductible would be adjusted for the difference between the corporate tax rate and the superannuation tax rate of 15%. This adjustment would depend on the corporate tax rate to be applied.
  • For ordinary investment policies, an offset would need to be established for any risk component of the premiums. An offset would also be appropriate for the cost of establishing prudential margins, however, this offset might be ignored on materiality grounds.

In addition for ordinary investment business, the new taxation basis may increase the total tax payable by the life insurer through levying additional tax on certain management fees (such as those embedded in premiums). On the assumption the existing business will be grandfathered (in terms of policyholder tax treatment) we have a situation where that business was written and appropriately taxed under the existing (I - E) regime. The total tax payable may now be increased and that appears to us to be unnecessary additional taxation - taxation that may well be passed onto the policyholder. We would be happy to provide more details in this respect.

B.8 Policyholder taxation issues

If the investment return on superannuation policies is taxed at 15%, there would be no requirement to tax superannuation trustees in respect of their investment in life insurance policies. This would apply if either of our proposed solutions was adopted.

In addition, the transfer of contributions tax liability could continue, on the basis that this will generate no franking credits. This will continue to allow superannuation funds that invest in life insurance policies not to prepare a tax return.

We understand that the Review does not envisage any change in the policyholder taxation of risk or annuity policies and we would support this.

In respect of ordinary investment policies, policyholders will need to record the amount of corporation tax paid on their investment income within their personal taxation return. If this amount is directly linked to the amounts of corporation tax paid by life insurance companies, a number of difficulties may arise:

  • The life insurer will only pay tax on gains when these are realised, whereas it is contemplated that the policyholder may have the option to pay additional tax or reclaim excess tax when these gains are credited to policies (ie before they are realised).
  • If the life insurer pays deferred corporation tax at the same time that a policyholder makes their tax declaration, this will result in the policyholder being effectively taxed on unrealised gains. As a result life insurers will be at a disadvantage to other investment alternatives (eg direct investment in property or shares).
  • To link both tax payments, either life insurers or the Australian Taxation Office will need to keep substantial records on both existing and, perhaps, even policies that have terminated.

On practical grounds, we would argue for a less exact but more workable solution. This would have the following features:

  • We suggest that policyholders should only settle their tax accounts on the surrender or maturity of the policy. Providing policyholders with a choice is likely to cause administrative problems in advising appropriate details on a regular basis. Many policyholders would rather not complete tax returns on an annual basis (particularly the case for lower tax rate payers).
  • The return on the policy would be determined as claim payments made on the policy; less premium payments. This return is equivalent to the value of investment returns less management fees net of corporate taxation.
  • The assessable income of the policyholder would be this return grossed up for corporation tax.
  • The imputation credits on the policy would be determined as the assessable income multiplied by the corporation tax rate. These imputation credits would be an offset to the amount of tax payable at the policyholder’s marginal income tax rate.
  • In parallel with this process of policyholder taxation, life insurers would pay corporation tax on policyholder investment income and gains when realised net of management fees. Any delay in paying tax on realised gains is unlikely to exceed the delay a policyholder obtains by not paying tax until the termination of the policy.