Submission No. 279 Back to full list of submissions
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Supplementary Submission to the Review of Business Taxation

Institute of Actuaries of Australia

May 1999


3 May 1999

The Secretary
Review of Business Taxation
Department of the Treasury
Parkes Place

Dear Sir

Review of Business Taxation – Pensions and Annuities

Further to our submission dated 19 April 1999, the Institute is pleased to forward a supplementary submission on the proposals to reform the taxation of life insurance annuities and superannuation pensions.

We have been endeavouring to develop a standard approach for pensions and annuities that could apply to superannuation funds and life insurers.

Significant progress has been made, however there are a number of issues that remain unresolved at this stage. We have indicated these issues in this submission.

Competitive neutrality will only be achieved, if the forces of supply and demand are consistent across all types of pensions and annuities. This requires competitive neutrality across all forms of superannuation as a prerequisite.

Once the Review has chosen the preferred approach to achieve consistency across all forms of superannuation further consultation may enable resolution of outstanding issues relating to pensions and annuities.

However, the Institute’s preferred position remains that this aspect of taxation should not be reformed without an overall review of the superannuation taxation system. To do so runs the risk of adding further instability to the complex and unstable superannuation system. It may also lead to outcomes that are inconsistent with longer term retirement income policy objectives of encouraging the use of income streams in retirement.

Yours sincerely


Richard Mitchell

Part I Detailed Findings

1. Supplementary Submission

This supplementary submission should be read in conjunction with our primary submission of 19 April 1999. Section 5.2 of the primary submission stated:

"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."

Attachment III contains detailed responses to the key issues raised in Chapter 34 relating to pensions and annuities provided by life insurers.

Attachment IV contains detailed responses to the key issues raised in Chapters 34 and 37 from the perspective of a superannuation fund with current pensioners.

The main unresolved issue is a preference for a passive interest rate approach for life insurers’ pension and annuity business (provided suitable transitional rules for existing business can be formulated) and a preference for a segregated asset approach for superannuation funds.

The Institute will continue to consider these issues and provide any further assistance to the Review that is possible over the coming months.

A. Refer to first submission for Attachments A & B


C. Attachment III – Life Insurance Pension and Annuity Business

C1. Taxation of allocated pension and allocated annuity business administered in the statutory funds of a life insurer

Currently, the investment income credited to policyholders in respect of these lines of business is zero taxed and the Institute strongly recommends this should continue to apply.

The methodology used to determine shareholders’ assessable income for these lines of superannuation business should be consistent with the methodology finally adopted in respect of taxable superannuation business.

The Institute put forward two possible approaches for taxable superannuation business in our 19 April 1999 submission. These were denoted the RSA approach and the PST approach. Under either approach shareholders’ assessable income for these lines of business would be taxed at the corporate rate.

The application of the RSA approach for these lines of business would require that the amount of policyholder investment income (excluding unrealised gains) credited to these policies would need to be quantified and that this investment income would continue to attract a zero tax rate.

The application of the PST approach for these lines of business would require that the investment income on policyholder funds, equal to the current termination values of these lines of business plus applicable smoothing reserves, would continue to attract a zero tax rate. Transfers out, at the end of the financial year, would be taxed at the corporate rate.

Note that under either approach, management fees paid by policyholders for these lines of business would receive no tax relief because their investment income attracted no tax.

C2. Taxation of immediate annuity and superannuation pension business administered in the statutory funds of a life insurer

Superannuation pension business written by a life insurer is contractually identical to immediate annuities. For both types of business, the life insurer, at the point of sale, guarantees future payments.

Management fees are not discernible nor is the yearly amount of investment income attributable to a particular annuitant.

For immediate annuity and superannuation pension business, we understand that the intention is that no tax applies to the investment income attributed to policyholders.

The Institute understands that the intention, for these lines of business, is that the corporate tax rate applies to the following items:

  • underwriting profits, plus
  • investment income attributable to supporting shareholder funds.

In principle, the Institute supports this intention, which means that interest on reserves representing monies held back and payable to policyholders in future years should not be taxable.

We also note that the proposed solutions in the consultation document are fundamentally different for fixed term and life time contracts. This may be quite difficult to apply because many annuities are a ‘hybrid’ contract where payments are initially payable independently of the survival of the annuitant (ie a fixed term contract) but after a period of time the continuation of the payments is totally dependent on the survival of the annuitant (ie a life time contract).

There are no compelling actuarial reasons why the same approach could not be successfully applied to fixed term, life time and ‘hybrid’ immediate annuity and superannuation pension contracts. Therefore, the Institute does not support the application of fundamentally different approaches to these contracts.

We have examined issues impacting all these lines of business in considerable detail. We believe the preferred approach for new business should be along the lines of that outlined in A Platform for Consultation for fixed term immediate annuity contracts.

This could be achieved for new business by taxing profit defined as:

  • Premiums; plus
  • Investment income; less
  • Expenses; less
  • Annuity and pension payments (claims); less
  • The change in liability (not reduced for the investment income credited to policyholders).

The change in liability for immediate annuity and superannuation pension business has to allow for the following:

  • Be consistent with the investment income definition.
  • Ensure that the impact of changes in prevailing market interest rates, which can produce temporary profits and losses, is avoided.

We interpret the suggestions in A Platform for Consultation for fixed term immediate annuities to imply that the change in liability could be determined on a passive or ‘original pricing interest rate’ basis. This passive approach is quite capable of being applied to fixed term, life time and ‘hybrid’ contracts.

The change of liability would be determined using the same interest rate in each period without regard to the prevailing market interest rates. The interest rate used would instead be based on interest rates that applied at the time the annuity or pension was purchased.

This passive approach is in line with the methodology set out in Example 34.2, which uses the ‘effective rate of return’ as the ‘original pricing interest rate’.

Although this passive approach would tax appropriate amounts of shareholder profit, it should be noted that it would be administratively quite difficult and potentially expensive to apply in practice. This gives rise to considerable reservations as to the practicality of the proposed approach for existing business (see below).

Nevertheless, if adopted, the parameters supplied by this calculation would provide a basis for calculating a deduction on the "passive" basis in each successive year.

In order to avoid the operation of discretions, it may be necessary to specify a basis for projected mortality, and periodically to revise the calculation when these assumptions are changed.

At this stage, time has not allowed the Institute to examine the most appropriate method to determine an ‘original pricing interest rate’. The use, in Example 34.2, of the ‘effective rate of return’ is one of a number of methods that could be employed to determine an appropriate ‘original pricing interest rate’.

C.3 Grandfathering of immediate annuity and superannuation pension business already issued by a life insurer

As stated in our 19 April 1999 submission, 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 management fees (explicit or implicit) used to recoup acquisition expenses that were not deductible because they were incurred prior to the start of the new system). Transition rules may be needed to provide relief on this latter point.

Approach 1: Passive approach

The difficulties with the above ‘passive’ approach are especially severe for the existing business of a life insurer, which would need to be divided into groups (or possibly dealt with at individual policy level), where each group (or annuitant) would have a different "original pricing interest rate". As insurers frequently change pricing rates, sometimes as often as weekly, even under a grouped approach, a multitude of such groups would need to be established.

The capital value would then be established at the point of implementation, and taken into account as both a notional "premium" and a carried-forward liability.

Although this approach is workable in theory, it should be noted that there is generally no facility for changing the expense charges applicable to this business after the point of sale, and so the administrative cost of any change in approach would inevitably fall on shareholders. Also, the original pricing of this business would not have anticipated the future taxation of underwriting profits. Therefore changes to the ‘status quo’ for existing business are unfair as between the investor and the provider, and might do lasting damage to an insurer.

Approach 2: Segregation approach

Having regard to all the above issues, an alternative approach for existing business would be to segregate the assets supporting the existing business of life insurers based on the Capital Adequacy Standard rather than current termination values that could apply to unbundled contracts where flexibility exists to modify the pricing basis during the duration of the contract.

The segregated fund size would be determined each year in accordance with Actuarial Standard 3.01 (the Capital Adequacy Standard) but excluding any components for resilience reserves, inadmissible assets and new business reserves. Therefore, the segregated fund would not capture substantial supporting shareholders capital. Thus, the aim of taxing investment earnings on shareholder’s supporting capital is maintained. Each year the size of the segregated fund would be reset based on the Capital Adequacy Standard.

The prudential requirements for this business when issued by a life insurer have, at this point of the interest rate cycle, frequently required considerable recent injections of shareholders capital to demonstrate solvency. If market interest rates increase in the future this capital will be released back to shareholders. It is the opinion of the Institute that the taxation of the return of this capital as ‘profit’ would be inappropriate. Therefore, transfers out of or into this segregated block at the time of the once a year resetting should not be taxable nor tax deductible. Investment earnings on this segregated block would continue to be zero taxed.

To avoid abuse, the movement of assets out of this segregated block, other than at the time of the once a year resetting, would be subject to tax.

Because of the complexity of issues relating to life insurers existing immediate annuity and superannuation pension business, we believe that a consultation process with Institute representatives is required to work through this detail to facilitate a satisfactory outcome.

D. Attachment IV – How Should a Superannuation Fund’s Pension Business be Taxed?

D.1 Introduction

The implementation of the proposals put forward in A Platform for Consultation would result in:

  • significantly increased administration requirements and costs for many superannuation funds currently providing pensions;
  • a considerably more complicated taxation system when compared to the current system; and
  • increased taxes payable on pension assets.

Before implementing a new and more complicated taxation system for pensions and annuities, we strongly urge the Review to attempt to resolve any specific problems with the current system first. We would be pleased to assist the Review to deal with any problems that are identified.

There are three major issues with the proposals as they currently stand which need to be clarified. These are discussed below.

Finally, the proposals do not seem to take into account the different nature of many superannuation funds. For this reason, we have also provided some background information on superannuation pension funds.

D.2 Background Information on Superannuation Pension Funds

Superannuation funds (ie funds with a trustee structure) which can and do provide pensions, range from the very large to the very small funds and include:

  • Employer sponsored funds;
  • Industry funds;
  • Excluded (ie self managed) funds;
  • Life office funds; and
  • Public offer (retail) funds.

Many of these superannuation funds are non-profit funds. Therefore, expenses have to be borne by the members as there are no surplus assets or profits to absorb additional costs.

Many self-managed funds (ie those funds with currently less than five members, now redefined as "self-managed" superannuation funds) provide pensions. These pensions are not limited to allocated pensions, but can now include fixed term and lifetime pensions subject to regular actuarial control and sufficient reserves.

Within the different types of superannuation funds there can be:

  • A mixture of pension and non pension liabilities or pension liabilities only;
  • Allocated, fixed term and lifetime pensions;
  • Any number of pensioners ranging from one to many, regardless of the type of pension provided.

Superannuation funds providing certain pensions will be required to hold reserves higher than otherwise required if market interest rate assumptions were used on commencement date. In particular, APRA has recently advised the Institute of Actuaries that this is the case for fixed term and lifetime pensions. Therefore, it must be emphasised that the level of reserves required is not always of the trustee choosing.

D.3 Current "Income" Proposals For The Taxation Of Pensions

The proposals outlined in sections 34.43 to 34.57 of A Platform for Consultation would result in three different taxation arrangements for allocated, fixed term and lifetime pensions. All three arrangements are based on the following concept:

  • That all superannuation fund investment earnings would be included in assessable income (to be taxed at 15%); with
  • A deduction provided for the interest credited to pension accounts.

The three major problems with the current proposals are as follows:

  1. No account is taken of the interest credited to reserves held solely for the benefit of pensioners.
  2. The proposals require the calculation of a "notional" interest credited to fixed term and lifetime pensions each year.
  3. No account is taken of the realised versus unrealised components of any interest credited to pension accounts.

No account taken of reserves:

Superannuation funds often hold reserves solely for the benefit of pension beneficiaries. These reserves can be:

  1. Investment reserves used to smooth the earning rates credited to allocated pension members each year;
  2. General reserves used to protect the superannuation fund against investment risk in the case of fixed term pensions and investment and mortality risk in the case of lifetime pensions (especially in relation to continued reduction in mortality rates leading to pensioners living longer and requiring greater reserves); and/or
  3. In the case of increasing pensions, monies held pack to be paid out at a later time.

For example, where a superannuation fund has an investment reserve, the annual interest rate credited to an allocated pension account will usually be more or less, but not equal to, the actual interest rate earned. The current proposals do not address the situation where the interest credited exceeds the actual interest rate earned in a year. Can this "loss" be used to offset other non-pension earnings? Can the "loss" be carried forward?

Calculation of notional interest credited to fixed term and lifetime pensions:

The current proposals require the calculation of a "notional" interest credited to fixed term and lifetime pension accounts each year.

Superannuation funds do not currently have the systems in place to calculate this notional interest. Although the larger superannuation funds and those funds operated by life offices have the capacity to develop systems to handle a passive interest rate approach, the majority of superannuation funds could not implement this approach without incurring significant additional costs. For many funds, particularly the non-profit funds, there would be no option but to pass these costs onto the pension members.

Again, it remains unclear what is to happen to the "loss", when the "notional" interest rate credited exceeds the actual interest rate earned that year.

Realised versus unrealised returns:

The current proposals do not seem to take into account the realised versus unrealised components of interest rates, whether notional or actual.

If it were intended that the deduction would be given for the total notional interest rate, then "tax losses" would arise most years.

If this were not the intention, then in addition to having to calculate a "notional interest rate" the notional rate would have to be split between realised and unrealised gains. Many superannuation funds invest through collective vehicles (such as PSTs etc) where the annual returns are not split between realised and unrealised returns. It is unclear how superannuation funds would be able to make this split on their notional interest rate.

D.4 Alternative "Segregated Pension Asset" Approach

Superannuation funds already have the option of using a segregated pension asset approach (Section 273 of the Income Tax Assessment Act) or unsegregated proportional income approach (Section 283). These approaches work well and it is unclear why they are not considered suitable by the Review. If the potential level of reserves were a problem, then suitable restrictions could be built in to the current approach.

For example, an alternative approach to the one put forward, based on segregated pension assets could operate as follows:

  1. The assets supporting the pensions in payment would be segregated from non-pension assets.
  2. All investment income arising from these segregated pension assets would be taxed at 0%.
  3. There may or may not be a maximum level of reserves that could be held for segregated pension assets (any maximum level should at least equal the level of reserves required by APRA).
  4. Any transfer of assets from the segregated pension assets to the non-pension assets would be taxed, for example, a transfer could be considered to be a realisation of assets and capital gains tax would be payable at 15%.

This approach would be readily accommodated by many superannuation funds large and small, excluding life office funds (see below), as it is consistent with the current practice, albeit with some refinements. The restriction on reserves plus taxation of assets on transfer reduces the potential for abuse.

There are still disadvantages with this option in respect to smaller superannuation funds for which the costs of running segregated assets for a small number of pension members would be significant.

These problems could be resolved by allowing superannuation funds the continued use of the proportional income approach as allowed for under the Section 283 taxation provisions. Section 283 provides an exemption for the proportion of income attributable to current pension liabilities where assets are unsegregated.

The problem with the "segregated pension asset" approach is that it may be unsuitable for many life office superannuation funds and annuity business. This is because the declining interest rate environment has seen many life offices having to inject shareholder capital into their annuity/pension business over the past years to ensure solvency. Over time, this additional shareholder capital may no longer be required. Under this method, transfers of capital back to shareholders could be taxed unless suitable protection mechanisms existed.

D.5 Conclusion

The existing taxation system based on segregated assets or proportional income works well for superannuation funds. Before implementing any new and more complicated system, we urge the Review to consider retaining the current approach and resolving specific problems rather then requiring all superannuation funds to adopt new and more complicated practices.

In particular, the current "segregated pension assets" approach could easily be refined and provides a simpler and cost effective option for many superannuation funds. As this approach could potentially impose an unfair taxation burden on life office pension and annuity business, specific provisions would be required to protect shareholder capital transfers.

The proposals (the "income" approach) put forward in A Platform for Consultation may be a viable approach for life office business and possibly some of the larger superannuation funds but would impose significant additional costs and complexities on many superannuation funds, particularly, smaller funds.

There are problems with the current proposals, which need to be clarified or resolved.

The different nature of many superannuation funds, may require a greater level of flexibility in the solution. That is, it may be necessary to allow some superannuation funds a choice as to the taxation system adopted for their pensions.