Tax reliefs (2020 April Q3ii)

[Trevor]

Hi all,

I am trying to understand 2 points in examiner report of 2020 April question 3 ii:

1. "Tax on Profits": if losses are made, tax relief can be differed on initial expenses
2. "I-E": companies that have XSI products can allow for tax relief on term assurance pricing

I want to understand these 2 points more, but I can't seem to find it in the 2021 CMP.

Can anyone direct me to the correct chapter, page, and section where I can find bookwork for these 2 points? So that I can study and understand what the solution really means.

Thanks.

 

[Lynn Birchall]

Hi

Keep in mind that the question is asking about 3 different possible ways in which term assurance business might be taxed. So, they are hypothetical tax systems, rather than the being the actual tax rules described in the Core Reading.

1. Tax on Profits. It's perhaps worth another look at Chapter 7, page 10 and the accounting profit formula and the comment underneath about acquisition expenses.

2. Impact of being XSI or XSE on pricing. Chapter 23, page 13 may be the place to revisit here. being XSI will mean that the company subtracts all of its E in its tax assessment, ie it gets tax relief on all its expenses. Applying it to the term assurance business in this question, this is likely to be a competitive advantage to companies who were able to do this (as expenses are relatively high for term assurance business, and so only needing to include a net of tax amount is an advantage). Just for clarity though, worth me repeating that this isn't how it actually works for term assurance business in the UK under current tax rules - it's a hypothetical for this question.

Hope this helps
Lynn

 

[Trevor]

Hi Lynn, thanks for the sign posting.

My understanding now is:

1. I noted that for non-blagab profit calculation, the expenses is all the one off expense (for UK rule). Referring back to our question which is not necessarily a UK tax rule. For the phrase "defer tax relief", does "tax relief" refer to the excess initial expenses that could have been been deferred just like how the BLAGAB E does it?

So the Examiner Report is saying, if Non-BLAGAB is used, the regulator could consider to spread the initial expenses over the year to even out (smooth) the taxable profits?

2. I am still struggling to understand why a company with XSI position will be at advantage. Although if they have I, then can offset the E from Term assurances.
However, if the new company is already in XSE, there is no tax to pay anyway. Isn't this even better?

Unless we are saying (a rather complex mechanic):
The large company with XSI can take the high E from term assurance to make the overall (I-E) tax lower, then other products that contributes to XSI (unit-linked policies for example) can be priced lower so having more profit.
The term assurance can than be sold at loss (low premium) because the excess profit from the XSI products will offset the term assurance losses. Therefore advantage.

 

[Lynn Birchall]

Hi

1. Yes, that's it

2. I think it's a rather complex mechanism for this one! Comparing:

• a company that is XSI, who when pricing term assurance will have to add in investment return netted down for tax but will be able to subtract expenses also net of tax
• a company that isn't, who when pricing term assurance will add in investment returns gross of tax but will also be subtracting gross expenses.

For a term assurance, with its low investment returns and high expenses, the downside of net of tax investment returns is smaller than the upside of getting tax relief on the expenses, so the XSI company has an advantage.

Lynn

 

[Trevor]

Hi

1. Yes, that's it

2. I think it's a rather complex mechanism for this one! Comparing:

• a company that is XSI, who when pricing term assurance will have to add in investment return netted down for tax but will be able to subtract expenses also net of tax
• a company that isn't, who when pricing term assurance will add in investment returns gross of tax but will also be subtracting gross expenses.

For a term assurance, with its low investment returns and high expenses, the downside of net of tax investment returns is smaller than the upside of getting tax relief on the expenses, so the XSI company has an advantage.

Lynn

Hi Lynn, thanks for the mechanics for item 2, but I still can't understand them.
Since a term assurance will have more expense than investment return, wouldn't both companies have 0 tax on it anyway?
If not, why is the XSI company including Investment and Expenses net of tax, but the XSE company is using the gross figure?

If possible, do you mind demonstrating the difference with a very basic numerical example? I am not too comfortable writing something I don't understand (or blind-memorised) in the exam.

 

[Lynn Birchall]

Since a term assurance will have more expense than investment return, wouldn't both companies have 0 tax on it anyway?

No. Remember that the tax is worked out by looking at all different policies in the same tax fund in aggregate, we don't 'separate out' the term assurance policies or do it on an individual policy basis.

Some completely made up numbers ...

Imagine we're pricing a term assurance policy and the cashflows we're including in our profit test include an investment income of +100 and an expense out go of -500. Of course there will be lots of other cashflows (premiums, claims, ....) but let's ignore those.

A company that is XSI (because it has other policies in the same fund that result in having more investment return than expenses in aggregate) will pay tax on the investment return and get tax relief on the expenses. Assuming a tax rate of 20% (say) this gives it a net investment cashflow of +80 and a net expenses cashflow of -400.

The other company doesn't pay tax on the investment return but nor does it get tax relief on the expenses. so it includes the gross figures of +100 and -500 when doing its profit test.

All else being equal, the XSI company (+80-400=-320) will end up with more competitive pricing than the other company with (-400)

Hope that helps a bit! As we said earlier, all 'hypothetical' tax system so I wouldn't worry too much about this idea

Lynn

 

[Trevor]

I see, so the idea is we want to "trigger" the tax payment so that we can make use of the tax relief on the expenses.
Thanks a lot!

The reason I am very keen to understand this is because I came across similar idea in the earlier past paper (2010 April Question 2 iv). It is also in the 2020 paper which means it is still within the scope and I should not ignore it as a question could be set on some jurisdiction who is still considering protection business on a BLAGAB basis.