Tax allowance in Unit pricing

Hi - don't worry, this is a really tricky part of the course. Let's work through each of these points in turn.

If the fund is open to new business, the net cashflow direction will be in - so the company probably doesn't have to sell its assets right now in order to meet cash outflows. So it won't be realising its existing unrealised gains until a few years' time, whenever it decides to sell the assets.

If the fund is invested in equities or property, the company doesn't pay tax on unrealised gains on these assets but it does have to pay tax on realised gains. If we let the unit prices increase in line with the unrealised gains without making any adjustment for tax, and then we only reduced the unit prices once the tax was actually payable (ie when we actually sell the assets) that would be unfair to those who were hit by the tax bill at the asset sale date, relative to those who exited the fund with the benefit of the unrealised gains shortly before that date without making any contribution to the tax bill.

Hence it is fair to deduct tax from the unrealised gains within the unit pricing. But we can allow for discounting in this deduction because the tax isn't due to be paid now - it is only payable once the asset is sold at a future date.

Therefore one approach is to allow for this tax by deducting the following from the asset value within the fund:
Unrealised gain (with indexation allowance if appropriate) x tax rate x v^n
where v is the net of tax investment return expected to be earned on assets held in the fund
and n is the number of years before the gain is expected to be realised (and thus the tax is expected to be payable).

However, rather than performing this calculation with explicit assumed values of v and n, some companies just replace {tax rate x v^n} with a lower tax rate (say 15% rather than 20%) to make an approximate allowance for discounting. This is a more pragmatic approach.

 

Yes, that's right. The tax rate used is normally the policyholder tax rate (since we are taxing the 'I' part of 'I-E' rather than taxing profits), so if the gross rate is 7% the net rate would be 5.6%.

 

The phrase used is 'a lower discounted tax rate' not 'a lower discount rate'. So it means that {tax rate x v^n} is lower (eg using 14% rather than 15% in the short-cut version above). Equivalently, the base tax rate is being more heavily discounted, to arrive at a lower discounted tax rate. Thus the value placed on a deferred tax liability or asset will be lower.

Hope that helps to clear this up?