Taxation in practice
The general principles of life insurance taxation can lead to very different results between jurisdictions. The UK provides an example of a system that distinguishes between the policyholder and shareholder shares of income; the other country examples show alternative ways of taxing contributions, investment growth and benefits.
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Life insurance taxation in the UK
Classification of business
In the UK, life insurance business has to be split between two tax categories:
Basic Life Assurance and General Annuity Business (BLAGAB), mainly comprising life assurance savings, plus general (non-pension) annuities, and some historic protection business. 'General annuities' are annuities that are not purchased using the proceeds of (tax advantaged) pension arrangements, but are instead purchased using individuals' savings which they have accrued from taxed income.
'Protection business' is broadly defined as a life insurance contract under which the benefit payable cannot exceed the value of premiums paid, except on death or sickness/disability. This would therefore include standard term assurance and critical illness business, but not endowment assurance or whole of life assurance savings contracts where significant surrender or maturity values can accrue. Protection business written on or after 1 January 2013 is generally treated as non-BLAGAB. Earlier business may remain in BLAGAB, subject to transitional provisions. HMRC guidance.
Non-BLAGAB business, mainly comprising pension business, other tax-advantaged products, more recent protection business, income protection insurance, and overseas business. Other tax-advantaged products included in non-BLAGAB include tax-exempt savings schemes such as those that are set up as savings funds for children. 'Overseas business' refers to policies that are written on the lives of policyholders who live in other countries.
If a company has only an immaterial amount of BLAGAB business, it would be taxed wholly on a non-BLAGAB basis. Investment returns on BLAGAB unit-linked business are also separately identified from the rest of BLAGAB investment returns.
Policyholder taxation
Term assurance and critical illness insurance
Premiums are payable from post-tax earnings. Investment earnings are immaterial for such business. Benefits paid under ordinary personal protection policies are generally free of income tax; inheritance tax and business-owned policies require separate consideration.
Life assurance savings products
Life assurance savings products include endowments and whole of life assurances.
Premiums are payable from post-tax earnings.
Investment earnings that accumulate within the policy are subject to the insurer’s I-E tax computation. The policyholder share is taxed at the applicable policyholder rate.
Benefits in excess of the premiums paid (known as the 'chargeable gain') may be taxable, though this is not necessarily the case on death, maturity, or late surrender for some products. Some policies, classed as 'qualifying policies', are not taxed on death, maturity, or surrender at late durations. However, such policies are less commonly sold now due to restrictions imposed on them (e.g. relatively low maximum premium). For many UK policies, a chargeable-event gain carries a non-repayable basic-rate tax credit. Further income tax depends on the policyholder’s circumstances, including the effect of the gain on their tax bands and any available reliefs. The chargeable gain is determined by statutory rules and is not always simply the cash benefit less all premiums paid.
General annuities (purchased life annuities)
Premiums are payable from post-tax earnings.
Benefits and investment earnings are taxed on part of the benefit received at the policyholder's full marginal tax rate. Each annuity payment received by the policyholder comprises a return of part of the policyholder's premium (the capital content) and part is, in economic terms, interest (the income content). The return of premium element of the annuity payments is free of UK income tax. The remaining proportion of each payment is subject to taxation as income (which is essentially how the investment earnings accumulated within the policy are taxed).
In broad terms, the return of premium element is obtained by dividing the purchase price of the annuity by the individual's life expectation (as given in prescribed mortality tables).
Pension products
The UK pension taxation system is broadly described as having an 'EET' basis: exempt contributions, exempt investment return, and tax on access to benefits.
Contributions can obtain tax relief, subject to conditions. The limit on relief for an individual’s contributions and the annual allowance are separate tests. The former generally depends on relevant earnings, with provision for some relief where earnings are low or absent. The annual allowance measures pension saving, including employer contributions, and can give rise to a tax charge. Carry-forward and reduced allowances can also apply. HMRC explanation of the annual allowance
Investment earnings generally accumulate free of tax within the pension, subject to restrictions. Certain investments, such as residential property and tangible moveable property held through investment-regulated pension schemes, can give rise to tax charges.
Benefits are partially tax-free, with the remainder generally taxable as income. A tax-free element of up to 25% is normally available, subject to the individual’s remaining lump sum allowance and any protection. This can be taken through different withdrawal arrangements; it need not all be taken when retirement first begins. Annuity income, taxable drawdown withdrawals and the taxable part of cash withdrawals are subject to income tax. Government guidance on the lump sum allowance
Death benefits have their own rules. Their treatment depends on matters such as the age at death, the form and timing of payment, and the applicable allowances.
Life insurance company taxation
Apportionment between tax funds
Because BLAGAB and non-BLAGAB business are taxed differently, it is necessary to divide out companies' trading profits and 'I-E' between these two categories.
In some cases, this split is clear (e.g. for linked business, or for premiums and claims), but in other cases apportionment is necessary (e.g. for assets which are not segregated between life and pension business, or for surplus assets). In other words: profits, investment income, capital gains, and expenses each need to be separated between those items which are to be treated as BLAGAB and non-BLAGAB. UK tax legislation provides principles which set out how such items should be apportioned between BLAGAB and non-BLAGAB. For example, if annuity liabilities are matched with bonds then tax authorities will expect the investment returns from those bonds to be allocated to the annuities for taxation purposes.
Tax calculations are more straightforward for companies where life assurance savings and pension assets of the company are clearly segregated (such as may be the case for purely unit-linked business). However, where all of a company's assets are managed together they may need to be apportioned for the purpose of tax calculations.
Non-BLAGAB
Non-BLAGAB business is taxed in the same way as the profits of any UK trading company. This reflects a government aim of tax being broadly equivalent for all companies. This means that insurers are liable to pay corporation tax on taxable trading profits, starting from the entity’s accounts and making the adjustments required by tax law. The Companies Act accounts are the published accounts prepared by all UK trading companies. These accounts may be prepared in accordance with IFRS or UK GAAP. Accounting losses can be used to offset profits in other tax years or in other companies within the group (subject to some restrictions).
BLAGAB
BLAGAB business is taxed on an 'I-E' basis and is subject to the minimum profits test.
The UK minimum profits test works as follows:
The shareholder share of dividends received is excluded from the minimum profit calculation (since dividend income is not included in I-E, against which the trading profit is compared).
The minimum taxable amount is restricted to be no less than zero (with losses carried forward, subject to restrictions).
The shareholder profit part of the taxable amount is taxed at the corporation tax rate and the policyholder part is taxed at the applicable policyholder rate.
Under UK tax law, the 'I-E' figure is calculated as follows:
'I' includes the following:
All investment income, other than dividend income from equities.
Realised chargeable gains on equities and properties, with some historical allowance for indexation (based on RPI up to the end of 2017, but not after this).
Unrealised chargeable gains on collective investment schemes holding equities and property (spread over 7 years).
Mark-to-market capital movements in gilts, bonds, and most derivatives. This means that gilts are taxed on their total return over the year. No indexation of capital movements in fixed-income assets is allowed (though index-linked securities do receive the benefit of indexation of capital gains).
'E' includes the following:
Expenses (with acquisition expenses spread over 7 years).
The income component of general annuities, reflecting the fact that this is taxed in the hands of the policyholder (which is included in the 'E' so that it is not double-taxed).
The carry forward of any XSE from the previous year.
Deferred tax
Because capital gains on directly held equities and property may not be taxed until they are realised, a tax liability can build up before payment is due. Allowance may also be needed for amounts whose taxation is spread over several years.
The basis of the allowance depends on its purpose. In IFRS financial statements, deferred tax assets and liabilities are not discounted. Solvency II also has specific rules for recognising and valuing deferred tax, including the need for probable future taxable profits before recognising an asset. These balance-sheet rules should not be confused with the allowance for future tax used in unit pricing or asset shares. IAS 12, paragraph 53; Solvency II deferred tax rules
For unit pricing and asset shares, the aim is to achieve fairness between policyholders. An economic allowance for future tax may take account of when gains are expected to be realised and, where appropriate under the fund’s pricing basis, discounting.
The variables affecting such an allowance within a BLAGAB internal linked equity fund include:
The size of the unrealised capital gain or loss to date, allowing for historical indexation where appropriate.
The time until gains are expected to be realised.
For losses, the further time until they can be offset against gains, and whether sufficient gains are expected.
The tax rate expected to apply when the gain or loss is realised.
Where the pricing basis uses discounting, the discount rate and its consistency with the expected net return on the fund’s assets.
A deferred tax asset may be recognised for losses only where the relevant recognition conditions are met; a loss does not automatically have its full nominal tax value.
Life insurance taxation in jurisdictions other than the UK
Ireland
Classification of business
In Ireland, life insurance business can be categorised into the following categories:
'Old basis business', written before 1 January 2001, which receives similar tax treatment to UK BLAGAB business.
'New basis business', written on or after 1 January 2001, which is taxed on a gross roll-up basis.
Policyholder taxation
For 'new basis business', investments are allowed to accumulate tax-free within the life insurance company until a chargeable event occurs (e.g. maturity, surrender, or an eight-year deemed disposal).
At the point of a chargeable event occurring, Life Assurance Exit Tax (LAET) is due on the gain made by the policyholder on the policy (i.e. on the excess of the policy benefit over the value of the premiums paid). The Life Assurance Exit Tax rate is specified separately from income and capital gains tax rates. A chargeable event can arise at each eighth anniversary even if no cash is paid to the policyholder. Irish Revenue guidance. Where a benefit is paid, the insurer deducts the tax and pays it to the tax authorities. At a deemed disposal, tax may instead be met from the policy’s assets, with credit allowed against later tax where the rules provide for this.
Pensions business is subject to separate tax rules, with contributions receiving tax relief (subject to limits) and benefits being taxed as income.
Life insurance company taxation
For 'old basis business', the shareholder profit component is taxed at the applicable corporation tax rate and the policyholder component is taxed at the applicable policyholder tax rate. 'New basis business' is taxed on profits at the corporation tax rate.
USA
Policyholder taxation
In the USA, life insurance business generally benefits from the gross roll-up of investment earnings. Death benefits from life assurance products are generally not taxable.
On a full surrender, the excess of proceeds over the policyholder’s adjusted investment in the contract is generally taxable as income. Partial withdrawals and loans can have different treatment. Heavy early funding can cause a policy to be classed as a modified endowment contract. This changes the ordering and possible additional taxation of distributions; it does not simply remove all recognition of premiums paid. IRS explanation.
Contributions to traditional retirement arrangements, such as the pre-tax component of a 401(k) plan, can be made from pre-tax earnings. Benefits from those pre-tax contributions are generally taxable as income. Roth contributions have a different treatment.
Life insurance company taxation
Life insurers are subject to federal income tax rules, and state premium taxes may also apply. Premium tax rates differ between states. Retaliatory tax rules can impose an additional burden on an out-of-state insurer where its home jurisdiction would tax a comparable domestic insurer more heavily. This should not be treated as a universal rule that corporation tax is paid only in the home state, or that every premium is simply taxed at the higher of two rates.
South Africa
Policyholder taxation
In general, premiums for life assurance products are paid out of post-tax earnings and do not qualify for tax relief, but benefits are not taxable (with some exceptions). There may be a tax charge on benefits if these form part of an inherited amount. Premiums paid into approved pension plans are subject to tax relief up to a defined limit. The division between lump sums and annuity income depends on the type of retirement arrangement, the component of savings involved and applicable protections. Lump sums and retirement income have different tax treatments.
Policyholders are not taxed on the accumulation of investment earnings. This is because (where applicable) tax has already been paid by the life insurer.
Life insurance company taxation
Life insurance companies are taxed using a 'five-fund approach' whereby business is allocated into five categories which are each subject to different tax treatment:
'Individual policyholder fund' - Mostly individual life assurance savings and historic protection policies. A rate of tax is applied that is intended to represent an average policyholder income tax rate.
'Company policyholder fund' - Corporate policies. Taxed at the corporation tax rate.
'Untaxed policyholder fund' - Annuities, policies owned by retirement funds, and other untaxed entities. Accrual of investment returns is tax-free.
'Risk policy fund' - More recent protection policies. Taxed at the corporation tax rate.
'Corporate fund' - All other assets and liabilities. Taxed at the corporation tax rate.
Australia
Classification of business
Business written by life insurers in Australia is split into categories in order to tax each type of business in line with the nearest equivalent of other financial instrument. The aim is to achieve consistency between how insurance and other financial instruments are taxed.
For example:
Protection business is taxed on a similar basis to general insurance.
Savings business is taxed on a similar basis to investment companies.
Pensions business is taxed in the same way as corporate pension funds.
Policyholder taxation
Australian superannuation distinguishes concessional contributions, such as qualifying employer or deductible personal contributions, from non-concessional contributions made from post-tax income. Concessional contributions are generally taxed within the superannuation fund; offsets may be available for eligible lower-income members.
Investment earnings in the accumulation phase are generally taxed, while eligible retirement-phase income streams can receive different treatment. Benefits from taxed funds can normally be taken tax-free from the specified age, subject to the applicable rules. Premiums for non-pensions life insurance business are not tax-deductible, but death benefits are generally not taxed.
Life insurance company taxation
Life insurance taxation in Australia is complex, but broadly aims to tax life insurance business in broadly the same way as the equivalent business of general insurers, investment companies, and corporate pension funds.
China
Policyholder taxation
Premiums for life insurance business are generally not tax deductible, but no tax is payable by policyholders on the accumulation of investment earnings or on benefits received.
Life insurance company taxation
Life insurers are taxed on profits at the corporate tax rate. Until 2016, an additional 5% business tax was imposed on the premium income received by Chinese insurance companies. This was replaced by the inclusion of insurance premiums in the VAT system, under which the treatment depends on the class of insurance and available exemptions. However, life and health insurance that exceeds a one-year term is excluded from this VAT requirement.
Hong Kong illustrates an alternative approach: life insurance taxation can use a deemed-profit basis related to premiums, with an election for an actuarial-surplus basis in appropriate circumstances.
Offshore business
Since the life insurance market operates across borders, certain centres have developed which attract customers from other countries by offering a different tax treatment from their domestic life insurance markets. The policyholder’s country of residence can still tax offshore policies, so gross roll-up offshore does not necessarily mean that the investor escapes domestic tax. Such cross-border business is known as 'offshore life insurance'. For example, offshore life insurance centres in Europe include Luxembourg, Dublin, the Isle of Man, and Guernsey. Offshore life insurance products are normally savings or investment-based, with customers typically being relatively wealthy (and often expatriates).