Implementing the fair dividend rate and certain equity capital gains exclusions in life insurance

Sections CX 55, EY 43, EY 43B, EY 43C, HL 2, HL 3, HL 5B, HL 11, HL 14 and YA 1 of the Income Tax Act 2007

Under current life insurance tax rules, a life insurer pays tax on what is commonly referred to as the life office base (which taxes all income from the business of life insurance) and policyholder income (which taxes net investment income accruing to policyholders). Tax paid on the life office base generates imputation credits which can be used to meet the policyholder income tax liability. The amendments discussed below integrate fair dividend rate (FDR) and certain portfolio investment entity (PIE) rules into the life insurance rules.

The FDR treatment of portfolio share interests in non-resident companies other than Australian-listed companies has been extended to a life insurer's policyholder income calculation. The change is intended to correct an anomaly arising from implementing FDR for life insurers.

Life insurers can also elect to have New Zealand and Australian-listed equity gains from investment-linked insurance products excluded from tax. The change allows policyholders with investment-linked life insurance products to access some of the benefits of the new PIE rules.

Background

Under recent changes to the taxation of offshore portfolio equity, all portfolio shares with interests of less than 10 percent in non-resident companies other than Australian-listed companies are taxed on a deemed FDR of 5 percent instead of actual returns (dividends, plus realised gains for revenue account holders). The FDR is effective from the beginning of the first income year beginning after 31March 2007. However, entities electing to become PIEs have the option of making the FDR apply from 1October 2007, regardless of their income year.

The FDR is applied to the relevant non-Australian listed foreign equities when calculating tax on the life office base as this is done using standard tax rules. However, tax on policyholder income is calculated on actual returns (through movements in reserves) of those equities rather than by the FDR method. The policyholder income tax calculation therefore required a change so that the FDR applies to both calculations.

While life insurers are allowed to invest through PIEs, a life insurance fund cannot be a PIE itself. If a life insurer invests through a PIE, then realised New Zealand and Australian-listed equity gains are excluded from the life office base calculation by the operation of section CX 55. Some life insurers offer products known as investment-linked funds. These products are similar to managed funds, and should be able to benefit from the Australasian equity gain exclusion. The amendments extend this exclusion to the life office base and policyholder income calculations of these products.

Key features

Life office base

Section CX 55 extends the exclusion of realised New Zealand and listed Australian equity gains to a life insurer, for the part of the business that is a "portfolio investment-linked life fund".

A "portfolio investment-linked life fund" is defined in section YA 1 to mean a fund where investments are held, subject to a life policy under which benefits are directly linked to the value of investments held in the fund. The portfolio investment-linked life fund must also be eligible to be, and elect to be, and has not ceased the election to be, a portfolio investment entity. New sections HL 3(7), (8), (9), (10) and (11) prescribe the eligibility requirements for life insurers to be a portfolio investment entity. New section HL 5B (1)(c) defines an investor in a portfolio investor entity which is a portfolio investment-linked life fund (not held through a portfolio investor proxy), as "a person whose benefits under the relevant life insurance policy are directly linked to the value of investments held in the portfolio investment-linked life fund".

Life insurers who elect into the new rules will have a deemed disposal of the excluded shares with any tax to pay spread over a period of three years, pursuant to section HL 14 (2).

Policyholder income

The policyholder income formula in section EY 43 (1) has been amended by amounts referred to in subsection (5B) as the "FDR adjustment" and in subsection (5C) as the "PILF adjustment". The amount of these adjustments are determined by whether the relevant equities are held on behalf of policyholders in portfolio investment-linked life funds, or in other life insurance products.

For the FDR adjustment, FDR income attributed from portfolio investment entity investments other than by portfolio investment-linked life funds are excluded from policyholder income. For the PILF adjustment, FDR income and New Zealand and Australian-listed equity gains derived by portfolio investment-linked life funds are also excluded.

FDR adjustment

New section EY 43B describes the "FDR adjustment" for life insurance savings products other than for those in portfolio investment-linked life funds with an attributing interest in a FIF, or a "portfolio tax rate entity" that the life insurer has directly or indirectly invested in, and for which the FDR is used. These include traditional participating life insurance savings products such as whole of life and endowment policies, and also investment-linked products which the life insurer has not elected to be portfolio investment-linked life funds.

The definition of a "portfolio tax rate entity" in section YA 1 has been amended to not include a portfolio investment-linked life fund. For the purposes of section EY 43B (1), subsection (2) provides that a life insurer is treated as indirectly investing in a portfolio tax rate entity (PTRE A) when a portfolio tax rate entity has invested in PTRE A and the investments may be traced back through an unbroken chain of investments in portfolio tax rate entities to a direct investment by the life insurer in a portfolio tax rate entity.

The life insurer may calculate the FDR adjustment either under the formula contained in subsection (5), or based on adjustments of actual amounts credited. The formula in subsection (5) is:

0.6 x (FIF result - FDR income)

"FIF result" is defined in subsection (7) as the life insurer's gains and losses for the income year, for the property, calculated using accepted accounting practice.

"FDR income", which is defined in subsection (8), refers to the amount of FDR income on that property, calculated using any reasonable method for the information available to the life insurer. It will be the same amount that was calculated in the life insurer's life office base income calculation.

The "0.6 factor" is a typical amount of the income included from these products in the annual policyholder base calculation and is used to minimise compliance costs.

As the intention of the provision is to ensure that the correct amount of policyholder income is taxed, as an alternative the life insurer can, using any reasonable method for the information available to the life insurer, use actual amounts credited to actuarial reserves of the relevant income after allowing for the FDR method to be applied. As a practical matter, it is anticipated that life insurers would adopt this approach rather than the formula in subsection (5), except if the actual allocation cannot be accurately calculated or if the compliance costs to do so would be material. The allocation method adopted must be used consistently between income years to prevent artificially maximising the policyholder income exclusion.

PILF adjustment

New section EY 43C (1) to (9) prescribes the "PILF adjustment" for assets held in a portfolio investment entity to the extent to which property that the life insurer holds to support actuarial reserves for a portfolio investment-linked life fund is:

• an attributing interest in a FIF held by the life insurer directly or by a portfolio tax rate entity that the life insurer has invested in directly or indirectly, and for which the life insurer or portfolio tax rate entity uses the FDR; or
• shares described in section CX 55 (Proceeds from certain disposals by portfolio investment entities or New Zealand Superannuation Fund).

In using the policyholder income formula, the life insurer can choose to calculate the PILF adjustment by either using the formula in subsection (5) or based on adjustments of actual amounts credited. The formula in subsection (5) is:

0.9 x (FIF result - FDR income) + 0.9 excluded shares

The part of the formula (FIF result - FDR income) is effectively the same as discussed earlier. The adjustment factor of 0.9 reflects the typical amount of income included in policyholder income with these products.

Also excluded from the calculation of policyholder income is 0.9 of "excluded shares". These are defined in subsection (9) and include realised gains or losses of New Zealand and listed Australian equities that were excluded from the calculation of tax under the life office base income calculation, in addition to unrealised gains or losses on those equities, but excludes dividends or distributions from these shares other than from a portfolio tax rate entity to which section CX 56 (2) applies.

Life insurers can, using any reasonable method for the information available to the life insurer, use the actual amounts credited to actuarial reserves of the products, after allowing for the FDR method and dividends or distributions from New Zealand and Australian-listed equities other than a distribution from a portfolio tax rate entity to which section CX 56 (2) (Portfolio investor allocated income and distributions of income by portfolio investment entities) applies. The allocation method adopted must be used consistently between income years.

Other amendments

Consequential amendments for portfolio investment-linked life funds are contained in sections HL 2(2), HL 3 and HL 11(2B), and to the definitions in section YA 1 for "portfolio investment entity", "portfolio listed company" and "portfolio tax rate entity".

Application date

The new sections are treated as coming into force on 1October 2007.

The FDR adjustments and PILF adjustments will be effective from:

• the beginning of the 2008-09 income year; or
• on or after 1 October 2007, if an election by the life insurer to do so is received by the Commissioner before 1 April 2008; or
• an income year beginning on or after 1 April 2007 if an election by the life insurer to do so is received by the Commissioner before 1 April 2008.

However, a life insurer can choose that the adjustments do not apply to them by furnishing a return of income for the 2008-09 tax year that ignores the adjustments.