In jurisdictions such as the UK and South Africa, some of the investment return earned by a life insurer is subject to tax in the hands of the insurer, as proxy for taxing the policyholder directly.
Some of the points made in this article may need to be considered in other jurisdictions where tax is charged to a participating fund. Where the UK or South Africa is a material component of a consolidated group of companies, there will likely be implications for disclosures in the group’s financial statements.
Tax in fulfilment cash flows
In general, FCFs include most transaction and product taxes but do not take account of corporate income taxes (which are generally in the scope of IAS 12 Income Taxes). Limited exceptions are made where part of the income tax charge is considered to be policyholder tax. See our article IFRS 17 – Tax Considerations for Insurers as we discuss taxes in FCF more generally (including premium and transaction taxes).
IFRS 17 Insurance Contracts was amended in June 2020 to clarify, amongst other things, which taxes should be included in FCF. This amendment was made following comments, in particular, from UK and South African insurers.
Prior to its amendment, IFRS 17 provided that payments made by the insurer in a fiduciary capacity to meet tax obligations incurred by the policyholder, and related receipts are cash flows within the boundary of an insurance contract. An example of a tax paid in a fiduciary capacity is the withholding of payroll taxes on pension payments. It was not clear, however, whether tax payments made in a fiduciary capacity would include income taxes on investment income where the tax is legally the obligation of the insurer, but the economic cost of the tax reduces the policyholder benefit under the terms of the insurance contract. [IFRS 17.B65(j)]
After the amendment, the revised wording states that the cash flows within the boundary of an insurance contract and hence the FCF include “any other costs specifically chargeable to the policyholder under the terms of the contract” but do not include “income tax payments and receipts the insurer does not pay or receive in a fiduciary capacity or that are not specifically chargeable to the policyholder under the terms of the contract” [IFRS 17.B64(m), B66(f)].
If an income tax cashflow is to be included in FCF, it must either be paid in a fiduciary capacity or be specifically chargeable to the policyholder, which would include income taxes on investment income paid by the company that reduce policyholder benefits.
Points of interpretation
In many cases the tax paid to the tax authority may not exactly equal the tax charged to the policyholder. For example, the company may benefit from a tax deduction for expenses related to the administration of a policy, but that benefit is not passed to policyholders. Also, the timing of tax payments may differ, particularly if taxes are charged to the policyholder on a net present value basis. There may also be tax losses from other parts of the business that reduce or eliminate the external tax liability, but that do not affect the amount of tax charged to policyholders.
As a result, the tax charged to the policyholder is often different from the amount of the tax paid to the tax authority. There could even be no external tax liability and, in such cases, the question arises if there is even a cash flow’ to include in the FCFs.
In many cases, the appropriate amount of tax to include in FCF will be equal to the amount charged to the policyholder rather than the amount of the cash flow to the tax authority. The income tax cashflows included in FCF will generally be equal and opposite to charges made to the policyholders (leading to net nil impacts on FCFs and the contractual service margin).
If tax is charged to a unit-linked fund, then it can be specifically chargeable to the policyholder as there is a direct link to the value of the policyholder’s balance. In contrast, if tax is charged to a participating fund where the crediting rate to policyholders is not mathematically linked to the overall performance of the participating fund, then the charge for tax does not directly affect customer account balances and so the ‘specifically chargeable’ condition may not to be met. [IFRS 17.B64(m)]
Interaction with IAS 12
IAS 12 is not amended by IFRS 17. As a result, including future income tax in insurance contract liabilities should have no direct implications for current or deferred tax accounting. Under IAS 12, current or deferred tax is recognised in respect of investment returns earned to the reporting date (whether realised or not). In contrast, taxes on future investment returns are considered for inclusion in IFRS 17’s FCF.
Care is needed where the insurer has booked a tax credit for losses under IAS 12, but a commercial decision has been made not to immediately add the credit to customer balances. These tax credits will not be part of the policyholder’s account balance at the reporting date but may need to be included in the FCF if they are likely to be credited to policyholders in the future.
Implications for profit or loss
Insurance revenue includes amounts related to income tax that are specifically chargeable to the policyholder. This revenue (being an amount deducted from policy balances) should naturally offset with the IAS 12 current and deferred tax charges included in the income tax line resulting in a broadly nil net impact on profit after tax. [IFRS 17.B121(a), (ia)]
A recurring variance between the tax charged to policyholders (which is accounted for as revenue) and that paid to the tax authority will result in a difference between the revenue and the IAS 12 income tax expense. A recurring income tax variance that will never be charged or credited to policyholders is not an IFRS 17 matter and so cannot be anticipated in advance nor included in the contractual service margin (CSM).
It can be challenging to develop a framework to operationalise these interactions. The revenue from charges made in respect of tax will also need to reflect variances between actual and expected investment returns. Care will be needed on the timing of recognition of this revenue to avoid unnecessary income statement volatility. IFRS 17 requires disclosure of a number of reconciliations. Where relevant, policyholder income tax adjustments will feature in these reconciliations. [IFRS 17.93–109, BC21, BC28]
A strong understanding of how the CSM unwinds, relevant tax laws, deferred tax accounting and the commercial features of the relevant products is essential for insurers. We would like to thank Philip Jacobs and Gordon Gray for their valuable contribution to this article. For more information, please contact a member of the team.