House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 8 - Average calculated liabilities of life assurance companies

Overview

8.1 Schedule 9 of the Bill will amend Division 8 of Part III of the Income Tax Assessment Act 1936 to require life companies to use average calculated liabilities as the basis for determining:

•

the amount of income that relates to immediate annuity policies;

•

the amount of income that is attributable to policies issued by overseas branches; and

•

the amount of income and capital gains to be allocated to each class of assessable income.

Summary of amendments

Purpose of amendments

8.2 The purpose of the amendments is to ensure that average calculated liabilities, rather than calculated liabilities at the end of the year of income, are used by a life company to determine:

•

the amount of income that relates to immediate annuity policies;

•

the amount of income that is attributable to policies issued by overseas branches; and

•

the amount of income and capital gains to be allocated to each class of assessable income.

8.3 The use of average calculated liabilities will provide a more accurate reflection of the liabilities a life company has for policies held during the income year to be used in the assessment of income tax.

Date of effect

8.4 The amendments apply from the first year of income that commences on or after 29 April 1997. However, the amendments will apply to the preceding year of income if a significant event occurred in one of the insurance funds of a life company in the period from 29 April 1997 to the end of that year of income. [Item 10]

Background to the legislation

8.5 Division 8 contains specific provisions that relate to life companies. These provisions include formulae a life company must use to determine how much of its income is exempt from tax because it relates to immediate annuity policies or that is attributable to policies issued by overseas branches (subsections 112A(1) and 112C(2) respectively). Division 8 also includes formulae that must be used to allocate capital gains and non-exclusive assessable income to the four classes of assessable income of a life insurance company (subsections 116CB(2) and 116CE(5) respectively).

8.6 All of these formulae use calculated liabilities at the end of the year of income as their basis. Calculated liabilities are an equalisation of the actuarial valuation of liabilities to ensure uniform treatment between life companies. The valuation of liabilities is the amount which, given a range of assumptions, would provide the amount required to pay in full on maturity the company's life insurance liabilities.

8.7 Using calculated liabilities at the end of the income year can cause distortions to the calculation of a life company's assessable income if the proportion of calculated liabilities for the various classes of policies at the end of the year of income does not reflect the respective proportions of calculated liabilities for those classes of policies held during the year of income. The use of average calculated liabilities as a basis for these formulae will remove these distortions.

Explanation of the amendments

Purpose of the amendments

8.8 The purpose of the amendments is to ensure that average calculated liabilities, rather than calculated liabilities at the end of the year of income, are used by a life company to determine:

•

the amount of income that relates to immediate annuity policies;

•

the amount of income that is attributable to policies issued by overseas branches (that is, by foreign permanent establishments); and

•

the amount of income and capital gains to be allocated to each class of assessable income.

What are average calculated liabilities?

8.9 Item 7 inserts new section 114A which sets out the steps that will be used to work out average calculated liabilities for a category of policies. [New subsection 114A(1)] A category of policies comprises all types of policies issued by a life company. It includes any policies that are in a class of assessable income, exempt policies and eligible non-resident policies.

8.10 The steps that will be used to calculate average calculated liabilities are:

•

divide the year of income into periods [New subsection 114A(2)] ;

•

work out the average calculated liabilities for a category of policies for each period [New subsection 114A(3)] ; and

•

work out the average calculated liabilities for a category of policies for the income year [New subsection 114A(4)] .

Step 1 - Divide the income year into periods

8.11 The income year is divided into periods for each of the insurance funds (which is defined in subsection 110(1) to mean the Australian statutory funds of a life company and any other funds it maintains in respect of it's life insurance business) according to the timing of significant events (if any) in that fund.

8.12 That is, the income year is divided so that:

•

the first period starts at the start of the income year;

•

each later period starts immediately after the last day of the previous period;

•

each period (except the last) ends immediately before the first day on which a significant event occurs in relation to the insurance funds in which policies of the category are held; and

•

the last period ends at the end of the year of income.

[New subsection 114A(2)]

8.13 For example, if no significant events occur in any of the insurance funds of a life company during an income year, the income year will consist of one period which begins on 1 July and ends on 30 June.

8.14 If, on the other hand, two significant events occur in one of the insurance funds of a life company during an income year , the income year for that fund is divided into three periods:

•

period 1 - from 1 July until the day before the first significant event;

•

period 2 - from the day the first significant event occurred until the day before the second significant event;

•

period 3 - from the day the second significant event occurred until 30 June.

Step 2 - work out the average calculated liabilities for each period

8.15 The average calculated liabilities for a category of policies for each period is the amount worked out using the formula:

Calculated liabilities (start of period) + Calculated liabilities (end of period) X Days in period/Days in year of income


8.16 Calculated liabilities of a life company for a category of policies at the start of the period are:

•

if the period is the first period - the calculated liabilities at the start of the income year (this will generally be the amount used as the value of calculated liabilities at the end of the previous income year);

•

otherwise - the calculated liabilities on the day after the significant event that caused the new period to start.

8.17 Calculated liabilities of a life company for a category of policies at the end of the period are:

•

if the period is the last period - the calculated liabilities at the end of the income year (this will generally be the amount used as the value of calculated liabilities at the start of the subsequent income year);

•

otherwise - the calculated liabilities on the day before the significant event that caused the period to end.

[New subsection 114A(3)]

Step 3 - work out the average calculated liabilities for the income year

8.18 The average calculated liabilities for a category of policies for the income year is the sum of the amounts worked out under new subsection 114A(3) for the category of policies. [New subsection 114A(4)]

8.19 If a life company does not experience a significant event during the income year, average calculated liabilities is simply the average of the calculated liabilities at the start and end of the income year.

What are the total average calculated liabilities?

8.20 The total average calculated liabilities of a life company for an income year is the sum of the average calculated liabilities for each category of policies for the income year. [New section 114B]

What is a significant event?

8.21 A significant event, in relation to any of the insurance funds maintained by a life company, will be any event that causes an abnormal change in the amount of the company's policy liabilities in that insurance fund.

8.22 Events that generally do not cause an abnormal change in the amount of a life company's policy liabilities include:

•

policy maturities;

•

new business;

•

death claims;

•

policy transfers under the contract that are initiated by the customer (eg. switching investment units and rollovers to immediate annuities); and

•

changes in the publicly quoted value of units in unit linked funds as a result solely of changes in values of investment incomes and expenses.

8.23 Events that may cause an abnormal change in the amount of a life company's policy liabilities in an income year include:

•

the sale or transfer of a significant amount of the policies to another entity;

•

the transfer of all or a significant amount of the policies of a class of assessable income from an insurance fund; or

•

the transfer of all or a significant amount of the policies of a class of assessable income to an insurance fund.

[Item 1 - definition of significant event]

Exemption of income relating to immediate annuity policies

8.24 Section 112A exempts from tax that part of the income derived by a life company that is referable to, generally, immediate annuity policies. Section 112A is amended so that the basis of calculation of exempt income relating to immediate annuity policies is changed from calculated liabilities at the end of the income year to average calculated liabilities. [Items 2 and 3]

Exemption of income relating to eligible non-resident policies

8.25 Section 112C exempts from tax that part of the income derived by a life company that is referable to eligible non-resident policies. Section 112C is amended so that the basis of calculation of exempt income relating to eligible non-resident policies is changed from calculated liabilities at the end of the income year to average calculated liabilities. [Item 4]

Meaning of calculated liabilities

8.26 Subsection 114(1) defines the term calculated liabilities for the purposes of the 1936 Act. The definition is currently based on an actuarial valuation of the life company's liabilities at the end of the income year. Generally, subsection 114(1) provides that calculated liabilities will be an amount less than that valuation where the basis of the valuation is compound interest at rate of less than four per cent.

8.27 Subsection 114(1) is amended to recognise that a valuation of liabilities may need to be made at any time in the income year because calculated liabilities need to be worked out if a significant event occurs during the income year. [Item 5]

8.28 Subsection 114(2) provides a basis for working out an actuarial valuation of liabilities at the end of an income year if an actual actuarial valuation of liabilities is not made at that time. Subsection 114(2) is redrafted to recognise that an actuarial valuation of liabilities may need to be made at any time in the income year because calculated liabilities need to be worked out if a significant event occurs during the income year. [Item 6]

Apportionment of gains and losses arising from the disposal of fund assets

8.29 A life company's assessable income is divided into four classes of assessable income. Section 116CB apportions gains and losses arising from the disposal of fund assets of a life company between those classes of assessable income. Subsection 116CB(2) is amended so that the basis of apportionment of gains and losses arising from the disposal of fund assets between the classes of assessable income is changed from calculated liabilities at the end of the income year to average calculated liabilities. [Item 8]

Allocation of income to classes of assessable income

8.30 Section 116CE allocates assessable income derived by a life company to the four classes of assessable income. Subsection 116CE(5) provides a basis for allocating assessable income between the classes of assessable income if that income is not specifically allocated to a class of assessable income under another provision . Subsection 116CE(5) is amended so that the basis of allocation of assessable income that is not specifically allocated under another provision is changed from calculated liabilities at the end of the income year to average calculated liabilities. [Item 9]

Example

8.31 A life company has one insurance fund with two categories of policies (category A policies and category B policies). No significant events occur in relation to category A policies during the income year. However, on 12 September 1997, a significant number of policies are transferred to category B. The total income for the company for the 1997-98 income year is $642.

8.32 The values of the calculated liabilities for each category of policy on the relevant dates are as follows:

8.33 No significant events occurred in relation to category A policies during the year of income, thus average calculated liabilities for category A policies (ACL(A)) is:

ACL(A) = 150 + 120 / 2 = $135


8.34 As a significant event occurred in relation to category B policies during the year of income, average calculated liabilities for category B policies (ACL(B)), is:

Step 1 - divide the income year into periods

•

Period 1 is from 1 July 1997 to 11 September 1997 (the day before the significant event), that is, 73 days;

•

Period 2 is from 12 September 1997 (the day after the end of the first period) to 30 June 1998, that is, 292 days.

Step 2 - work out the average calculated liabilities for each period

ACL(B) for period 1 = 50 + 60 /2 X 73/365 = $1
ACL(B) for period 2 = 75 +95 /2 X 292/365 = $68


Step 3 - work out average calculated liabilities for the income year

8.35 Average calculated liabilities for category B policies (ACL(B)), is the sum of the average calculated liabilities for each period:

ACL(B) = 11 + 68 = $79


Total average calculated liabilities

8.36 The total average calculated liabilities for the life company is $214 (ie. $135 + $79).

Allocate income to categories of policies

8.37 The amount of income apportioned to category A policies is:

135/214 x $642 = $405


8.38 The amount of income apportioned to category B policies is:

79/214 x $642 = $237


Regulation Impact Statement

Specification of policy objective

8.39 The policy objective is to remove distortions in calculating a life company's calculated liabilities for the purposes of the Income Tax Assessment Act 1936 (the Tax Act). Amendments to the Tax Act will require life companies to use average calculated liabilities for life insurance policies held during the income year, rather than calculated liabilities at the end of the year of income, as the basis for determining:

•

the amount of income that relates to immediate annuity policies;

•

the amount of income that is attributable to policies issued by overseas branches; and

•

the amount of income and capital gains to be allocated to each class of assessable income.

Background

8.40 The Government announced the proposal on 29 April 1997 because using calculated liabilities at the end of the year of income distorts these calculations if the proportion of calculated liabilities for all policies at the end of the income year does not reflect the respective proportions for these groups of policies held during the income year.

8.41 The proposed measure will require life insurers to value calculated liabilities annually except where there is a significant event which substantially alters the value of calculated liabilities. If a significant event occurs, the life insurance company will be required to do an additional valuation of calculated liabilities at that time. Average calculated liabilities will be worked out on the basis of the value of calculated liabilities at the start and the end of the income year except where there is a significant event.

Identification of implementation options

8.42 Only one implementation option is feasible to give effect to the proposal. That implementation option is outlined in the paragraph 8.41. This approach was proposed in the Treasurer's press release for the transitional year (ie. the year of income in which 29 April 1996 occurred) and will continue to apply to future years.

Assessment of impacts (costs and benefits) of option:

Impact group identification

8.43 Life companies, the ATO, the Insurance and Superannuation Commission (which examines life company annual returns and other financial information for solvency and reporting policies), actuaries and accountants.

Assessment of costs

8.44 Life companies currently are required to obtain an actuarial valuation of calculated liabilities for tax purposes at the end of each financial year. An additional actuarial valuation of calculated liabilities will be required only if the life company has a significant event during the income year which substantially alters the calculated liabilities belonging to a particular category of policies.

8.45 The number of life companies that will encounter a significant event in an income year will vary from year to year depending on the amount of restructuring in the industry. In a particular income year it is expected that the number of life companies that have a significant event will be less than 5 (but could be zero) out of the 52 companies currently registered under the Life Insurance Act 1995.

8.46 Performance of actuarial valuations is considered to be time consuming, costly and inconvenient. However, because of the limited number of life companies involved, and because such a calculation is likely to be required for prudential and accounting purposes, the cost of compliance of the proposal is expected to be small.

8.47 All life companies will be required to do additional calculations to work out average calculated liabilities each year using set formula. These additional calculations will require minimal resources and impose no significant compliance costs.

8.48 The ATO will not incur any significant additional costs as a result of the proposal.

Assessment of benefits

8.49 The proposal will ensure that the income derived by life companies is allocated more accurately for tax purposes between the different categories of life insurance policies and will remove some uncertainty in the income tax law. It will protect the revenue and life companies from anomalous results arising from the use of calculated liabilities at the end of the income year as the basis of these allocations.

8.50 The measure is expected to protect revenue in the order of $100 million.

Consultation

8.51 The Life, Investment and Superannuation Association (LISA) were consulted on the proposed implementation method and agree that the approach of valuing calculated liabilities annually except where there is a significant event should be used as the basis for working out average calculated liabilities. LISA suggested that the concept of a significant event should be exhaustively defined and should apply to future years as well as the transitional year. LISA raised concerns about the application of the changes to life companies with substituted accounting periods. Those concerns are addressed in the application date for the amendments. Finally, LISA raised some practical concerns about valuing calculated liabilities.

Conclusion

8.52 The Government considers that the method of valuing calculated liabilities annually except where there is a significant event as the basis for working out average calculated liabilities achieves the policy objectives with minimal regulation impact on life companies.

8.53 The Treasury and the ATO will monitor the measure as part of the whole taxation system on an ongoing basis. In addition, the ATO has consultative arrangements in place to obtain feedback from life insurance industry representative bodies.