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FSA Consultation paper 05/9

The proposals in this quarterly consultation paper of most direct relevance to general insurers are amendments to:

• the integrated prudential sourcebook and the interim prudential sourcebook for insurers – to make a number of clarifications following the introduction of the FSA’s new prudential regime for insurers; and

• interim prudential sourcebook for insurers – regarding a form for private submission of the solo Enhanced Capital Requirement "soft test" at 31 December 2005. In addition there is a proposal to require public disclosure of the capital adequacy position of insurance groups and insurance led conglomerates at 31 December 2005 with the requirement becoming a "hard test" at 31 December 2006.

This consultation paper published in October 2005 deals with a number of matters, with the following summarising those relevant to insurers and insurance intermediaries:

• proposals to amend the Integrated Prudential sourcebook, the Interim Prudential Sourcebook for Insurers and the Lloyd’s Sourcebook to ensure sufficient transparency in financial returns regarding financial reinsurance agreements;

• proposals to amend the Integrated Prudential sourcebook and the Supervision manual regarding the inclusion of unaudited reserves and unverified interim profits within firms’ capital resources and RMAR. The FSA propose that firms able to take advantage of the Companies Act provisions that enable them not to appoint auditors will be able to include unaudited reserves within their capital resources and RMAR; and

• proposals to amend the Insurance Conduct of Business sourcebook to make miscellaneous clarifications and corrections, including regarding the provision of information to the customers of general insurance firms.

In July 2005 the European Parliament approved the proposed Directive on reinsurance. The Directive would establish supervision of reinsurers by competent authorities in their "home" country, on the basis of which they could operate throughout the EU. That supervision would have to be exercised in line with provisions which all Member States would need to apply.

There are currently no harmonised reinsurance supervision rules in the EU. The lack of an EU regulatory framework for reinsurance has resulted in significant differences in the level of supervision of reinsurance undertakings between different EU Member States. These different national rules have led to barriers to trade within the internal market, as well as giving rise to administrative burdens and costs. The lack of a European framework has also weakened the EU’s position in international trade negotiations aimed at opening up the insurance market worldwide.

The proposed Directive provides for a regulatory framework based on the existing regime introduced by the Third Insurance Directives to establish the internal market in insurance. The proposal would extend to reinsurance companies the system for the authorisation and financial supervision of an insurance undertaking by the Member State in which it has its head office ("home country control"). Such authorisation would be for reinsurance companies, exactly as it is for direct insurers, a true "single passport" which would enable them to carry on their business anywhere in the European Union. The proposal also sets out prudential rules for the supervision of reinsurance undertakings.

Member States are to apply the Directive two years after adoption. However, in order to take account of potential difficulties that Member States might encounter with the abolition of collateral requirements in national legislation, the European Parliament has proposed a transitional period of 12 months to comply with this requirement in addition to the two years provided for the application of the Directive as a whole.

Following an announcement in a speech by John Tiner on 13 December 2004, the insurance industry were set a challenge of finding a solution to the issue of contract certainty by the end of 2006. The London insurance Market Reform Group (MRG) has recently stated that:

Contract Certainty is achieved by the complete and final agreement of all terms (including signed down lines) between the insured and insurers before inception.

In addition:

The full wording of the submission to insurers will be a combination of:

Brokers may choose which combination is submitted to insurers; insurers may choose whether to accept this or require a different approach.

The work the industry will need to do fits within the FSA’s strategic aim of promoting efficient, orderly and fair markets. This work will reduce the operational and legal risks to brokers and insurers and improve service and clarity of insurance cover to customers.

The MRG has set the following milestones (for contracts that meet the definition of contract certainty) to aid achieving the challenge set by the FSA:

• 30% of monthly volume by end 2005;

• 60% of monthly volume by end June 2006;

• 85% of monthly volume by end 2006.

Whilst the MRG will report aggregate progress to the FSA, the FSA will monitor the industry on an organisation by organisation basis. This process is likely to start from the next round of Arrow visits, which will examine the progress the organisation is making towards contract certainty.

To aid organisations in achieving contract certainty the MRG has developed a code of practice that firms should adopt formally through their corporate governance process prior to the end of 2005 and checklist for organisations to consider.

In July 2005, H.M. Revenue and Customs (HMRC) released a consultation document regarding the proposed changes to the UK legislation following the European Court of Justice (ECJ) judgment in the case of Arthur Andersen & Co (Accenture). In the consultation document, HMRC stated that it intends to amend the current UK VAT legislation to narrow the exemption for insurance intermediary services. The proposed new UK legislation will be similar to the current European Union equivalent. It is currently planned that these changes will take effect from 1 January 2006. In summary, it is our view that HMRC’s proposed changes to the VAT exemption for insurance related services go beyond the principles set out in the Accenture decision.

The Accenture case concerned the VAT exemption applied to "back office" services supplied to an insurer. In short, the ECJ held that Accenture’s activities did not fall within the scope of the exemption because it did not qualify as an insurance agent or an insurance broker. The Court found that Accenture were not acting as brokers because they did not have complete freedom of choice of the insurer and were not acting as insurance agents because they did not find prospective customers and introduce them to the insurer.

This means that the UK VAT exemption for insurance related services is drawn too widely. It should be noted that, compared to the other EU Member States, the UK’s VAT exemption for insurance related services has historically been relatively wide. Because of this we understand that the Accenture decision will not necessitate legislative changes in the vast majority of the other Member States.

For the purposes of the exemption, insurance brokers or agents will only be defined by the services they carry out rather than by their regulatory status. The Intermediaries Directive will not determine the status of an insurance agent or broker for VAT purposes. Where there is more than one broker in the supply chain of a particular insurance contract, this alone will not preclude exemption.

Our response to the consultation document is that HMRC’s proposed approach goes beyond the findings in the ECJ judgment. HMRC have set out a two test approach to assess whether insurance related services fall within the VAT exemption. HMRC propose that an insurance intermediary’s activities will be exempt only if they involve finding/introducing prospective customers to the insurer (or in the case of a broker have complete freedom as to the choice of the insurer for their clients) and they carry out a function of intermediation through their independent status e.g. negotiating terms of the contract.

It is arguable that the proposed revised legislation removes much of the clarity that had existed. This means that there will be significant need and scope for HMRC to apply their own interpretation of the law and this will result in considerable uncertainty. Consequently, this will allow HMRC to amend the scope of the exemption at their own discretion.

In light of the Accenture ECJ decision and the potential changes that this may cause in the UK, there has already been a slowdown in the number of new contracts for insurance outsourcing work. It appears that UK insurance companies that buy in outsourced services will face the likelihood of an increase in the irrecoverable VAT they incur. The wider effect of this decision and HMRC’s proposed application of it will lead to a reduction in the competitiveness of the UK insurance sector.

However, Deloitte is actively working with its clients to develop solutions that will minimise the impact of this decision.

HMRC are intending to issue a further Business Brief in respect of the ECJ judgment in the Kretztechnik case. The ECJ found that the issue of shares by a company represents the raising of finance and is not a supply for VAT purposes.

It is expected that the Business Brief will confirm that the issue of securities, in addition to that of shares, is not a supply for VAT purposes. Related input VAT that has been incurred will therefore be treated as a general overhead of the business, recoverable through its partial exemption method. However it is expected that the Business Brief will confirm that intermediary services provided in respect of share issues will remain exempt from VAT. The Business Brief should also confirm that the input tax incurred when providing intermediary services will be recoverable under the Specified Supplies order when the customer is based outside the European Union but that the existing recovery for intermediaries organising securities issues by an EU customer to non-EU entities will cease. There is also an argument that this decision could be extended to the sale of shares and other securities although it is less likely that HMRC will accept this interpretation.

Deloitte is continuing to advise companies that may have underrecovered input VAT in light of this judgment to submit claims to recover it.

Please contact Richard Vitou on 020 7007 0578 if you require assistance or any further guidance.

The VAT Tribunal found in favour of the appellant in the recent case concerning the VAT treatment of costs incurred centrally which are re-allocated to connected companies in various jurisdictions. Deloitte understands that HMRC are planning to appeal this decision. The appellant, Zurich Insurance Company (Zurich) is based in Switzerland. Zurich signed a global implementation agreement with a third party provider established in Switzerland to provide it with IT consultancy services. Zurich has a UK branch (Zurich UK). The project entailed staff from both the provider’s Swiss and UK businesses working with staff from Zurich’s Swiss and UK staff at various locations. Although the entire cost of this project was billed to Zurich in Switzerland, a percentage of this was recharged to the client’s UK VAT group, who accounted for VAT on this. However HMRC argued that, despite Swiss VAT already being levied on this cost, the UK VAT group should also account for VAT on it. The Tribunal found in Zurich’s favour, with the key principles in reaching this decision being those of the basis of rationality, economic reality and the distortion of competition.

In practice this means there are a number of criteria on which similar cases will be decided, such as who signed the contract and is responsible for settling any bills arising from it. However it is clear that such decisions are reached on an individual basis. Deloitte would be happy to assist your business in a review of the VAT treatment currently applied to such recharges. Equally, if HMRC’s proposed appeal does not take place or is unsuccessful then businesses that have accounted for VAT on the full amount on such recharges may be entitled to submit a reclaim for over-charged VAT. Again, we would be happy to help your business with this process.

HMRC are currently considering revoking the Staff Hire Concession, which allows VAT to only be charged on the margin paid to employment agencies on the hire of temporary staff members. VAT is not charged on the wage related element of this cost. The concession has been particularly beneficial to financial services businesses that are unable to recover the VAT they incur in full. These changes come as a result of the Department of Trade and Industry’s Conduct Regulations which were introduced in July 2004. The regulations state that employment agencies are no longer able to introduce and pay workers themselves. HMRC believe that this legislation effectively makes the need for a Staff Hire Concession redundant.

HMRC is due to be undertaking a review of this issue in early 2006, which will include a consultation period. However Deloitte is already developing several potential solutions for its clients should the concession be revoked.

Following a VAT Tribunal decision in July 2005, HMRC now accept that the reinsurance of surety bonds should not attract IPT. This case was successfully taken against HMRC by several insurance companies and HMRC have confirmed their revised position on this issue in the recent Business Brief 13/05. This now allows reclaims to be made to HMRC for any IPT accounted for on the reinsurance of surety bonds since 1 April 2004. Deloitte has already assisted clients in calculating and submitting reclaims and would be happy to assist your business with a similar claim.

The recent Advocate General’s opinion in the FCE case states that the Italian and Portuguese governments are incorrect in requiring entities to apply VAT to cross-border supplies made between branches of the same legal entity. In the AG’s opinion, only when an entity is legally separate (i.e. is a subsidiary) should supplies to it from a parent be subject to VAT. This opinion reinforces the current position in most EU Member States, including the UK.

Although the ECJ judgment on the FCE case is still being awaited, Deloitte is already advising its clients with entities in Italy and Portugal on the potential consequences of this case.

These changes are considered necessary mainly in the light of the new currency accounting rules which took effect from 1 January 2005 and principally affect insurers preparing their accounts in currencies other than sterling. However, they are also intended to correct some anomalies elsewhere in the existing regulations and so potentially affect earlier periods.

The amendment regulations are expected to be published before the end of 2005. The stated aim of the currency accounting revisions is "to achieve continuity with the old FA1993 rules and to ensure that the [discounting] calculations required by the GIRTR are unaffected by exchange fluctuations."

The other minor changes are proposed to tighten up the operation and/or the interpretation of certain aspects of the discounting of general insurance reserves legislation (s 107 FA2000 and the GIRTR) that have come to the Revenue's attention over the past couple of years.

There has been extensive consultation by HMRC with the ABI and representatives from industry and their professional advisers, including Deloitte. We have contributed fully to the discussions with the Revenue on all of these points.

General insurance companies should ensure, when submitting their UK tax returns, that any adjustments to taxable profits made under s107 FA2000, are calculated using the most up-to-date regulations.

In June, the OECD published for consultation a draft of the fourth and final part of its report on Attribution of Profits to a Permanent Establishment (PE). This fourth part concerned insurance, and comments were invited by 16 September 2005 (the first three parts dealt with general considerations, banking and global trading respectively).

The consultation document considered the main factors and risks involved in insurance business, but lacked positive recommendations regarding certainty in the acceptable approaches or methods required for attributing profits to insurance PEs that eliminate double or less than single taxation. Our response to the consultation reflected these conclusions, focussing on the key issues and concerns with the report. Once finalised, the conclusions of Parts I-IV of the Report will be implemented through revision of the Commentary on Article 7 of the OECD Model Tax Convention and/or the Article itself. Further practical guidance will be produced in the form of background Reports and/or Chapter(s) of the OECD Transfer Pricing Guidelines.

The projected completion date for the project is no later than January 2007.

The OECD has also recently published an updated version of its Model Tax Convention. The 2005 edition incorporates the latest changes to the Model which were approved by the OECD Council on 15 July 2005. These changes result from work done by the Committee on Fiscal Affairs, in particular on:

• the tax treatment of activities related to international shipping and air transport;

• cross-border income tax issues arising from employee stock-option plans;

• tax issues arising from cross-border pensions;

• the issue of multiple permanent establishments;

• the revision of Article 26 and its Commentary concerning the exchange of information; and

• technical issues related to the interpretation of tax conventions.

Details of the new Closing Agreements between Lloyd's and the IRS were published in Lloyd's Market Bulletin of 8 July 2005. These Closing Agreements establish the basis on which US source Lloyd's business will be subject to US Federal Income Tax (FIT) and US Federal Excise Tax (FET) and reflect the terms of the latest UK/US Double Taxation Treaty.

Members that are entitled to the benefits of a US tax treaty are now taxed on profits attributable to a US permanent establishment that consists only of 70% of the profit from Illinois and Kentucky licensed business and 35% of the profit from US binding authority business other than Illinois and Kentucky licensed business. No other business is attributed to the US permanent establishment. This is a significant reduction from the previous FIT tax base.

1% FET is due on the reinsurance of all US risks to an unprotected reinsurer, whether US Connected Income (USCI) or non-US Connected Income (non-USCI). The previous agreement specified only that this tax applied to USCI. However, as virtually all US situs risks were USCI under that agreement, the monetary effect of changing the agreement to include non-USCI is expected to be slight.

Lloyd’s issued a Market Bulletin in November detailing the practical steps that Lloyd’s Corporate Members need to take to ensure that they receive the full benefits available under the new Closing Agreements. This requires completion of a US tax return form W-8BEN (by 15 December) which identifies the basis on which the Name is eligible for treaty benefits under the complex Limitation of Benefits (LOB) rules in the Double Tax Treaty.

The 2005 Finance Acts contain a number of specific measures intended to counter corporation tax avoidance. These include provisions targeting:

• tax ‘arbitrage’, being the use of structures or instruments which are intended to exploit asymmetries of tax treatment between jurisdictions, or in some cases within the UK;

• arrangements under which double tax relief is claimed as part of a scheme or arrangement with tax avoidance purposes; and

• tax avoidance through arrangements involving financial products.

The legislation in all these areas, particularly the tax arbitrage rules, is complex and potentially wide-ranging.

A growing number of claims are bring pursued under European Union Law in which it is being argued that the UK’s domestic tax laws are inconsistent with the Treaty of Rome, because they treat domestic and foreign transactions and taxpayers differently. The process of making such claims is difficult and expensive. Accordingly, claims on the same legal point are often aggregated in Group Litigation Orders (GLOs) which allow costs to be shared between the parties.

Issues which are currently the subject of GLOs against the UK government include cross border loss relief, and the taxation of foreign source dividends.

It is anticipated that these issues may not be resolved for some considerable time.

The insurance team at Deloitte is a dedicated group embracing senior professionals from all areas of the business, many of them with first-hand experience of working in the industry.

The team draws on a blend of skills to deliver outstanding financial, commercial and technical advice as well as a premier actuarial and insurance solutions service with a reputation for outstanding technical quality and thought leadership.

Our insurance sector has a wide range of clients, including insurance and reinsurance companies, insurance brokers, corporate capital vehicles including managing agents and syndicates.

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