Allocation deficit debit rules for life insurance companies
2005 amendment to the allocation deficit debit rules for life insurance companies relating to ratio of dividend withholding payment credits.
Sections ME 18, ME 26, MG 5, MG 15, MG 16A, NH6, OB1 and new section MG 8B of the Income Tax Act 1994 and the Income Tax Act 2004
The allocation deficit debit rules for life insurance companies have been amended to prevent the inappropriate results that could arise under the previous rules.
The new rules in section MG 8B are designed to ensure that the ratio by which dividend withholding payment (DWP) credits are attached to shareholder dividends does not exceed the equivalent ratio for policyholders.
To the extent that the shareholder ratio exceeds the policyholder ratio, an allocation deficit debit will arise in the life insurer's DWP account. This debit, in appropriate circumstances, will result in a corresponding credit to the policyholder credit account (PCA) of the life insurer.
The general policy approach in former section MG 8(5), which is to discourage refundable DWP credits from being streamed to shareholders so they are advantaged relative to policyholders, remains unchanged.
The former section MG 8(5) was intended to operate as an anti-avoidance rule to discourage life insurance companies streaming refundable DWP credits to their shareholders in preference to their policyholders. It operated by recording a debit, called an allocation deficit debit, to a life insurer's DWP account when the fraction of DWP credits transferred to the PCA in an imputation year was less than the fraction of imputation credits transferred to the PCA in the same imputation year.
The provision was enacted as part of the new rules for the taxation of life insurance companies in 1990. It was intended to operate as an anti-avoidance provision to prevent a life insurer streaming refundable DWP credits to its shareholders and non-refundable imputation credits to its policyholders. At the time the rules were enacted, the Commissioner of Inland Revenue stated in Tax Information Bulletin Vol 2, No 3, October 1990 (Appendix C) at paragraph 17.4:
". . . The life insurer is able to elect to make transfers to its PCA from its WPA [DWP account]. However, as dividend withholding payments are refundable if not fully utilised by the person who ultimately receives them, there are provisions to ensure that a life insurer is unable to stream these credits to its shareholders as opposed to its policyholders . . ."
Some of the larger distortions under the previous rules arose because they focused on credits and debits arising to the memorandum accounts in one imputation year. They did not take into account opening and closing balances and, therefore, did not recognise that some life insurers may not clear out their DWP and imputation credit accounts each year by either transferring credits to the PCA or attaching them to dividends. If, for example, a life insurer had a substantial opening credit balancein its imputation credit account (ICA) and it elected to transfer a large proportion of these credits to the PCA, the imputation credit transfer fraction may well have been significantly higher than the DWP transfer fraction, even if the company had transferred all available DWP credits to the PCA.
The following policy issues were taken into account when developing the new allocation deficit debit rules:
- The application of the legislation should be limited to potential streaming events. Potential streaming events would arise in years when DWP credits are attached to dividend payments to shareholders.
- Once the threshold event has occurred, the penalty calculation should take a cumulative approach rather than focusing on memorandum entries in separate imputation years.
- The calculation should not rely solelyon memorandum account entries but should have regard to distributions to bothshareholders and policyholders.
- The allocation deficit debit in the DWP account should, when appropriate, result in a corresponding credit to the PCA.
The calculation should not result in inappropriate or disproportionate penalty amounts.
The new allocation deficit debit rules for life insurance companies apply generally for the 2004-05 and subsequent imputation years.
Life insurance companies are also able to elect to apply the new rules retrospectively for an imputation year that begins after 31 March 1995 and before 1 April 2004. It is expected that only taxpayers that have incurred allocation deficit debits under the previous rules will do so. If a company makes such an election, the new rules apply to the imputation year specified in the election and subsequent imputation years.
An amalgamated company is entitled to make an election for an amalgamating company (which has ceased to exist on amalgamation) to apply the new rules retrospectively up to the date of amalgamation. A nominated company for a consolidated group is also able to elect that the new rules apply retrospectively for the consolidated group.
The formula used in former section MG 8(5) could give rise to distorted and inappropriate results, including the imposition of excessive allocation deficit debits. For example, it was possible for a life insurance company to incur a large allocation deficit debit even when it had not paid a dividend to its shareholders and, therefore, by definition, could not have streamed any DWP credits to its shareholders.
The amendments implement a new basis for calculating allocation deficit debits, to deal with the previous rules' deficiencies. The new allocation deficit debit rules should prevent the distorted and unintended results produced under the previous rules.
The new allocation deficit debit rules no longer compare the fraction of DWP credits transferred to the PCA to the fraction of imputation credits transferred to the PCA. Instead, the DWP crediting ratio for shareholders (measured by DWP credits attached to dividends/amount of dividends) is compared against the equivalent ratio for policyholders (measured by DWP credit transfers to PCA/policyholder base income).
The new rules apply only to an imputation year in which a dividend payment (with DWP credits attached) is made. However, for the purposes of the allocation deficit debit calculation, the relevant period of time to be considered is from the end of that imputation year back to the start of the imputation year following the imputation year in which a shareholder dividend was last paid - the DWP reference period. The first DWP reference period will start no earlier than 1 April 2004 unless a taxpayer elects to apply the new rules from an earlier date.
The key legislative aspects of the new allocation deficit debit rules for life insurance companies are:
- New section MG 8B replaces former section MG8(5) to (7). Under this new section an allocation deficit debit arises when the "shareholder DWP ratio" exceeds the "policyholder DWP ratio" in a "DWP reference period".
- "Shareholder DWP ratio" is defined as total DWP credits/total dividends paid.
- "Policyholder DWP ratio" is defined as DWP credits transferred to the policyholder credit account/net policyholder income.
- "DWP reference period" is defined as the current imputation year plus previous years if no dividend was paid with DWP credits attached.
Therefore the new method is based on ensuring that the ratio by which DWP credits are attached to shareholder dividends does not exceed the equivalent ratio for policyholders.
If an allocation deficit debit arises in the DWP account under the new rules, a corresponding credit is recorded in the PCA to the extent the DWP account has a closing credit balance. If the allocation deficit debit exceeds the DWP account closing credit balance, that excess is not creditable to the PCA. In particular, the legislation works as follows:
- New sections ME 18(1)(bb) and ME 26(2)(d) allow a credit to the policyholder credit account of the allocation deficit debit if it is less than or equal to the closing credit balance of the DWP account.
- New sections ME 18(1)(bc) and ME 26(2)(e) allow a credit to the policyholder credit account equal to the closing credit balance of the DWP account if the allocation deficit debit exceeds that balance.
The basis for the new allocation deficit debit rules is to regard policyholders and shareholders as equity participants in a life insurance company. Shareholders receive rewards by way of dividends, and policyholders receive rewards by way of deemed distributions measured using the policyholder base.
To the extent that the shareholder DWP ratio is greater than the policyholder DWP ratio, a debit will arise in the DWP account.
These ratios have specific DWP reference period rules for the purpose of calculating the numerator and denominator. The DWP reference period is from the end of the imputation year in which a dividend (with DWP credits attached) was paid, back to the start of the imputation year following the year in which the previous shareholder dividend (with DWP credits attached) was paid. For example, if DWP credits are attached to dividends paid on 15 March 2008, and the previous dividend with DWP credits attached was paid on
15 March 2005, the DWP reference period concerned would be 1 April 2005 to 31 March 2008. The first DWP reference period starts no earlier than the date the new rules first apply to a taxpayer. This is 1 April 2004 unless the taxpayer elects to apply the new rules from an earlier date, in which case the first DWP reference period starts from that earlier date.
The new rules require each life insurer to make the following calculations in the year that DWP credits are attached to dividends paid to shareholders:
Step 1: Determine DWP reference period
This includes the current imputation year plus any imputation years immediately before the current imputation year in which no dividends with DWP credits attached were paid.
Step 2: Determine whether policyholder income is positive
If the total of the policyholder income and net loss for the DWP reference period is zero or a net loss, the following allocation deficit debit rules do not apply - sectionMG8B(2)(a).
Step 3: Determine shareholder DWP ratio
The formula for determining the shareholder DWP ratio is:
|f||=||total DWP credits attached to the dividend(s) in the DWP reference period|
|g||=||total amount of dividends paid in theDWP reference period|
Step 4: Determine policyholder DWP ratio
The formula for determining the policyholder DWP ratio is:
|c||=||total net transfers from the DWP account to the PCA in the DWP reference period|
|d||=||policyholder base income in the DWP reference period|
|r||=||the rate of tax|
Policyholder base income in the denominator is the aggregate of policyholder base income in respect of the income years the PCA has been debited to meet the company's policyholder base liability in the DWP reference period. This definition is consistent with the PCA debit timing rules in sections ME 18(3)(a) and ME 18(4)(a). For example, if a life insurer has a 30 September balance date and attached DWP credits to dividends paid on 15 March 2004, the policyholder base income would include the 30 September 2003 income year results, but not the 30 September 2004 income year results. This is because the DWP reference period rule would only include the 31 March 2004 imputation year. The debit to the PCA in that imputation year would be made on 30 September 2003 in respect of the 2003 income year income tax liability.
For the purposes of calculating item "d", if the policyholder base has recorded a loss then this loss can be offset against other policyholder base income in the DWP reference period. Item "d" is, therefore, the net amount of policyholder income in respect of the DWP reference period.
As the policyholder base income is the pre-tax amount in the current section CM 15 formula, the factor (1-r) is needed to make policyholder base income net of tax, in the same way that shareholder dividends are net of tax.
Step 5: Determine whether an allocation deficit debit is required in the DWP account
If the shareholder DWP ratio f/g is greater than the policyholder DWP ratio c/d(1-r), streaming is deemed to have occurred and the DWP account must be debited. This allocation deficit debit may result in a corresponding credit to the PCA, an allocation deficit debit solely in the DWP account, or a combination of both (as calculated in steps 6 and 7, below).
If the shareholder ratio f/g is smaller than the policyholder ratio c/d(1-r), no adjustment is required as section MG 8B(2)(b) would not apply.
Step 6: Allocation deficit debit when the DWP account balance remains in credit
The amount to be debited to the DWP account depends on whether the DWP account will be in debit or credit after the allocation deficit debit is made.
The first step requires calculation of the potential DWP allocation deficit debit or "maximum deficit debit", as set out in new section MG 8B, which is calculated as follows:
Maximum deficit debit = (shareholder DWP ratio minus policyholder DWP ratio) × d (1-r)
Then the maximum deficit debit is compared with the balance of the DWP account at year end (before any allocation deficit debit is imposed).
If the DWP account balance is greater than or equal to the maximum deficit debit - that is, if it will remain in credit or be zero after the allocation deficit debit is imposed - the amount of the maximum deficit debit is debited to the DWP account and credited to the PCA - refer sections ME 18(1)(bb) and ME 26(2)(d).
This places the accounts in the same position as if the transfer had been made at the time the dividend was paid and no streaming would be involved.
Step 7: Reduced allocation deficit debit when the DWP account balance goes into debit
If the DWP account credit balance is less than the "maximum deficit debit" (before any allocation deficit debit is imposed), the allocation deficit debit would leave the DWP account in debit. In this case, a reduced allocation deficit debit is calculated.
The purpose of this further formula is to ensure that the credit ratio is the same for both policyholders and shareholders. It is designed to ensure that inappropriate or disproportionate debits do not arise.
While the reduced deficit debit is one formula, in substance, it consists of two parts. The first part takes into account that for both parties (shareholders and policyholders) the maximum DWP credit ratio that can be supported is:
DWP credits attached to dividends + Total net
Expressed algebraically, this reads:
f + c + DWP closing balance
The DWP closing balance is the DWP closing balance before the initial allocation deficit debit is imposed and is represented by item "e" in the reduced deficit debit formula in new section MG 8B(4).
The maximum credits that can be attached to dividends is, therefore, the maximum DWP ratio, f + c + e multiplied by the dividends paid (item "g") divided by g + d(1 - r).
On this basis, the reduced allocationdeficit debit would be:
| The closing DWP credit balance before any allocation deficit debit is made (item "e") plus DWP credits attached to dividends (item "f") minus: |
|g||x|| (f + c + e) |
g + (d x (l - r))
which makes the complete formula for the reduced deficit debit as:
|e + f - g||x|| (f + c + e) |
g + (d x (l - r))
After the reduced deficit debit is imposed, the closing debit balance in the DWP account will be subject to a 10% dividend withholding payment penalty tax under section 140C of the Tax Administration Act 1994.
Although the PCA receives a credit equal to the amount of the DWP account closing credit balance before the initial allocation deficit debit is imposed - sections ME 18(1)(bc) and ME 26(2)(e) - it is not credited with any other part of the reduced deficit debit.
The reason for not crediting the PCA with the full amount of the reduced deficit debit is linked to the nature of this debit. The DWP account closing debit balance indicates shareholders have received more DWP credits than were available (if streaming had not occurred). The payment required from the company to clear the balance, therefore, represents DWP credits which have been used by the shareholders inappropriately and so must be repaid. The repayment would leave the tax base in a neutral position. However, if the payment was also creditable to the PCA the tax position would no longer be neutral. Effectively, the shareholders would continue to receive a benefit because fewer imputation credits and DWP credits would need to be transferred to the PCA in the future.
New sections ME 18(2)(bb) and ME 26(3)(d) ensure that the credits to the PCA are made on the last day of the imputation year in which an allocation deficit debit arises.
Sections MG 5(1)(f) and MG 15(1)(f) have been clarified to provide that they apply only to allocation deficit debits arising under section MG 8(4).
Sections MG 5(1)(g) and MG 15(1)(g) have been updated to refer to the allocation deficit debits arising under new section MG 8B.
New section MG 16A(1B) deals with the application of new section MG 8B to consolidated groups. In particular, it ensures that any dividends paid within a consolidated group are not taken into account in new section MG 8B.
Section NH 6(3) and (4) have been repealed because they replicated the rules - now contained in section MG 16A(1) and (1B) - concerning the application of sections MG 8 and MG 8B to consolidated groups.
The definition of "allocation deficit debit" in section OB1 has been updated to include a reference to the debits arising under new section MG 8B.
The following examples illustrate the calculations:
- Suppose one year is involved and, during that year, a (net) dividend of $10m is paid with $4m DWP credits attached. The (net) policyholder base income is $50m and, during the year, net credits of $15m were transferred from the DWP account to the PCA. At year-end the closing balance in the DWP account was a credit of $8m (before any allocation deficit debit). The DWP reference period in this case is the imputation year.
The shareholder DWP ratio (f/g) is: 4/10 = 40 %
The policyholder DWP ratio (c/d(1 - r)) is: 15/50 = 30 %
As the ratio for shareholders is greater, under section MG 8B(2)(b) streaming has occurred and an allocation deficit debit must be recorded. The maximum deficit debit is:
(Shareholder DWP ratio - policyholder DWP ratio) × (net) policyholder base income
This $5m maximum deficit debit is less than the $8m DWP account credit balance, so $5m is transferred from the DWP account to the PCA. After the transfer, $3m credit remains in the DWP account.
This places the insurer in the same position as if it had transferred net credits of $20m from the DWP account to the PCA during the imputation year. The crediting ratio would then have been 40% for both shareholders and policyholders.
- The facts are the same as in the preceding example but at year-end only $2m remains in the DWP account (before any allocation deficit debit).
Now the maximum deficit debit of $5m exceeds the $2m credit balance in the DWP account. In order to prevent an inappropriate or disproportionate penalty amount, the allocation deficit debit will need to be capped at the level of the reduced deficit debit.
The first step is to calculate the maximum DWP ratio used in this calculation.DWP credits attached to dividends + Total net transfers from DWP account to PCA + DWP closing balance 2
Shareholder dividend + (net) policyholder base income
Expressed algebraically, this reads:
f + c + e
g + d(1 - r)
=$4m + $15m + $2m
$10m + $50m
The reduced deficit debit is:
e + f - (35% x g) = $2m + $4m - (35% x $10m) = $2.5m
A debit is made to the DWP account of this amount,
and a credit of $2m is made to the PCA equal to the DWP closing credit balance (before the allocation deficit debit) - section ME 18(1)(bc).
After this transfer, the DWP account will be $0.5m in debit and must be cleared by a cash payment which will not get credited to the PCA.