Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello MP)Chapter 7 - Passive income of insurance companies
Overview
7.1 Schedule 8 of the Bill will replace the formulae contained in subsections 446(2) and (4) of the Income Tax Assessment Act 1936 (the Act) used to calculate the passive income of life assurance and general insurance companies, respectively.
Summary of the amendments
7.2 The purpose of the amendments is to correct a deficiency in the current formulae used to calculate the passive income of the controlled foreign companies (CFCs) of Australian life and general insurance companies.
7.3 The amendments will replace the existing formulae used to calculate the passive income. The new formulae will exclude from a company's passive income only the income derived on assets that are referable to insurance policies owned by non-residents that are not related to the company.
7.4 The amendments will apply to passive income derived on or after 1 July 1997.
Background to the legislation
7.5 Special rules are contained in the CFC measures (Part X of the Act) to provide concessional treatment to Australian taxpayers who are shareholders of foreign life assurance and general insurance companies which are CFCs. The concessional treatment reduces the amount of passive income that may be attributed to those shareholders under the CFC measures. The rules for calculating the passive income of life insurance companies are contained in subsections 446(2) and (3) and those for calculating the passive income of general insurance companies are contained in subsections 446(4) and (5).
7.6 In the case of life assurance companies, the formula contained in subsection 446(2) reduces the passive income of a life assurance CFC by the proportion of its calculated liabilities that relate to policies owned by unrelated non-residents. (Such policies do not give rise to tainted services income (paragraph 448(1)(c)). Thus, only the passive income derived from assets that are employed to meet the calculated liabilities of policy holders who are associates of the company or Australian residents is passive income for the purposes of Part X of the Act.
7.7 The passive income of general insurance CFCs is reduced in a similar way using the formula in subsection 446(4). Under this formula, the passive income is reduced by the proportion of the outstanding claims that relate to policies owned by unrelated non-residents. (Such policies do not give rise to tainted services income (paragraphs 448(1)(d) and (e)). Thus, only the passive income derived from assets that are set aside to meet the outstanding claims of policy holders who are associates of the company or Australian residents is passive income for the purposes of Part X of the Act.
7.8 The deficiency in each existing formula is that it excludes passive income derived from assets that are held by the CFC which are in excess of those needed to meet the calculated liabilities of policy holders of life assurance CFCs, or those needed to be set aside to meet outstanding claims of general insurance CFCs. The problem with each existing formula is that if none of the policies give rise to tainted income (that is all the policies are held by unrelated non-residents) there are no tainted calculated liabilities (in subsection 446(2)) and no tainted outstanding claims (subsection 446(4)). Where this is the case, the numerator of each formula is zero and the result is there is no passive income, even if the company has derived passive income on assets in excess of those referable to insurance policies.
Explanation of the amendments
7.9 The existing formulae in subsections 446(2) and (4) will be replaced. The new formulae will include in the passive income of life assurance and general insurance companies the passive income derived on assets held:
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- to meet liabilities on policies that give rise to tainted services income; and
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- that are in excess of the assets required to meet the liabilities referable to policies.
7.10 The passive income of a life assurance company will be reduced by the proportion of total assets that relate to insurance policies that do not give rise to tainted services income of the company. The life assurance policies that give rise to tainted services income are those where the owner of the policy is an associate of the company or an Australian resident (paragraph 448(1)(c)).
7.11 The proportion of a life assurance company's assets that will be taken into account in the formula for calculating passive income is the excess of the company's total assets over the average calculated liabilities that are referable to policies that do not give rise to tainted services income. [New subsection 446(2)]
7.12 The untainted average calculated liabilities of a life assurance company is the amount of the total average calculated liabilities of the company that relates to insurance policies owned by unrelated non-residents. [New subsection 446(2)]
7.13 Total average calculated liabilities has the same meaning as in Division 8 (which deals with the taxation of life assurance companies). The total average calculated liabilities of a life assurance company for an income year is the sum of the average calculated liabilities for each category of policies under new section 114B. [New subsection 446(3)]
7.14 Total assets will also be taken into account on an average basis and will be the average of the company's total assets for the statutory accounting period calculated on a reasonable basis. [New subsection 446(2)]
7.15 A life assurance company has total assets of $100,000 and total average calculated liabilities of $50,000 of which $25,000 relate to policies that give rise to tainted services income. The company derives passive income of $4,000 during the statutory accounting period.
The passive income of the company is:
Adjusted passive income x Total assets - Untainted average calculated liabilities/Total assets
= $4,000 x $100,000 - $25,000/$100,000
= $3,000.
7.16 The passive income of a general insurance company will be reduced by the amount of passive income that is derived on assets referable to policies owned by non-residents who are not related to the company.
7.17 The company's passive income will be reduced by the proportion of total assets that relate to insurance policies that do not give rise to tainted services income of the company. However, in the case of general insurance companies there is no item which is a reasonable estimate of the amount of the company's liability in respect of a particular policy. It is therefore necessary for the formula to contain additional items to arrive at an estimate of the proportion of the company's assets that are referable to policies that give rise to tainted services income.
7.18 The proportion of a general insurance company's assets that will be taken into account in the formula for calculating passive income is the sum of the net assets and tainted outstanding claims reduced by an amount referred to as the solvency amount. [New subsection 446(4)]
7.19 Net assets is the excess of total assets over total liabilities. [New subsection 446(4)]
7.20 Tainted outstanding claims is the amount of outstanding claims at the end of the statutory accounting period that is referable to general insurance policies that give rise to tainted services income. [New subsection 446(4)]
7.21 Insurance policies (other than life assurance policies) give rise to tainted services income (under paragraph 448(1)(d))) where:
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- the insured person is an associate of the company or an Australian resident;
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- the insured property, at the time of the making of the contract, was situated in Australia; or
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- the insured event is one that can only happen in Australia.
7.22 Reinsurance policies also give rise to tainted services income where the risks of an associate are being reinsured by the company or where the insurer dealing directly with the company is an associate or an Australian resident (paragraph 448(1)(e)).
7.23 The outstanding claims of a company is the amount which it is necessary for the company to set aside at the end of the statutory accounting period which, when invested by the company, will provide sufficient funds to pay the outstanding claims of the statutory accounting period. The amount of outstanding claims should be reduced by any amounts recoverable by the insurer in respect of the claims. [New subsections 446(4) and (5)]
7.24 The solvency amount represents a concession which recognises that the amount of assets referable to policies that give rise to tainted services income is greater than the assets held to support the outstanding claims on those policies. This solvency amount will be calculated under a separate formula. [New subsection 446(5)]
7.25 The items to be used in calculating the solvency amount, minimum solvency and maximum event retention , are terms in common usage in the general insurance industry. General insurance companies under the supervision of the Insurance and Superannuation Commissioner, that is insurance companies carrying on general insurance business in Australia, are required to furnish information concerning these matters in their annual returns to the Commissioner.
7.26 Minimum solvency is the greater of:
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- 20 per cent of the company's premium income during the statutory accounting period; or
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- 15 per cent of the company's outstanding claims at the end of the statutory accounting period.
Premium income has the same meaning as in the Insurance Act 1973. [New subsection 446(5)]
7.27 The maximum event retention amount for a statutory accounting period is the amount the company has determined, on the basis of a reasonable and proper estimate, would be payable to the owners of policies from the happening of one event. This amount is the maximum possible loss (net of re-insurance) in respect of any one event and is the sum of the maximum possible loss for each particular class of business from that event. [New subsection 446(5)]
7.28 The solvency amount will be reduced by the proportion of the company's outstanding claims that relate to tainted outstanding claims. If none of the company's outstanding claims relate to policies that give rise to tainted services income, the solvency amount will not be reduced. If all of the company's outstanding claims relate to policies that give rise to tainted services income, the solvency amount will be nil. Similarly, if 50 per cent of the company's outstanding claims relate to policies that give rise to tainted services income, the solvency amount will be reduced by 50 per cent.
7.29 A general insurance company has net assets of $50,000, total assets of $100,000, outstanding claims of $50,000 of which $25,000 relate to policies that give rise to tainted services income. The company derives passive income of $4,000 during the year of income and the premium income for that year is $30,000. The company has calculated that its maximum probable loss across all classes of business from the happening of one catastrophe is $2,500.
(1)Calculate the solvency amount:
(Minimum solvency + Maximum event retention) x (1 - Tainted outstanding claims )/Outstanding claims
Minimum solvency = greater of 20% of premium income (20% of $30,000 = $6,000) and 15% of outstanding claims (15% of $50,000 = $7,500).
Minimum solvency = $7,500
Solvency amount = ($7,500 + $2,500) x (1 - $25,000 )/$50,000
= $10,000 x 0.5
= $5,000
(2)Calculate passive income:
Adjusted passive income x (Net assets + Tainted outstanding claims - Solvency amount)/Total assets
= $4,000 x ($50,000 + $25,000 - $5,000)/$100,000
= $4,000 x $70,000/$100,000
= $2,800.