Corporate owned bonds – corporation tax
Corporation tax implications of a company investing in an insurance bond.
- Companies commonly hold cash on the balance sheet that is surplus to working capital requirements.
- With interest rates at historically low levels, companies are increasingly seeking a better return for that cash.
- Investment bonds offer an investment vehicle for corporate money.
- Companies can invest in UK and offshore bonds.
Holding surplus cash
For a variety of reasons, it is common for a company to hold cash on the balance sheet surplus to working capital requirements. The company will receive gross interest from the bank and pay corporation tax annually on the interest earned.
Budget 2021 introduced a three-pronged approach to corporation tax in the future.
- Corporation tax will be 19% for the years starting 1 April 2020, 1 April 2021 and 1 April 2022.
- From 1 April 2023, the headline (i.e. main) corporation tax rate will be increased to 25% applying to profits over £250,000.
- A small profits rate (SPR) will also be introduced for companies with profits of £50,000 or less so that they will continue to pay Corporation Tax at 19%. Companies with profits between £50,000 and £250,000 will pay tax at the main rate reduced by a marginal relief providing a gradual increase in the effective Corporation Tax rate.
The SPR will not apply to close investment-holding companies. An example would be a company controlled by a small number of people which doesn’t exist wholly or mainly for the purpose of trading commercially or investing in land for (unconnected) letting. A Family Investment Company might therefore be an example of a company not eligible for the SPR.
In his speech, the Chancellor stated that around 70% of companies (1.4m businesses) will be completely unaffected, and just 10% will pay the full higher rate. For the 30% that are impacted then those looming corporation tax increases will begin to focus minds, and might influence behaviours. For example, and where appropriate, might the directors expedite the disposal of company owned assets to realise gains while subject to lower corporation tax rates? Regarding corporate owned bonds, as set out below, a ‘micro entity’ uses historic cost accounting for an insurance bond. The company achieves tax deferral until there is a disposal event such as full surrender, and assuming a gain arises, that profit is taxed at the prevailing corporation tax rates. If it’s a UK bond then the company enjoys a 20% tax credit which more than wipes out 19% corporation tax due on the bond gain. Consideration may be given to crystallising the gain while the 19% rate applies and reinvesting those proceeds. For those bigger companies using fair value accounting, then tax will be paid on an annual basis and so, on an ongoing basis, investment gains will attract those 19% rates until April 2023.
Note that these measures do not impact the 20% ‘tax credit’ on UK bonds available to individuals, trustees and corporate investors.
With interest rates at historically low levels, companies are increasingly seeking a better return for that cash. Low volatility is generally important as those funds will be required for business purposes at some point.
Bonds are taxed under the 'loan relationship' rules, the remit of which extends well beyond insurance bonds.
Although complex in nature, in very broad terms, these rules require the taxation treatment of the item in question (in this case an insurance bond) to follow the accounting treatment. To understand the tax treatment of a corporate owned insurance bond, it is therefore necessary to consider the accounting treatment. There are a number of accounting standards that a company might use – principally historic cost and fair value.
The bond is simply shown in the balance sheet at the end of the company's accounting period at the original premium amount, regardless of the actual surrender value. No annual gain (or loss) is recognised in the company accounts, meaning no corporation tax consequences arise. The company achieves tax deferral until there is a disposal event such as full surrender, partial surrender or death of last life assured.
In this case, the balance sheet at the end of the accounting period will include the bond at its surrender value at that date. That means the movement in value (either a gain or loss) has been processed through the profit and loss account. That movement has corporation tax consequences. The company does not achieve tax deferral since the increase in value will be subject to corporation tax (any decrease is potentially relievable for corporation tax purposes).
Historic cost v fair value
‘Micro entities’ can use historic cost accounting for insurance bonds. Larger companies use fair value rules when accounting for insurance bonds.
It had been the case previously that 'small' companies used historic cost, with large companies obliged to use fair value. The reason for this was that small companies used a set of less complicated accounting standards known as the Financial Reporting Standard for Smaller Entities (FRSSE) which permitted historic cost accounting. FRSSE was however withdrawn, meaning the majority of large and medium-sized UK entities now apply FRS 102 (see below) when preparing their annual financial statements. As mentioned above, ‘micro entities’ e.g. contractor type companies, will use historic cost accounting for insurance bonds.
With a micro entity being small in size, it can enjoy the least complex and comprehensive financial reporting requirements possible by applying FRS 105. Overall, the financial accounts will be straightforward, require limited disclosure of information and will be constrained as regards accounting policies. In particular, no assets can be measured at fair value or a revalued amount. In other words, historic cost will apply. Note that the company may opt up to a more comprehensive accounting regime if it considers that FRS 105 doesn’t meet its needs.
Accounting standards are complex and the recognition of the bond in the accounts is, in every case, a matter for the accountant to determine.
What is FRS102?
FRS 102 is the main new UK Generally Accepted Accounting Practice (GAAP) standard. It replaces all of the current Financial Reporting Standards (FRSs) and Statement of Standard Accounting Practices (SSAPs).
FRS102 replaces over 70 accounting standards and Urgent Issues Task Force interpretations, spanning more than 2,400 pages with one succinct standard of a little over 300 pages. It reflects developments in the way businesses operate and uses up-to-date accounting treatment and language. In short, FRS102 is concerned with wider issues than insurance bonds.
While format requirements of the Companies Act remain, in many cases the terminology used in FRS 102 differs from old UK GAAP. For example, a profit and loss account is now an "income statement" under FRS102, and a balance sheet is a "statement of financial position".
Under FRS102, "basic financial instruments" (see the definition of basic financial instruments below) can be valued at historic cost but a typical insurance bond would not fall within the definition. Insurance bonds falling outside the definition of a 'basic financial instrument' will be accounted for under the fair value regime.
When the company makes a part or full disposal, this is called a 'related transaction'. The profit (or loss) on that is treated as a non-trading credit (NTC) or a non-trading debit (NTD). Where the bond in question is a UK bond, then relief is obtained for the basic rate tax deemed paid within the fund. This amounts to 25% of the NTC profit on disposal. That amount can be offset against the company's overall corporation tax liability for the accounting period in question. If it exceeds the company's tax liability then the excess is not repayable and neither can it be set off against any prior or future accounting periods.
The implications of FRS102
Where the company is using fair value accounting with a UK bond, then annual increases in value are taxable despite the fact that the underlying life fund is subject to tax. In other words, that net growth is taxed. The ‘tax credit’ on the UK bond does not apply on those annual increases but instead it only applies on a subsequent disposal. Directors should be aware therefore that double taxation occurs on those annual increases i.e. life fund tax suffered and corporation tax paid by the investing company on that net return. The benefit of the ‘tax credit’ on disposal rectifies that, but it should be noted that the credit can only be offset against the company's overall corporation tax liability for the accounting period in question. If the credit exceeds the company's tax liability then the excess is not repayable and neither can it be set off against any prior or future accounting periods. Therefore for a company which encashes the bond in an accounting period in which there are no other profits and no corporation tax liability, then the benefit of that tax credit might be lost. Therefore, for those ‘fair value’ companies concerned about ‘fluctuating’ results and potentially wasting a tax credit in the accounting period of disposal, then an offshore bond may be the solution. The investing company simply pays tax annually on a gross return (i.e. gross roll-up within the fund) with no tax credit on disposal. The taxation of offshore bonds for fair value and historic cost companies are considered below.
There is a category of businesses called ‘small entities’. A company will qualify if it does not exceed two or more of the following criteria:
- Turnover: £10.2m
- Balance Sheet: £5.1m
- Number of employees: 50
These entities are required to use the FRS102 accounting rules outlined above (i.e. fair value for a typical insurance bond) but have reduced presentation and disclosure requirements
Very small companies (e.g. contractor type companies) can continue with historic cost. A company qualifies if it doesn’t exceed two or more of the following criteria:
- Turnover: £632,000
- Balance Sheet total: £316,000
- Number of employees: 10
Under this regime, no assets can be measured at fair value or a revalued amount and instead must be held at cost.
Do the normal bond chargeable event rules apply to companies?
No. Following Finance Act 2008, the loan relationship rules apply and not chargeable event gain rules (5%s do not apply to companies). As mentioned above, the loan relationship rules have a much wider remit that just investment bonds.
The examples below consider a company investing in a UK bond. If however the company invests offshore then the position is as follows.
In the same manner as a UK bond, under fair value rules, any increase in value will be subject to corporation tax with any decrease potentially relievable for corporation tax purposes. When the company makes a full or part disposal and a profit arises, there will be no grossing up of that profit required and accordingly no tax treated as paid for offset against the company’s corporation tax liability. This is logical, as that mechanism is in place simply to give the company a measure of relief similar to the basic rate tax treated as paid on chargeable event gains on UK policies owned by non-corporates (i.e. individuals and trustees). The potential ‘double taxation’ problem that could arise with a UK bond, as mentioned above, will not apply.
If a micro entity invests in an offshore bond, then how is that taxed under historic cost rules? As with a UK bond, no annual gain (or loss) is recognised in the company accounts, meaning no corporation tax consequences arise. When the company makes a full or part disposal and a profit arises, then no ‘basic rate’ adjustment mechanism is required and that profit is simply at the prevailing corporation tax rates.
Example – UK bond investment accounting
Fair Value Ltd has an accounting date of 31 March. In September 2019 it invests £200,000 in a UK bond which is valued at £220,000 by 31 March 2020.
Accounting Period Ended (APE) 31 March 2020 - bond valued at £220,000
- Non-trading credit (NTC) £20,000 x 19% = £3,800
APE 31 March 2021 - bond valued at £215,000
- Non-trading debit (NTD) £5,000 (no tax payable)
In October 2021 the company surrenders 50% for £120,000 when the bond is worth £240,000. By 31 March 2022, the bond is valued at £127,500
APE 31 March 2022
50% of bond surrendered for proceeds of £120,000
50% of value at 31 March 2021 (£107,500)
NTC on part surrender £12,500
Also there is an overall profit of £20,000 (50% yielded proceeds of £120,000 yet 50% of premium cost £100,000). Gross up @ 100/80 = £25,000. Therefore tax credit = £5,000
Annual movement £127,500 less 50% of £215,000 = £20,000
Total NTCs £12,500 + £5,000 + £20,000 = £37,500
@ 19% = £7,125
Tax credit (£5,000)
Tax due £2,125
Example continued – encashing a UK bond
Now let's assume that Fair Value Ltd encashes the bond in April 2022 for £127,500. The bond has therefore not changed in value since 31 March 2022. This disposal occurs in APE 31 March 2023.
The full surrender is called a 'related transaction'. This means we recognise the fact that the life fund has suffered tax at a rate equal to basic rate.
We must calculate 'PC' which is the profit from the contract.
PC equals proceeds of £127,500 less £100,000 (50% of original cost) = £27,500
PC is also obtained by summing the previous NTCs & NTD = £20,000 less £5,000 plus £12,500 = £27,500
PC must be grossed up to reflect the tax suffered within the fund
- £27,500 x 100/80 = £34,375
- £34,375 - £27,500 = £6,875 (this is a NTC)
Corporation tax due on the NTC = £6,875 x 19% = £1,306
Tax treated as paid = (£6,875)
Available for offset = £5,569
The company invested £200,000 and it has received proceeds of £120,000 plus £127,500. Total gain therefore of £47,500. Given that this is a UK bond, then overall the company will not pay any corporate tax due to the tax suffered within the fund. This is demonstrated by the following summary which shows that in net terms no corporation tax is due and indeed a net £594 tax credit is available assuming that the company has sufficient corporation tax liabilities on other profits to fully utilise the tax credits.
31 March 2020 - £3,800 tax paid
31 March 2021 - (£950) tax relieved against other profits
31 March 2022 - £2,125 tax paid
31 March 2022 - (£5,569) tax relieved against other profits
The figure of £594 is reconciled as follows. If we gross up the total gain of £47,500 by 100/80 then the figure is £59,375. If we tax that at 19%, the figure is £11,281. Deduct the tax credit of £11,875 to arrive at (£594).
Example continued – identical investment but historic cost accounting
Let's now consider the exact same bond purchase and surrender as was the case for Fair Value Ltd, but let's assume a micro entity using historic cost accounting.
Micro Entity Ltd also has an accounting date of 31 March. In September 2019 it too invests £200,000 in a UK bond. In October 2021 it also surrenders 50% for £120,000 when bond is worth £240,000. And it also encashes the bond in April 2022 for £127,500.
APE 31 March 2020 – changes in value during an accounting period are not recognised under historic cost accounting. Therefore no tax consequences.
APE 31 March 2021 – changes in value during an accounting period are not recognised under historic cost accounting. Therefore no tax consequences.
APE 31 March 2022 – gain of £20,000 but no corporation tax due as a result of tax suffered within the fund. The 20% tax credit of £5,000 exceeds the 19% corporation tax liability of £4,750.
APE 31 March 2023 – gain of £27,500 but no corporation tax due as a result of tax suffered within the fund. The 20% tax credit of £6,875 exceeds the 19% corporation tax liability of £6,531.
Definition of a basic financial instrument
An insurance bond would need to satisfy the following conditions contained in 11.9 of FRS102
(a) Returns to the holder are:
(i) a fixed amount;
(ii) a fixed rate of return over the life of the instrument;
(iii) a variable return that, throughout the life of the instrument, is equal to a single referenced quoted or observable interest rate (such as LIBOR); or
(iv) some combination of such fixed rate and variable rates (such as LIBOR plus 200 basis points), provided that both the fixed and variable rates are positive (eg an interest rate swap with a positive fixed rate and negative variable rate would not meet this criterion). For fixed and variable rate interest returns, interest is calculated by multiplying the rate for the applicable period by the principal amount outstanding during the period.
(b) There is no contractual provision that could, by its terms, result in the holder losing the principal amount or any interest attributable to the current period or prior periods. The fact that a debt instrument is subordinated to other debt instruments is not an example of such a contractual provision.
(c) Contractual provisions that permit the issuer (the borrower) to prepay a debt instrument or permit the holder (the lender) to put it back to the issuer before maturity are not contingent on future events other than to protect:
(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or
(ii) the holder or issuer against changes in relevant taxation or law.
(d) There are no conditional returns or repayment provisions except for the variable rate return described in (a) and prepayment provisions described in (c).
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