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III. Life Insurance
Background and Present Legislation
Deductibility of Premiums
21.134. The granting of some form of tax concession in respect of premiums paid on life insurance policies is of long standing, both in Australia and overseas, going back in the case of the United Kingdom to 1799.
21.135. In Australia the position is now governed by section 82H of the Act the predecessors of which date back to the first levying of income tax by the Australian Government in 1915. The concession granted in respect of life insurance premiums has at various times taken the form of a deduction from income or a rebate of tax and, since 1936, amounts paid as premiums have been aggregated with superannuation contributions for the purpose of determining the maximum amount in respect of which the concession is granted. Since 1951 the concession has been by way of a deduction the maximum amount of which has, since 1968, been $1,200 per annum.
21.136. Section 82H as it now stands provides in subsection (1) (a) that:
‘(1) Amounts paid by the taxpayer in the year of income…as—
(a) premiums or sums—
(i) for insurance on the life of, or against sickness of, or against personal injury or accident to, the taxpayer or his spouse or child; or
(ii) for a deferred annuity or other like provision for his spouse or child …
shall be allowable deductions.’
Subsection (1) (b) allows as a deduction payments to superannuation funds and friendly societies, while subsection (2) provides that the total deduction allowable under this section is not to exceed $1,200.
21.137. Section 82H was amended in 1973 by the insertion of new subsections (1A)-(1H). These were directed to curtailing abuses that had developed in relation to policies of a very short term or policies surrendered shortly after being effected. The amendments result in the deduction of premium payments being disallowed if the policy is for a term of less than ten years and in the retrospective disallowance (by the reopening of past assessments) of all or a part of the deduction of premiums paid on a policy taken out for a term greater than ten years if discontinued within ten years of its commencement for any reason other than serious financial difficulty. These provisions apply only to policies the first premium on which was paid on or after 1 January 1973.
21.138. Deductions for premium payments may also be available under section 51 (1) in certain circumstances where an employer effects a policy on the life of an employee. Such cases are relatively few in number and will not be further considered.
21.139. The total amount of deductions claimed under section 82H for life insurance premiums is extremely large, as is the number of taxpayers claiming a deduction. Statistics published by the Life Insurance Commissioner indicate that as at 31 December 1973 approximately $696 million per annum was being paid in premiums on life insurance policies (excluding superannuation policies) and most of this amount would have qualified for deduction under section 82H. No estimate is available of the precise number of taxpayers claiming a deduction for life insurance
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premiums, but at 31 December 1973 there were nearly 8 million individual life insurance policies in force in Australia.
Taxation of Life Insurance Companies
21.140. Life insurance companies are the subject of a special tax regime under Division 8 of Part III of the Act. The underlying approach is that the company is taxed on its investment income; but the fact that this is not the only possible approach to taxing life insurance companies is illustrated by the diversity of practice in other countries and, indeed, the diversity that existed in Australia before the introduction of the principle of uniform taxation legislation in 1936.
21.141. Prior to 1936 life insurance companies were taxed on the basis of their investment income under Commonwealth, New South Wales and Western Australian legislation. In Victoria, Queensland and Tasmania they were taxed on a percentage of premium income, while in South Australia the taxable income was based on the amount of the company's actuarial surplus. All these methods, and others, are in use overseas and a brief summary of some of them is contained in paragraphs 21.150–21.157 below.
21.142. Since 1936 all life insurance companies have been taxed on a basis that owes its origin to the pre-1936 Commonwealth legislation. This followed the recommendation of the Ferguson Commission (1932–34).
21.143. The assessable income of a life insurance company, in respect of its life insurance business, comprises its investment income. Dividends are included in assessable income, though resident life insurance companies are entitled to the rebate of tax thereon provided by section 46. Premiums received in respect of policies and considerations received in respect of annuities are excluded from assessable income under section 111 but form part of the total income of the company for the purpose of determining certain deductions. Furthermore, subject to compliance with the 30/20 requirements, that portion of investment income referrable to superannuation policies is exempted by virtue of section 112A.
21.144. The main deductions allowed in computing the taxable income of a life insurance company are as follows:
- (a) A deduction under section 51 (1) for expenses directly incurred in earning the assessable (investment) income. These are usually a small part of the total expenses of a life insurance company.
- (b) A proportion of the ‘expenses of general management’ of the company. The practical effect of section 113 is to allow a deduction of the proportion of those expenses which is equal to the proportion that the assessable income of the company bears to the total income of the company. Expenses incurred wholly in gaining or producing non-assessable income (primarily salary and commission to salesmen) are specifically excluded from the definition of ‘expenses of general management’, as are expenditure of a capital nature and expenditure incurred in producing assessable income.
- (c) A deduction is allowed in full under section 82AAC of contributions to superannuation and pension funds.
- (d) A deduction is allowed under section 115 of a percentage of the ‘calculated liabilities’ of the company. This is a controversial deduction and is further considered in the next paragraph.
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(e) Rebates of tax are granted to resident life insurance companies on dividends (under section 46) and a rebate of 10 per cent is granted under section 160AB on interest received on certain Australian and State Government securities issued before 1 November 1968.
21.145. The Ferguson Commission stated in paragraph 858 of its Report:
‘In our opinion a life assurance company should be taxed on the basis of its investment income, which cannot be correctly determined without providing for the interest assumed to be earned on the investments set aside to provide for the payment of the liabilities of the company to its policy holders.’
The Report noted that this principle had already been conceded under Commonwealth legislation, by an amendment made in 1933. The recommendations of the Ferguson Commission were subsequently adopted and a deduction of 4 per cent of the calculated liabilities of a life insurance company was allowed. This figure was reduced to 3 per cent in 1942 when the income tax field was taken over wholly by the Commonwealth. The figure remained at 3 per cent until the 1973–74 Budget which reduced it to 2 per cent and made certain other changes that had the effect of greatly increasing the amount of tax paid by life insurance companies. The figure was further reduced to 1 per cent in the 1974–75 Budget, with the inference that the deduction would be removed completely in the near future.
21.146. Finally, section 116 of the Act provides that a life insurance company shall not be liable to pay income tax in respect of the income derived by it from business of life insurance if its calculated liabilities exceed the value of all its assets.
The 30/20 Requirements
21.147. Under provisions introduced in 1961 a life insurance company is virtually obliged to maintain 30 per cent of its assets in public sector securities, and at least 20 per cent of its assets in Australian Government securities. Failure so to do results in:
- (a) the loss of exemption on the income derived from assets referable to superannuation business; and
- (b) a reduction in the section 46 dividend rebate available.
Over-compliance with the 30/20 requirements generates ‘bonus points’ for a life insurance company in that the section 115 deduction is slightly increased. This has had the effect of making investment in public sector securities relatively more attractive, other things being equal, than investment in the private sector and has led to a greater margin between public and private sector interest rates than would be accounted for by market factors alone. However, the reduction in the section 115 deduction has led to a lessening of the value of such bonus points and the abolition of the deduction would mean that no tax advantage could be gained by exceeding the minimum requirements.
Taxation of Policy Proceeds
21.148. Policy proceeds are in general regarded as a non-income receipt and are accordingly exempt from tax. Exceptions to this arise in the case of certain policies effected by employers on the lives of employees but these are relatively few in number and do not have a significant impact on the overall picture.
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21.149. The actuarial surplus of Australian life insurance companies is distributed in the form of reversionary bonuses—i.e. additions to the sum insured. By virtue of section 26 (i) such reversionary bonuses are exempt from tax in the hands of the policy-owner.
International Comparisons: A Brief Summary
21.150. The manner of taxing life insurance in countries with which Australia is broadly comparable presents a pattern of considerable diversity, perhaps indicative of the fact that the taxation of life insurance does not fit easily into any of the accepted categories of taxing income moving through intermediaries.
21.151. The United States and Canada give no tax concessions for premium payments as section 82H does in Australia. New Zealand broadly follows the Australian pattern of giving a concessional deduction (called there a ‘special exemption’) with an overall dollar limitation which applies to the aggregate of life insurance premiums and superannuation contributions. In the United Kingdom relief is allowed in the form of a rebate calculated at the basic rate of tax (currently 33 per cent), subject to a restriction on the amount of premiums qualifying for relief to one-sixth of the taxpayer's total income. Both New Zealand and the United Kingdom have found it necessary to legislate to restrict the availability of the concessions to long-term policies, as was done in Australia in 1973.
21.152. It is in the area of the definition of the taxable income of a life insurance company that the greatest differences emerge.
21.153. The basis used in the United Kingdom is the closest to that employed in Australia. The company is in practice taxed on its investment income but is allowed a deduction for all expenses, including those incurred solely in gaining non-taxable income, such as expenses of selling new policies. Furthermore, the rate of tax is limited to 37½ per cent.
21.154. In New Zealand a life insurance company is taxed on its annual actuarial surplus calculated on a specified basis. The rate of tax is limited to 40 per cent of the general rate of company tax.
21.155. Life insurance companies in the United States are taxed in a complex series of operations which, in substance, include in the tax base both investment income and underwriting profit or loss.
21.156. A life insurance company in Canada is taxed in a manner analogous to the taxation of a general insurance company in Australia. All receipts, whether by way of premiums or investment income, are included in its assessable income; a deduction is allowed of all expenses, claims and increases in policy reserves. In addition, a separate tax is levied on investment income subject to certain deductions.
21.157. The proceeds of life insurance policies are wholly exempt from tax in normal circumstances in New Zealand and the United Kingdom. In Canada policy proceeds received otherwise than on death or permanent disability are taxable to the extent that the amount received exceeds the adjusted cost base of the policy, which is the premiums paid less any dividends paid during the currency of the policy. The United States treatment is similar to the Canadian. Unlike life insurance companies in Australia, New Zealand and United Kingdom, which distribute their surplus in the form of reversionary bonuses, United States and Canadian companies traditionally distribute their surplus in the form of cash dividends.
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Conclusion
21.158. Having regard to the fact that two of its members are directors of Australian life insurance companies, the Committee feels that it is unable to make detailed recommendations on tax changes in this area. In addition, the subject is one of considerable complexity, particularly when it comes to determining the correct basis of taxing life insurance companies themselves. Life insurance is distinctive in combining elements of investment, protection and mutuality. The very diversity of overseas practice is an indication that no single method of taxing a life insurance company is accepted as correct. It often tends to be arbitrary.
21.159. Accordingly the Committee, while acknowledging assistance received from several submissions, recommends that a review of the taxation aspects of life insurance be undertaken by a separately constituted committee which can consider the particular problems in this area in greater depth than the present Committee has been able to do. Though minor anomalies such as the denial of the section 46 dividend rebate to non-resident life insurance companies and the treatment of foreign-source income may be noted, the Committee wishes to confine itself to some observations of a general nature.
21.160. Firstly, as with superannuation, the taxation of life insurance must be considered as a whole. There must be harmony between the treatment of premium payments, the income of the life insurance fund and payments of policy proceeds. No one element can be looked at in isolation from the other two.
21.161. Secondly, unlike the situation with superannuation benefits, it is neither feasible nor desirable to tax the proceeds of a life insurance policy; nor is it possible to impute to a policy-owner for tax purposes his share of the company's income during the term of the policy. Because of the insurance, as distinct from investment, aspects of life insurance, there is no reasonable way of taxing the excess of the policy proceeds over the amount of premiums paid. This being so it is necessary to exact some tax from the company itself, particularly since there is no way of imposing a limit on the extent to which high-income taxpayers may use life insurance as a saving and investment medium. Maximum benefit limitations can be imposed on tax-exempt superannuation funds to prevent the tax-free accumulation of excessive amounts, but this approach cannot be adopted with life insurance.
21.162. Thirdly, if it is desired that life insurance be encouraged there is justification for giving some form of concession related to the payment of premiums. The Committee has already recommended in paragraph 21.103 that superannuation contributions be taken outside the ambit of the present section 82H and divorced from the treatment of life insurance premiums. While a deduction system should be retained for superannuation contributions, largely because the benefit will emerge in taxable form, it is felt that a rebate, which is an equal per-dollar subsidy, is more appropriate in the case of premiums for life insurance the benefits from which are non-taxable.
21.163. Fourthly, and most significantly, the Committee wishes to stress that the tax treatment of life insurance should not be subject to abrupt changes. Life insurance is a long-term undertaking for both the policy-owner and the company. The long-term financial plans of individuals should not be lightly interfered with and it should be borne in mind that a life insurance company must be able to build up assets to meet liabilities due many years in the future. Because of the long-term nature of the contract entered into between the policy-owner and the company, it is necessary that there be some stability of the tax structure within which this contract will function.
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21.164. Finally, regard must be paid to the eroding effect of inflation on the protection and savings provided under life insurance policies. No less than in the case of business and professional income, the tax system should have regard to the impact of inflation on the income of life insurance funds, which are particularly vulnerable because of their required holdings of fixed-interest securities.