GIM5180 - Taxation of the investment return: investment gains: periods of account beginning before 1 January 2002: the realisations basis

Before 1997

The rule that no account may be taken of a change in value of the investments of an insurer before they are actually realised is derived from case law that predates the accounting practice of re-valuing investments annually (on a mark-to-market basis). This practice is now enshrined in the Insurance Accounts Directive and Schedule 9A Companies Act 1985 (see GIM2020).

Up to 1997 the Inland Revenue’s view was that realisation basis was still good law for insurance companies, despite the trend towards a mark-to-market basis for accounting purposes. The 1995 ABI SORP, whilst requiring mark-to-market for accounting, did not require profits or losses to be taken to the profit and loss account. It was thought that, like the basic distinction between capital and revenue, it was an example of a situation in which judge-made rules about the measurement of profit for tax purposes could be expected to take precedence over accounting practice.

After 1997

Since 1997 there have been three major developments:

• The enactment of FA98/S42, which made it clear that accounts which show a true and fair view should be used as the basis for tax computations of the profit or loss of a trade, subject to any adjustments required by law. Section 42 applies to periods of account beginning on or after 7 April 1999.
• The publication of the ABI SORP in December 1998 which made it mandatory for investments to be accounted for on a mark-to-market basis. Specifically, paragraph 232 required any unrealised profit or loss arising from a comparison of opening and closing fair values to be taken to technical or non-technical account, and thus to form part of the profits of the period. This applies to accounting periods ended in or after December 1998.
• The decision in Herbert Smith v Honour (72TC130) in February 1999, which was the final factor which overturned the view that we could rely upon the judge-made principles. Lloyd J said that generally accepted accounting principles embodied these rules so far as it was necessary to take them. So, for example, a provision for future losses did not anticipate them if the calculation of the provision was in accordance with accounting standards and principles.

Taking these factors together, the Revenue view is now that for periods to which the 1998 ABI SORP applies, mark-to-market or fair value accounting is the only valid and acceptable basis to follow for tax purposes. It is not acceptable under FA98/S42 to make adjustments to the accounting profit to remove unrealised gains or losses, in other words, to use the realisation basis. This change of view was announced in a Press Release published on 1 August 2001. However, published guidance at the time suggested that it was mark to market which was the invalid basis. Consequently, at the same time as the press release, draft clauses were issued to sanction the realisation basis as an acceptable and valid basis for tax for an insurance company until the first period of account to begin on or after 1 January 2002. There was, however, nothing in these rules that prevented a company from changing to follow mark-to- market for tax purposes from an earlier date.

There was also a package of measures to ease the transition for companies in the accounting period in which they began to follow mark-to-market for tax purposes.