GIM7240 - Equalisation reserves: the tax rules: shadow equalisation reserves: worked example

This example demonstrates how separate ‘shadow’ reserves operate. A reserve of £105m has been built up in years prior to the current year ended 31.12.96. The example shows how the regulatory reserve for the year ended 31.12.96 will be calculated and how the shadow reserve will be calculated for tax purposes.

Calculation of transfer in or out

There is a potential transfer in of 75% of technical surplus

75% of the technical surplus of £30m = £22.5m

This is subject to a limit of 12% of the written premiums for that financial year:

The maximum transfer in is therefore £9m (12% of £75m). Because the potential transfer in exceeds the limit, it must be capped. Transfers in are therefore limited to £9m.

At this point the equalisation reserve looks like this:

Calculation of maximum reserve

The reserve carried forward may have to be capped if it exceeds the maximum reserve level. The reserve maximum will be 150% of the highest annual amount of premiums written in any year out of the last 5 years. In this example the annual premium is assumed to have been constant at £75m for the past 5 years. The highest annual premium will therefore be £75m.

The maximum reserve is therefore:

The maximum reserve limit of £112.5m would be exceeded by £1.5m so the amount of the reserve carried forward is limited to £112.5m giving an effective transfer in of £7.5m instead of £9m.

Calculation of shadow tax equalisation reserve

The shadow tax equalisation reserve will be calculated taking no account of the reserve of £105m brought forward from earlier years

The maximum reserve limit of £112.5m would not be exceeded for tax purposes so the full transfer in of £9m may be made and tax relief will be given on this amount.