Deemed Disposal - Life policy vs UCITS when tax rate changes

[Corola]

I have been studying this interesting example and this is my read.
For a Life Policy the one and only taxable entity is that policy. Units are mere internal book-keeping. So when a LC pays DD tax it will reduce the value of the LP by cancelling units but note that crucially it does not reduce the Acquisition Cost of the LP. On eventual encashment the policy is worth what it is worth albeit calculated by reference to these notional units. The acquisition cost of the LP has not changed but its final encashment value has been reduced by the DD tax deducted This needs to be added back to the Exit Tax calculation to calculate overall profit on the policy which would now be subject to Exit Tax at the going rate with a deduction for DD tax already paid.

In the case of UCITs etc. the taxable entities are the units themselves. The UCITS will enforce actual encashment of some units to pay DD tax and indeed this encashment will incur its own actual Exit Tax. When the remaining units are eventually encashed the taxable profit will be calculated without the necessity to add back previous tax deducted and as with the LP any such DD deducted can be set against this final tax. The main difference, so far as I can see, is that with the LP the initial acquisition cost is unaffected whereas with the UCITS it has been reduced by the earlier enforced encashment of units.

So I agree that the average cost basis does not seem to be relevant.

Is this still true when the tax rate changes at the subsequent disposal? If so, it makes different scenarios more or less favourable to the LP.

If the tax rate falls, the LP benefits more than the UCITS because all the previous tax paid by the LP is rebased to the lower rate. The units encashed by the UCITS at the higher rate are not rebased.

If the tax rate rises, the UCITS benefits more than the LP because all the previous tax paid by the LP is rebased to the higher rate. The units encashed by the UCITS at the lower rate are not rebased.

Given that the exit tax rate has risen to 41% since it was introduced hasn't the LP been penalised by this adding back of the tax?

 

[Duke of Marmalade]

Is this still true when the tax rate changes at the subsequent disposal? If so, it makes different scenarios more or less favourable to the LP.

If the tax rate falls, the LP benefits more than the UCITS because all the previous tax paid by the LP is rebased to the lower rate. The units encashed by the UCITS at the higher rate are not rebased.

If the tax rate rises, the UCITS benefits more than the LP because all the previous tax paid by the LP is rebased to the higher rate. The units encashed by the UCITS at the lower rate are not rebased.

Given that the exit tax rate has risen to 41% since it was introduced hasn't the LP been penalised by this adding back of the tax?

First of all, I should say that I am not familiar with UCITS taxation but this is my read of the example you provided.
Yes, there is a difference of treatment but it is second order. Note that after a DD a unit holder is still sitting on (most of) their units with their original base. Therefore there is still a big taxable unrealised gain, on which they have paid DD. Ultimately when they encash these units they will be taxed at the then rate but they will get credit for DD already deducted.
Both have been forced to encash "units" to pay DD. The difference is that with a LP the "encashment" is internal book-keeping and of itself does not incur Exit Tax. If the LP instead was partially encashed to pay the DD then they would be in the same position as a UCITS holder, they would be subject to actual Exit Tax on the partial encashment.
The difference with UCITS is that they are enforced to make actual taxable encashments. In overall terms this does seem to give the LP a slight advantage as they do not pay actual Exit Tax until final encashment, so they have a time value advantage, but as I say it is second order.

 

[Corola]

The example is not intended to be specific to UCITS, the Revenue document is about all unit-linked funds. Isn't a life policy simply a wrapper around a unit-linked fund(s)?

I don't see any time value advantage due to the LP encashment only being notional on the deemed disposal, doesn't the policyholder immediately see a drop in their fund value and number of units held? There is no subsequent growth attributable to the units that were notionally encashed that would create a second order effect.

The gross value at final disposal is the same for LP and UCITS, but the final tax credit allowable for deduction is seemingly on the original number of units for the LP and the remaining number of units for the UCITS.

 

[Duke of Marmalade]

The example is not intended to be specific to UCITS, the Revenue document is about all unit-linked funds. Isn't a life policy simply a wrapper around a unit-linked fund(s)?

I don't see any time value advantage due to the LP encashment only being notional on the deemed disposal, doesn't the policyholder immediately see a drop in their fund value and number of units held? There is no subsequent growth attributable to the units that were notionally encashed that would create a second order effect.

The gross value at final disposal is the same for LP and UCITS, but the final tax credit allowable for deduction is seemingly on the original number of units for the LP and the remaining number of units for the UCITS.

The difference is that LP units are notional so if an LP reduces the units attaching to the policy, for sure it reduces the value of the policy but it is not the same as physically partially encashing the policy. Indeed a LP needn’t be unitised at all. But I think you are right that there is no time value advantage for whilst the UCITS holder would be subject to actual ET on their encashment they would be able to offset that by dipping into their DD payment on account, so no cashflow disadvantage.
So the difference is very slight. The UCITS holder uses up a small part of their DD payment on account earlier than the LP so there is a slight difference due to the possibility of changes in the rate.
Essentially it is the same as Brendan illustrated it for an LP.
Going back to the adding back the DD tax in the final calculation it is the same as reducing the Acquisition cost of the LP.
I think.

 

[Corola]

Going back to the adding back the DD tax in the final calculation it is the same as reducing the Acquisition cost of the LP.

You can show it is the same when the tax rate stays the same by following the notional number of units and price, for example 100 units @ €100 per unit.

Adding back the tax

	Value
Original investment	€10,000
Value after 8 years	€20,000
Gain	€10,000
Deemed Disposal @ 41%	€4,100
Cashed after 10 years when worth	€30,000
Original investment	€10,000
Gain + add back the tax	€24,100
Exit tax @ 41%	€9,881
Tax already paid	€4,100
Tax due now	€5,781

Following the units

	Value	Nb units	Unit price
Original investment	€10,000	100	€100
Value after 8 years	€20,000	100	€200
Gain	€10,000
Deemed Disposal @ 41%	€4,100	20.5	€200
Value net of tax + units encashed	€15,900	79.5	€200
Tax paid per unit	€41
Cashed after 10 years when worth	€30,000	79.5	€377
Original value of remaining units	€7,950	79.5	€100
Gain	€22,050
Exit tax @ 41%	€9,041	23.96	€377
Tax already paid on remaining units	€3,260	79.5	€41
Tax due now	€5,781

 

[Corola]

Whereas if the tax rate drops to 33% it is no longer the same.

Adding back the tax

	Value
Original investment	€10,000
Value after 8 years	€20,000
Gain	€10,000
Deemed Disposal @ 41%	€4,100
Cashed after 10 years when worth	€30,000
Original investment	€10,000
Gain + add back the tax	€24,100
Exit tax @ 33%	€7,953
Tax already paid	€4,100
Tax due now	€3,853

Following the units

	Value	Nb units	Unit price
Original investment	€10,000	100	€100
Value after 8 years	€20,000	100	€200
Gain	€10,000
Deemed Disposal @ 41%	€4,100	20.5	€200
Value net of tax + units encashed	€15,900	79.5	€200
Tax paid per unit	€41
Cashed after 10 years when worth	€30,000	79.5	€377
Original value of remaining units	€7,950	79.5	€100
Gain	€22,050
Exit tax @ 33%	€7,277	19.28	€377
Tax already paid on remaining units	€3,260	79.5	€41
Tax due now	€4,017

 

[Duke of Marmalade]

@Corola We are in violent agreement; I must not have explained myself well.
The difference between the two scenarios is that in the first there is only one actual chargeable event - at the end. In the second there are two chargeable events - one occurring after 8 years to pay the DD tax. The reduction of units under a LP wrapper is not a chargeable event.
Therefore the chargeable gain in (1) at the end is €24,100 whilst in (2) it is €22,050, a difference of €2,050 and this suffers the 41% rate instead of the 33% rate, a difference of €164.