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Wrapper Rage Back  
The Minister for Finance issued a press release on 26 September indicating that the Finance Act 2002 will impose a surcharge of 20 per cent on top of the normal exit tax of 23 per cent when ‘life assurance wrappers’ are cashed in. The surcharge is to apply to existing wrappers as well as any issued after that date.

What is a wrapper?
A wrapper is a life assurance policy. It is a life assurance policy whose value is dictated by the value of a portfolio of investments selected by the life policy holder. The investments don’t belong to the life policy holder. They belong to the life assurance company which issues the policy. However the life assurance company’s liability to pay out on foot of the policy is dictated by the value of the selected investments.

The only thing that distinguishes the life assurance wrapper from any other life assurance policy is that the policy holder has the right to indicate the portfolio of investments to which the value of the policy is to be related. In most life assurance policies (ie those which are not regarded as wrappers) the right of the policy holder to choose the investments to which the policy will be linked is limited to indicating very broad choices eg UK equities, Nasdaq investments, properties etc.

Minister’s concern
Why is the Minister concerned about the method of determining the value of life assurance policies? His interest stems from the taxation treatment of the policies.

Many life assurance policies nowadays have little or nothing to do with insuring against the possibility of early death. They are savings vehicles whose returns are expected to be enjoyed in the lifetime of the policy holder. Along with unit trusts and similar collective forms of investment they enjoy a special tax regime. The life company is not charged to capital gains tax when it disposes of investments underlying its policies nor is it charged to corporation tax when it receives dividends from those investments. Instead, when the policy holder cashes in his policy the life company withhold a tax of 23 per cent of the growth in value of the policy over the sums subscribed for it. That is a final tax charge and the policy holder has no further tax liability.

Is tax regime that good?
A tax charge of 23 per cent looks favourable when compared with the top marginal income tax rate of 42 per cent (currently). The comparison however is misleading.

In normal market conditions the greater part of the gain in value in any policy will be created by gains in the value of the underlying investments. If such gains arose directly to the individual he would pay capital gains tax at a rate of 20 per cent on the inflation adjusted gain. This is actually lower than the 23 per cent tax charged on the gain (not adjusted for inflation) on encashing the life assurance policy.

However the dividend income accruing to the individual on directly held investments are charged at his marginal tax rate – in many cases 42 per cent. The additional 3 per cent (over the capital gains tax rate) charged on the encashment of a life policy to some degree offsets this apparent advantage.

Purely in terms of tax rates, the life assurance policy does not obviously offer significant tax advantages compared to direct private investment. The advantages the wrapper possesses, as all life policies do, lies in a different area. An individual who holds equities directly and wishes to switch out of investment in one quoted company, and into another quoted company, may well crystallise a capital gain when making the switch. Tax will arise in such an instance.

In contrast, the life assurance company can buy and sell investments linked to its life policies without crystallising any capital gains tax charge. The life assurance company may therefore make its investment decisions almost without any regard to taxation considerations. The individual direct investor on the other hand has to balance the prospect of an immediate tax charge against the less certain prospect of making a better investment than he has at present.

All other things being equal, the ability of the life company to make its investment decisions without regard to tax should result in a better performance for its portfolio overall, than could be achieved by an individual who is constrained by tax.

What’s wrong with a wrapper?
The Minister’s statement indicated that he had intended the special tax regime for life companies to apply only to forms of collective investment employing the professional expertise of the life company in the management of pooled investments. He did not intend that it would be available where the investment expertise was not that of the life company, and the policy was not sharing in a pooled investment.

The Minister has clearly stated his focus, and his problem with the wrapper. But is the wrapper truly objectionable? And if there are objections to it, is the imposition of a 20 per cent tax surcharge a proportionate response to that that objection?

The Minister’s objection boils down to no more than this, that he favours professional management on a collective basis as opposed to individual judgement at the individual’s sole risk. He prefers collectivism over individualism. Where did we hear that slogan before? It would have sounded familiar in the Soviet Union of the 1920s when millions of kulaks were murdered by Lenin and Stalin so that the professionally managed collective farms could replace individually owned and managed small holdings. The subsequent history of Soviet agriculture was 75 years of failure to feed its own people.

What about proportionality?
The Minister is probably correct in believing that professionally managed collective investment is a safer form of investment than personally managed and directly held portfolios. But does that belief justify a savage 20 per cent tax surcharge (almost the doubling of tax)? Does it justify introducing this change without giving those holding wrapper policies the opportunity to transform them into the collective policies favoured by the Minister, but not required by existing legislation?

To ask whether such changes are justified is not merely an appeal to justice. It raises a constitutional point. The Supreme Court has held that taxation measures aimed at correcting what the Government believe to be an abuse must be proportionate to the abuse. If they are disproportionate, they are entirely void. A number of tax measures have already been struck down by the Supreme Court on this basis.

The justifications offered by the Minister for his extraordinary taxation proposals of 26 September would not seem to be proportionate to what he is proposing. It may be that before the Finance Act appears that the Minister will be able to offer more convincing explanations.

Lords say ok
Wrappers have been around for a long time. As long ago as 1986 Professor Willoughby (now deceased) invested in such policies. The Inland Revenue in the UK treated it as objectionable tax avoidance. The subsequent law case went as far as the House of Lords which ruled in favour of Professor Willoughby in 1997. There Lord Nolan said ‘The personal portfolio bond holder (ie wrapper owner) may fare better or worse in terms of benefits by reason of control over investment policy than does his fellow bond holder with the standard type of bond, but the difference between them seems to me to have nothing to do with tax or with tax avoidance. I can see no reason why Parliament should have intended to distinguish them in fiscal terms.’ Four other Law Lords concurred in that judgement.

Mr McCreevy is right not to be bound by the views of foreign courts. However it would be prudent of him to respectfully consider that they might not be right in this instance.

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