Equalisation reserves: the tax rules
On trading income principles as understood in 1996, transfers to or from an equalisation reserve would not affect taxable profits, following the rule that neither a profit nor a loss could be anticipated. For later developments in this area see BIM31100. Further, transfers were not based on any reliable calculations of the related losses (see Owen v Southern Railway of Peru 37TC602). Finally, it could be argued that additions to reserves were simply an application of profit, so that profits could not be said to be misstated in the absence of a deduction. For all these reasons, there was no relief.
Tax legislation prescribing certain reliefs and charges was introduced in 1996 as ICTA88/S444BA to ICTA88/S444BD, and the Insurance Companies (Reserves) (Tax) Regulations 1996 (SI1996/2991). The Regulations apply for accounting periods ending on or after 23 December 1996.
The principles involved in computing tax relief are straightforward. The equalisation reserve (or reserves if the company carries on both credit insurance and other business) is calculated according to the supervisory rules outlined in the previous paragraphs. Net transfers into each reserve are allowed as a deduction in computing the profits of the insurer’s trade. Net transfers out of each reserve are treated as a receipt of the trade whether they are triggered by excessive claims or by an alteration in the maximum reserve level.
For business other than credit insurance it is only the final net figure transferred in or out that is relevant for tax purposes, not any transfers in or out in the computational stages. This is the figure which is referred to in ICTA88/S444BA (2) and ICTA88/S444BA (3) as “the amounts which, in accordance with equalisation reserves rules are transferred into the equalisation reserve in respect of the company’s business for the accounting period in question”. For credit insurance transfers in and out cannot occur in the same year, even at the computational level.
The additions and deductions that are authorised by ICTA88/S444BA are made in the computation of trading profit. They therefore have no effect on the tax liability of companies that conduct the whole of their business on a mutual basis, for whom there is no such computation. See GIM7360 below where part of the business is mutual.
In the example in GIM7110 a deduction in the computation of trading income would be given for the net transfer into the reserve of £76,000.
A company supervised by the FSA might choose to set up an equalisation reserve that is greater than the amount required by the Regulations. Historically such voluntary reserves have been mainly confined to mutual companies, where they have no effect on the tax liabilities, and it is unlikely that proprietary companies will put extra capital aside and so exceed the minimum requirement. If, exceptionally, they do so, the excess reserve will need to be separately identified in the shareholder accounts, and calculations relating to it should not be included on the forms 37 to 39 in the FSA return. So there should be no difficulty separating out the calculations relating to the statutory reserve. No tax deduction is available for transfers into such a voluntary reserve, and corresponding transfers out are not taxable. A different principle applies to the voluntary reserves that may be maintained by corporate members of the Lloyd’s insurance market - see the Lloyd’s Manual (LLM).