Tax Research: Greater Bay Area Series
Comparison of tax systems across the region for the financial industry: (3) insurance
In the opinions on the implementation measures of the Outline Development Plan for the Guangdong-Hong Kong-Macao Greater Bay Area (GBA) of Guangdong Provincial Party Committee and Provincial Government, insurance innovation has been mentioned repeatedly. Here, we focus on tax issues related to the insurance business.
As one of the three driving forces of the financial industry, the insurance sector plays an important role in risk management, financing and social services. Most jurisdictions have entry requirements and impose strict supervision on the insurance sector. Recently, the mainland has amended the Regulations on the Administration of Foreign-funded Insurance Companies to loosen the restrictions and improve the environment for foreign-funded insurance companies setting up operations in the mainland.
Insurance businesses in Hong Kong and Macao are relatively more mature. Following 40 years of reform and opening up, the insurance sector in the mainland has also formed a business system covering all insurable risks. The insurance business is mainly comprised of property insurance and personal insurance. They have different business features, and there are certain differences in tax policies, which we focus on here. Other types of businesses such as reinsurance, co-insurance and captive insurance are out of the scope of this article.
The insurance business is complex with a long time horizon. There are many parties involved, such as the insurance company, the policyholder, the beneficiary and the insurance intermediaries. There is a long business chain mainly including insurance consultation, sales, underwriting, investigation, loss assessment, claim assessment, claim settlement, investment and dividend distribution and possibly long time span such as long-term life insurance. All of these factors result in multiple tax processes and complexities in actual collection and management. Apart from tax treatment on insurance premiums, insurance companies also have to consider tax deductions of acquisition costs (e.g. commission fees) and risk items (e.g. claims and reserves), as well as potential withholding tax obligations. Policyholders will normally pay attention to tax deduction of premium payments. Beneficiaries need to consider the tax issues on claims or dividend income. Insurance brokers or agencies need to understand the tax treatment on commission income. This article focuses on tax issues from the standpoint of insurance companies.
Moreover, as cross-border economic activities and individual travels become more frequent, the parties involved and the covered matter of the insurance are increasingly likely to be located in different jurisdictions, offering broad prospects for cross-border insurance business. In addition, to actively respond to the Outline Development Plan for the GBA, and explore the path of innovation of insurance services in the GBA in the future, stakeholders, including the regulators and insurance companies, should take into account the tax issues related to cross-border insurance business.
Figure 1: Diagram of the insurance business model
Local insurance business
The local insurance business discussed here refers to situations where the policyholders, insurance companies, covered matters of insurance and beneficiaries are all local. Cases with one of the parties situated in another tax jurisdiction are considered cross-border insurance business and are discussed below.
In the mainland, value-added tax (VAT) of 6% is levied on premium income, and net operating income is subject to enterprise income tax (EIT) of 25%, but specified insurance types are entitled to tax relief. In Hong Kong, profits tax of 16.5% would be charged on taxable profits derived from insurance businesses carried on in Hong Kong. The taxable profits of a life insurance business are deemed to be either 5% of the net premiums or are assessed on changes in adjusted surplus based on an actuarial report. In Macao, complementary tax of 12% is levied on premium income.
Based on the features of the insurance business, special rules have been set in respect of treatment of tax incentives, acquisition expenses, and risk items, in different regions accordingly.
(1) Tax incentives
In the mainland, tax relief is granted to premium income, or income earned from specific insurance types. For example, for agricultural insurance covering planting and breeding, 90% of premium income is allowed to be assessed as taxable income in the calculation of EIT1. For income earned from agricultural and animal husbandry insurance, and personal insurance of over a 1-year term (including traditional life insurance, health insurance, pension insurance and other annuity insurances), VAT exemptions are granted. In Hong Kong and Macao, there are currently no tax incentive measures on the general premium income of insurance companies2.
(2) Acquisition costs
The most significant acquisition costs of an insurance company are the commissions paid to insurance brokers or agents. Whether such expenses are deductible before tax will have an impact on the net taxable income of the insurance business.
In the mainland, the EIT deduction ceiling of commissions is 18% of the balance after deducting such payment as the surrender value from the premium income for the current year. The excess, if any, is allowed to be carried forward to subsequent years for tax deduction. In terms of cash flow, with regard to personal insurance companies, as the rates of commissions of single premium, first-year premium and renewal premium paid under regular premium differ significantly, there would be a big gap between the actual EIT payments (or cash tax) and the EIT expense accrued for the relevant period (or book tax) in these companies. In addition, mainland insurance companies are obligated to withhold tax when paying commissions to individual agents, which primarily include individual income tax (IIT) (3%-45%) and VAT3 (3%).
In Hong Kong, commission expenses of non-life insurance companies are tax deductible. For life insurance companies, if the taxable income is calculated based on 5% of the net premium, deduction of commission expenses is not relevant; if the taxable income is calculated based on the change in adjusted surplus, commission expenses are generally deductible. For commissions paid to individual agents, there is an employer's reporting obligation but no withholding obligation in Hong Kong.
In Macao, insurance companies are subject to the requirements of the Monetary Authority of Macao related to the maximum rate of commissions paid to intermediaries. Such commissions can be fully deducted for the purpose of complementary tax. Although insurance companies in Macao are not subject to withholding obligations when paying commissions to non-employee agents, the Monetary Authority of Macao and Financial Services Bureau of Macao require them to provide the details of the commission recipients.
(3) Claim and reserves
If an incident related to the covered matter of insurance occurs, insurance companies need to pay the claim filed pursuant to the insurance contract. Besides, to guarantee insurance companies' ability to perform the contracts and protect the interests of the beneficiaries, insurance companies also have to allow for reserves for various risks according to regulatory requirements. These two types of expenses are the most significant costs of insurance companies. Whether such expenses are fully deductible before tax will have a considerable impact on the net income of the insurance business.
Claim expenses are generally tax deductible in all three regions (except life insurance companies in Hong Kong which are taxed on the 5% net premium basis). In the mainland, most insurance claims paid are not eligible for input VAT credit, while property insurance may have the possibility under the premise that obtaining special VAT invoices for the claim payment in the form of in-kind compensation. As most of the premium income of personal insurance companies are exempt from VAT, the absence of input VAT credit of claim expenses may have less impact on them compared to property insurance companies.
For reserves, the types and requirements of reserve allowance in the three regions are different. In the mainland, rules vary by type of reserves in the calculation of EIT. The insurance protection fund paid in accordance with the rules are generally deductible on an actual basis. A pre-tax deduction is allowed for some statutory reserves withdrawn in accordance with the relevant rules set by the regulator, such as unearned premium reserve, life insurance reserve, long-term health insurance reserve and agricultural catastrophe insurance reserve. But certain reserves are deductible with some limitations (e.g. deduction of reported but not settled reserves is capped at 100% of the claim expenses accrued or claim payment for the current period; deduction of incurred but not reported reserves (IBNR) is capped at 8% of the actual amount of claim payment for the current year). Some reserves are not allowed to be deducted (e.g. reserve for other claim expenses). In Hong Kong, insurance contract reserves allowed for under Hong Kong Financial Reporting Standards and/or regulatory requirements are generally deductible for tax purpose (except for life insurance companies which are taxed on the 5% net premium basis). In Macao, reserves allowed under regulatory requirements are all deductible on an actual basis.
Considering the above factors, we have made a comparison of the tax liabilities and net incomes of domestic insurance business among the three regions, assuming the pre-tax revenues of the insurance business are the same:
Table 1: Comparison of tax implications of local insurance business
[Assumption] An insurance company has earned a premium income of 1060 (inclusive of VAT where it applies). The agent commission expense was 200 (assuming it is below the VAT threshold, and thus not subject to VAT), and claim expense was 600 (in cash). For simplicity, the following calculations have not taken into consideration of expense items other than commission and claim expenses, and tax implications other than EIT and VAT.
EIT = (1,0004-1805-600) x 25% = 55
Life insurance (taxable profits calculated at 5% of net premium)
Complementary tax = (1,060–200–600) x 12% = 31.2
Cross-border insurance business
Currently, the regulatory authorities in Hong Kong and Macao have not set any special restrictions on cross-border insurance business, and no additional tax liabilities will be incurred. In the mainland, the cross-border businesses of local insurance companies traditionally focus on areas related to exporting goods or international shipping. As Chinese companies "go global" and the Belt and Road Initiative (BRI) develops, local insurance companies are willing to provide insurance services for the "going-global" projects of Chinese companies. For Hong Kong and Macao insurance companies, due to regulatory restrictions in the mainland, there is currently no legitimate channel or marketplace in the mainland for them to directly underwrite, the covered matter of which is located in the mainland (including property and personal liabilities).
In the mainland, the EIT treatment on the income from cross-border insurance business earned by local insurance companies is basically the same as that from local insurance business. In terms of VAT, there are differences in the tax treatment. The current regulations have only explicitly stated that premium income related to insurance for export goods or qualified international shipping insurance are exempt from VAT; no exemption rules have been set for other cross-border insurance. Besides, at the policy level there is no specific tax relief on premium income earned by overseas insurance companies from providing insurance services to domestic policyholders. Based on the general principles of existing tax provisions, overseas insurance companies may need to consider the implications of EIT (10% of gross income or 25% of deemed profits) and VAT (6%).
In Hong Kong and Macao, the premium income earned by insurance companies from their life or non-life insurance businesses are taxable income, regardless of whether the policyholders, beneficiaries, or subjects underwritten are domestic or overseas. Hence, the tax treatment is basically the same as the local insurance business.
(1) Local insurance business
In recent years, the mainland insurance market has demonstrated strong demands and growth potential. However, compared to the more mature insurance market in Hong Kong, there is still a gap in the availability and range of insurance products and services in the mainland. The further opening-up of the mainland insurance sector and the improvements in the business environment will gradually attract more foreign-funded insurance institutions, including Hong Kong and Macao-funded insurance companies, to enter the market. These companies should pay attention to the differences in the tax systems among the mainland, Hong Kong, and Macao.
For income tax, the higher statutory tax rate and the restrictions on tax deductions of acquisition costs and risk reserves in the mainland may result in higher income tax liabilities for local insurance businesses run by mainland insurance companies, when compared to Hong Kong and Macao insurance companies. The restrictions on deductions of commissions, in particular, may have impacts on after tax cash flow due to the different product structures of insurance companies. In addition, as VAT is levied in the mainland, whether input VAT credit is available depends on the form of the claim payment. This will directly affect the claim cost of property insurance companies. For personal insurance companies, relevant input VAT associated with the purchase of services is not creditable due to the VAT exemption on income from large amount of qualified insurance products. Such non-creditable input VAT could be part of the cost of the companies, too. Hence, the differences in the VAT management methods and levels in mainland insurance companies may have significant impact on their cost.
(2) Cross-border insurance business
In recent years, Hong Kong's insurance products have attracted a large number of mainland clients with lower premium rates, higher dividend payout ratios, greater number of choices, and better service quality. It is noticeable that the number of people traveling to Hong Kong to purchase insurance products has significantly increased. Such products mainly include life insurance saving plans, critical illness insurance, and high-end medical insurance. Nevertheless, there has been no official channel for mainland individuals to purchase insurance in Hong Kong. To progressively promote cross-border transactions of insurance products in the GBA, the Outline Development Plan for the GBA explicitly proposed the plan to "support insurance institutions in Guangdong, Hong Kong and Macao to jointly develop innovative cross-border motor vehicle and medical insurance products". This may help address the difficulty in outward remittance of insurance funds and inward remittance of claim payments under the current foreign exchange control policies, and promote services for cross-border policyholders in areas such as underwriting, investigation and claims.
Regardless of the approaches in getting through the supervisory and foreign exchange barriers, the manner in which taxes are levied on these businesses in the mainland will have a direct impact on the premium rates. Therefore, taxation is a vital factor to consider. As mentioned in the opening of this article, the insurance business involves many parties and a long business chain. Most business processes are shaped by the flow of "people", which has made the determination of tax obligations more difficult:
- For income tax, the tax obligations of each party in each jurisdiction are determined based on the "resident status" of the parties involved and the place where the related income is sourced. There is still a lack of clear rules and guidelines on how they are determined. For the cross-border flow of people involved in each process, companies may also need to consider how the double tax arrangements between the mainland and Hong Kong/Macao would be applied, especially the articles related to the permanent establishments and income of individuals;
- For VAT, the critical factor to determine VAT obligation in the mainland is to assess whether the services are performed in the mainland. The "place of performance" of the services is generally considered as located in the mainland if either the seller or purchaser of the service is in the mainland, unless it can be clearly shown that the services fully take place outside the mainland. The varying interpretation of the right to apply VAT on insurance products has led to inconsistencies across geographies and has often seen disagreement on whether the mainland tax authorities holds the right to tax across different cities in the mainland.
- Moreover, cross-border insurance contracts may have longer terms of coverage. Future changes or reforms in the tax system in the mainland may also have impact on insurance paid in installments, which further increases the uncertainties in determination of premium rate.
In further formulating policies for cross-border insurance in the GBA, it is suggested that the relevant departments conduct a detailed study on the potential tax issues of each business process involving the relevant parties. Reasonable and practical standards and guidelines on tax collection should be developed which mitigate the adverse impact of tax uncertainties on the abovementioned cross-border businesses.
Last but not the least, a qualified and competent service institution might be introduced to act as a platform to facilitate cross-border insurance business in the GBA. While free flow of talent and access to insurance offerings across the GBA would produce the greatest business opportunities, the tax implications would be extremely complex and be carefully considered. A simplified and convenient tax system might be developed to account for the VAT and IIT obligations of brokers and agents conducting business throughout the GBA.
Deloitte China will continue to keep track of the latest updates and developments of the tax systems of the financial business in Guangdong, Hong Kong and Macao, and maintain active communication with regulators and industry to contribute to the promotion of financial innovation in the GBA. In our upcoming articles, we will provide discussion and comparison for other financial businesses. Please join our discussion if you have any suggestions and insights in this regard.
1 The tax relief policy on premium from agricultural insurance has expired by the end of 2019.
2 Hong Kong has recently introduced tax incentives for general insurance business which are not yet in effect to date. Please refer to the relevant Tax Newsflash for details.
3 Individual monthly commission income below RMB100,000 is not subject to VAT.
4 Taxable income of EIT and VAT should be net of VAT: 1,060/(1+6%) = 1,000
5 EIT deduction ceiling of commission expenses for the current year =1000*18%=180