WRUNG OUT TO THE LAST CENT

Property and casualty insurers in Canada pay the federal and provincial governments about $4 billion a year in combined taxes, of which transactional-based charges such as general and provincial sales taxes added to “premium taxes” account for a significant piece of the pie. Many of these taxes also apply to other companies thrown under the ambit of “financial services”. But, unlike the banks, the insurance industry is inconsistently subject to premium and capital taxes in some cases, as well as sales taxes without the benefit of being able to claim the latter’s cost “input credits”.

The end result of this, according to a report published last year by tax experts Jack Mintz and Duanjie Chen of the University of Toronto, is that p&c insurers in Canada incur a significantly higher transactional tax cost than other financial service players, while the sector’s effective tax rate is much higher than other non-financial service industries. “In Ontario, Quebec, and Newfoundland, this tax gap between the p&c insurance industry and other non-financial industries ranges from 13 to 22 percentage points,” the report states.

Although the p&c insurance industry faces an added burden through the application of federal-driven taxes such as the general sales tax levied on policies, and the cost of “a deemed annual capital gains tax” based on the “mark-to-market” rules applied to financial service operators, the real concern of the industry lies with provincial transactional taxes. These forms of taxation result in a “cascading” or “tax on tax” cost effect.

Notably, the Mintz report observes, the biggest cost component within these transactional taxes is the premium tax, which was supposedly introduced as an alternative to capital taxation. “Even with a conservative estimate of a premium to capital ratio of two, the current premium tax of over 3% [in most provinces] is equal to a capital tax of over 6%, which is unbearably high by any standard,” the report states. The Insurance Bureau of Canada (IBC) also notes that transaction-based taxes as a whole have risen by 60% over the last 30 years, with roughly $2.7 billion collected from the industry in 1998.

Therefore, it is in this area that the IBC is leading its lobby charge for tax reform. Why now? The bureau regards the current “political environment” to be highly favorable with many of the provincial government’s sitting on financial budget surpluses as a result of the strong economic growth over recent years.

The campaign strategy

There are signs of hope that the provincial governments may address tax reform initiatives during the course of this year and 2002, says Eileen Young, chair of the IBC’s tax panel. The Ontario government recently announced that it plans to review the current business capital tax – beginning this year, with the first $5 million of a company’s taxable capital expected to be made exempt. This follows an announcement last year by the provincial government to cut the corporate income rate by 7% over the next five years. The Ontario government also intends to reduce the sales tax on insurance auto products by 1% through to the end of 2004 at which point it would be eliminated (although the tax will remain on property insurance policies).

This, however, is but a small chip off the tax burden foisted onto the insurance industry, Young concedes. And, while the IBC was pleased with the Ontario government’s intent to reduce capital taxation, this does not mean that the authorities will necessarily look at reducing the premium tax rate – which insurers pay in Ontario in lieu of capital tax. In fact, after the recent concession to reduce the sales tax on auto insurance, Young is not hopeful of further reform this year. “Basically, we’re going to keep hammering away at the provincial governments. Our target is to promote reform initiatives at this time in anticipation of next year’s governmental budget plans.”

Steve Donohoe, vice-chair of the IBC tax panel, points out that the negative impact of sales taxes on insurance is two-fold: firstly, they – being general and provincial sales tax – are applied on top of the premium tax and therefore add a “tax on tax” component to the cost equation, and thereby reduce the affordability of insurance. Secondly, the sales tax is also levied on claim costs, which the industry cannot reclaim as an input credit as p&c insurance is defined as a financial service for tax purposes. “In the end, we’re looking at a tax on a tax on a tax in some cases,” he surmises.

As a result, the IBC’s manager of policy development, Ian Campbell, says the bureau’s main lobby focus will be on reducing premium taxes to an average 2% rate, which at the moment across the provinces hovers between 3% to 4% (a 2% premium tax rate is prevalent within the U.S.). Ultimately, the IBC would like to see premium taxes eliminated, which as the Mintz report notes, “this special tax, originally a substitute for capital taxes, has lost its purpose. The insurance premium tax is neither a capital tax nor a conventional sales tax, but an excise tax on special products like fuel, alcohol and tobacco taxes.” Essentially, the IBC states, insurance policies are being selected by the governments similar to the way so-called harmful products are subjected to “sin taxes”.

That said, Campbell says the IBC has no illusion that the provincial governments will be willing to move immediately on reducing or eliminating premium, capital and/or sales taxes. And, on top of this burden is health levies charged on auto insurance covers, which in provinces such as Alberta and Ontario where personal injury claim costs have escalated dramatically, the need for taxation and product reform has become critical, he emphasizes. That said, Campbell adds, “we realize that the governments have become reliant on these revenue streams, and we’re not expecting the premium tax to be eliminated overnight”.

There are, however, some signs of light at the end of the tunnel, he observes, as many of the provincial governments have expressed interest in cutting taxes in general. Recent discussions between the IBC and the federal tax collector have also produced positive feedback on creating a fairer approach to the deemed capital gain tax under the “mark-to-market” rules. “We’re looking in the long run to have this tax eliminated, Canada is the only country among the G-8 that applies ‘mark-to-market’ capital taxation to financial services, and this is out of step with international trends.”

Weighing the odds

“I think the [p&c] insurance industry has done an excellent job of identifying the cost [of taxes],” says Nunzio Tedesco, a tax partner at KPMG – which acts as advisor to the IBC. The industry is not out looking for favors from a tax perspective, he adds, but seeking fair treatment. The tax systems are supposed to be based on a rule of fairness, and in this respect p&c insurers have a strong case for reform, Tedesco points out. “The industry is not asking for special treatment, but simply that it is being over-taxed, and this is the message we need to get out.”

From a pragmatic standpoint, Tedesco concedes that achieving the goal of tax reform is easier said than done. Governments have come to rely on this revenue, he notes, but some concessions have been recently made by the provincial authorities. Specifically, the proposed reduction in capital tax in Ontario this year, plus a battle won last year by the industry to dissuade the Manitoba government from extending its premium tax with an add-on “fire levy”, all bode well for a more progressive attitude by the tax authorities toward how insurers are taxed, he says.

Dean Summerville, a senior partner at PriceWaterhouseCoopers Canada, says the p&c industry has been identified by the tax authorities for “special treatment, “which is not the kind of ‘special treatment’ that I would like to face”. His comment refers to the deemed capital gains tax insurers face under the “mark-to-market” rules whereby “paper gains” on equity investments are taxed annually. The manner in which this tax is calculated can therefore have an advers e impact on the balance sheet as it is not based on annual income performance. Hence, should an insurer have a bad financial year, the capital tax is still owing, he adds. Conversely, should a company incur a capital gains loss, but rising revenue income, this formula can be worked to advantage. Ironically, with governments such as Ontario now looking to reduce capital tax rates when equity market prices are falling and premium income revenues are rising, the tax benefit insurers would gain from capital losses is greatly diminished.

The IBC also draws attention to the fact that the p&c insurance industry is statutorily required to maintain high capital reserve levels. The fact that a large component of these reserves is invested in equities compared with other financial services companies (see chart: Exposure to Equities) adds to the industry’s unfair tax treatment, the Bureau claims.

While it appears that the governments now have a more sympathetic ear to the plight of insurers, Summerville is not optimistic of radical tax reform. “You can sometimes succeed in staving it [new tax proposals] off at the pass, but once they are in place, it’s difficult to get them out.” Notably, he points to the premium tax which was supposed to replace capital taxes on the insurance industry. This tax has been around for a long time, he notes, and it is buried from the consumer’s view – this stable inflow of revenue can be additive to governments, particularly when they are looking at budget cutting and reducing personal income tax levels.