Tax Insights: Department of Finance’s policy direction on IFRS 17 for insurance contracts

Issue 2021-14

In brief

On May 28, 2021, the Department of Finance (Finance) released a backgrounder¹ that provides a high level indication of its policy direction in regards to International Financial Reporting Standard (IFRS) 17. Generally, the federal government supports using IFRS 17 accounting income as a basis to determine income for tax purposes, which is welcome news to the insurance industry. However, the government has indicated that it will not allow insurers to deduct the “contractual service margin” (CSM) as an insurance reserve for tax purposes. The government is launching a consultation with industry stakeholders² on how best to implement its policy position, as well as on other tax issues that may arise on the adoption of IFRS 17.

In detail

Background

In May 2017, the International Accounting Standards Board released IFRS 17, which will replace IFRS 4 for accounting for insurance contracts and will be effective January 1, 2023. IFRS 17 will substantially change financial reporting for insurance and reinsurance companies, including:

• life insurers – which includes annuity, accident and health insurance providers
• property and casualty (P&C) insurers – which includes auto, personal property, commercial property, liability and title insurance providers

IFRS 17 will significantly alter the measurement of income from insurance contracts, particularly those that relate to life and other long-term insurance contracts.

The unique nature of insurance, where premiums are pooled and then invested to pay claims, often years after contracts are sold, has led to specific rules being developed regarding the computation of income for tax purposes. These special tax rules permit insurers to deduct reserves from premiums received, in recognition of the future claims that will be paid. Under IFRS 17, reserves will continue to be determined actuarially when insurance contracts are sold; however, IFRS 17 will introduce a new reserve, the CSM, which will represent a portion of the profits on underwritten insurance contracts that is deferred and gradually released into income over the estimated life of the insurance contracts.

Government of Canada’s position

The government intends to implement changes that will generally support using IFRS 17 accounting for income tax purposes — with adjustments being made to recognize profits as taxable income in a manner that the government believes better aligns with economic activities.

Finance’s view is that if the CSM mechanism is adopted for tax purposes, it would lead to a deferred recognition of profits for tax purposes. Finance has also noted that IFRS 17 will introduce an asymmetrical treatment of certain types of profit and losses, because profits (but not losses) will be deferred through the CSM. Specifically, this is a concern because the “onerous contracts” rules in the new accounting standard will (if, at the moment of underwriting, a group of contracts is expected to generate a loss over its lifetime) require the insurer to immediately recognize such loss in income.

In response to the above accounting treatment, Finance has stated that the CSM would not be considered a deductible reserve for tax purposes. In its view, this approach would largely preserve the existing tax rules.

Impacts

Tax treatment of CSM

Excluding the CSM component of insurance reserves will effectively accelerate taxable income permanently when compared with IFRS 17 computed book income. This will generate a structural deferred tax asset (DTA) and may impact the utilization and recognition of newly recognized and pre-existing DTAs, which may have pervasive implications on modelling and forecasting the effects of implementing IFRS 17. The impact of deferred tax items on capital sufficiency computations (e.g. MCT, LICAT and LIMAT) should also be considered.

The government did not provide comments on whether other changes to reserves under IFRS 17 will be accepted for tax purposes, although this position seems to be implied. As such, insurers should consider whether permitted tax reserves will increase or decrease overall once the standard is adopted.

Although Finance’s announcement suggests that there was a concern regarding the perceived imbalance of deducting losses on onerous contracts up front, there was no mention of a specific adjustment in respect of these contracts. Presumably this means that Finance will accept an immediate deduction for onerous contracts, since profitable contracts will also be taxed up front. Consistent with this outcome, we anticipate that policy acquisition costs (that would otherwise be deferred in conjunction with CSM) will effectively be deductible as incurred for tax purposes.

The government did not provide any indication on how the transitional impacts of IFRS 17 adoption to insurance reserves will be treated from a tax perspective. If transitional adjustments relating to the measurement of reserves are brought into taxable income over time, as has been the case in previous accounting changes, then additional deferred tax balances will arise. Absent a deduction for CSM, it remains to be seen to what extent the remaining transitional adjustments will impact insurers upon adopting IFRS 17. Transitional measures will also be required to address contracts that will no longer be treated as insurance under IFRS 17.

The government also did not provide any indication on whether the denial of the CSM component of reserves will be treated for other relevant tax areas, including the calculation of the Canadian Investment Fund (CIF), which is relevant to multinational insurers and branches; and relevant balance sheet amounts for purposes of Part VI (capital) tax, which applies to some life insurers.

As noted, Finance’s commentary focused on the impact of CSM, and is therefore primarily relevant to life insurers that issue longer term contracts. The government was silent on any tax policy considerations related to insurers that expect to primarily utilize the optional premium allocation approach (PAA model), which applies to most Canadian P&C insurers. P&C insurers using the general measurement model (and therefore reporting CSM) should also closely consider the impact of this policy announcement on their tax positions.

IFRS 17 as a basis for taxation

While no substantive details were provided, the government’s intention to support the use of IFRS 17 as a basis for computing income for tax purposes is welcome news for the insurance industry. This means that the existing legislative mechanisms will largely stay in place, but with required adjustments (including those relating to CSM). However, the significance of the required modifications to the Income Tax Act will vary depending on the particular tax issue, and the overall volume of required changes should not be understated.

In addition to working through the required legislative changes, it is expected that a corresponding workstream will be undertaken to address the administrative aspects of adopting and determining income for tax purposes under IFRS 17. This includes the practical aspects of how tax returns are completed and how income is reconciled between accounting and tax. Tax forms may be redesigned or newly created as part of this process. This workstream is expected to facilitate the Canada Revenue Agency’s (CRA’s) administration of the tax system. However, we expect the CRA and Finance to work together closely to integrate the legislative and administrative aspects of adopting IFRS 17.

Consultation process and next steps

The government is seeking input on how best to enact IFRS 17 in a way that facilitates its implementation by insurance companies and is auditable by the CRA. The government is also seeking views on other potential taxation issues that could arise from the implementation of, or transition to, the new standard. This consultation will assist the government in developing potential modifications to the Income Tax Act and other administrative tools (e.g. tax forms).

The insurance industry, specifically life insurers, will not be enthusiastic about disallowing the CSM as a tax reserve, and may question the government’s view that this policy position aligns taxation with the timing of economic activity. The industry’s view has merit, given that:

• the principles underlying IFRS 17 align recognition of profit with the provision of services
• the government’s stated tax policy is not followed for the many comparable products and services offered across the financial services industry

Based on how the consultation is positioned, it appears that the government is seeking input on both the legislative changes and the administrative elements discussed above. It is less clear whether the government is open to considering views on the alignment of insurance profit with economic activity, and the resulting denial of CSM as a tax reserve.

We hope that the government will seek to work closely with the insurance industry over the coming months to identify and properly address these implementation issues. Stakeholders who want to make a submission must do so by July 30, 2021.

The takeaway

The government has put forth its approach on using IFRS 17 balances for tax purposes — it will not allow insurers reporting under the general method to deduct the CSM as an insurance reserve, but otherwise largely preserves the other existing tax rules relevant to insurers.

The government has stated that, other than making the above modification for the CSM, it generally supports the use of IFRS 17 accounting for income tax purposes and that "auditability" is a key goal; this gives some comfort to insurers concerned about the adequacy and sufficiency of IFRS 17 financial reporting balances for tax purposes. 

While insurers search for predictability and stability as the IFRS 17 implementation date approaches, we believe that the government’s signal to use accounting income as a starting point for tax purposes is a positive development. However, the industry still needs more clarity on the extent to which incremental tax information and reporting requirements are imposed to address administrative considerations, and the resulting need for data sourced from financial systems that are currently being designed and implemented. 

The government’s consultation process is open until the end of July. We hope that this will accelerate the process to address many of the other outstanding issues. With the Office of the Superintendent of Financial Institution’s third Quantitative Impact Study on the horizon, insurers should consider using this exercise to undertake modelling to better refine how these proposed changes will impact their particular circumstances.

<sup>1. Department of Finance backgrounder for “Consultations on tax implications of international accounting rules for insurance contracts (IFRS 17)” (May 28, 2021).
2. For more details on the Department of Finance’s consultation, see “Consultations on Tax Implications of International Accounting Rules for Insurance Contracts (IFRS17).”</sup>