Make the connection between tax issues and business models

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As Quantitative Impact Study 5 approaches, companies are constructing their economic balance sheets on a Pillar 1 basis and evaluating their Solvency Capital Requirements.

Tax is a critical component of the Pillar 1 calculations. In many cases, companies may be including tax-deferred assets in their regulatory balance sheets for the first time. Whether derived through the standard formula or internal models, solvency capital calculations will require companies to make assumptions on how deferred tax balances perform in stressed situations.

Often the computation and stress testing of deferred tax are driven by actuaries who have an under-standing of tax but for whom the tax accounting concepts required by Solvency II are new ground.

How should tax directors ensure that tax is being adequately considered in their Solvency II programs?

      Tax in Solvency II programs - chart

  1. Measurement — computing the deferred tax balances to be included in the economic balance sheet
  2. Valuation — valuing the tax-deferred assets using IFRS tax-deferred valuation principles
  3. Stress testing — validating how tax performs in models and solvency capital calculations

Identification of tax as a Pillar 2 risk
Tax directors need to demonstrate that they are effectively managing tax risk and understand how risk equates to capital in the Pillar 1 and Pillar 2 calculations.

Tax risk can range from the strategic (e.g., whether it is adequately addressed in structural change) to the financial (e.g., the method by which tax is reported). Product strategies and insurance business models are also heavily influenced by tax risk. This is coupled with change of law — another key risk that is being driven by Solvency II and is likely to impact business models.

Defining the future tax profit and loss
In many European Union countries, the tax computation return is driven by Solvency I regulation. Solvency II will not necessarily create a viable alternative source of taxable profit. Many European countries are considering a shift toward an IFRS based profit as the starting point for tax purposes.

The shift in the tax base will require additional time and effort beyond the usual reporting and process pressures on companies. This shift must be planned for and implemented as part of the Solvency II program and could also affect the business model.

We can help you plan for change
EY can help your organization plan for change by analyzing potential scenarios and their impacts on the tax position and business model. We can also assist with process changes, system implementation and help to influence regulatory change. Contact us to get started.

Hannah Cleaton-Roberts 
+44 20 7951 3586