This article is one of a series on tax considerations arising from IFRS 17 Insurance Contracts and focuses on the interaction with Pillar 2 of the OECD’s Base Erosion and Profit Shifting project (known as BEPS 2.0). BEPS 2.0 introduces a package of global tax reforms including a global minimum 15% tax rate. The focus of this article is the impact of IFRS 17 on an entity’s effective tax rates (ETRs), which are calculated to determine whether top-up tax is required to be paid under the new rules.
This article does not address the impact of BEPS 2.0 on deferred taxes in financial statements prepared under IFRS® Standards.
Two transitions or one?
IFRS 17 applies for accounting periods beginning on or after 1 January 2023. The aim is for BEPS 2.0 to also to take effect in 2023 but, in some jurisdictions, there is a growing expectation that it could be delayed at least by a year.
If BEPS 2.0 were to apply in 2023, the IFRS 17 transition adjustment would be treated as an item of Global Anti-Base Erosion (GloBE) income or loss in 2023. Logically, the BEPS rules need to be interpreted or implemented in a way that includes the tax effect of that transition in Covered Tax otherwise the effective tax rate (ETR) will be distorted.
In contrast, if BEPS 2.0 were delayed till 2024, the IFRS 17 adjustment to equity at transition would not be part of the GloBE income (but, as described below, covered taxes in later years could still be affected if the transition is spread for tax purposes). Thus, some insurers may be sensitive to the timing of adoption of BEPS 2.0 as even a 1-year delay could materially affect the profits which are subject to 15% minimum taxation.
Effective tax rate
Core to the BEPS rules is the calculation of an ETR on a jurisdiction-by-jurisdiction basis. The ETR is largely based on the net profit or loss reported in the financial statements and the amount of covered tax charged.
Book profit is used for this purpose and IFRS 17 has the potential to materially change the timing of book profits. Furthermore, IFRS 17 gives insurers accounting policy choices to recognize certain items in Other Comprehension Income (OCI). Items taken to OCI are generally excluded from the computation of GloBE Income or Loss.
The release of the contractual service margin (CSM) – i.e. deferred profit on an insurance contract – will be the driver of future book profits. Output from IFRS 17 projects could therefore be of great value in understanding the future profit profile and hence the exposure to GloBE top-up tax.
IFRS 17 may also impact the calculation of covered taxes, which include current and deferred taxes, although the deferred tax numbers reported in the financial statements may be adjusted significantly for the purposes of the BEPS ETR calculation (see below).
Deferred tax – impact on ETR
The adoption of IFRS 17 has the potential to create material deferred tax balances in respect of temporary differences or losses, particularly for insurers writing long-term business.
These balances could arise if the local tax rules do not follow IFRS Standards. They could also arise where tax follows IFRS Standards, either because a large tax loss arises at the point of transition or because of transitional tax rules that spread the current tax impact of the transition.
For the purposes of the BEPS ETR calculation, various adjustments may need to be made to deferred tax income or expense for the period – e.g. recasting it at 15% unless the local tax rate is below 15%.
Thus, the ETR can deviate significantly from a statutory tax rate in a specific jurisdiction. In addition, the ETR could be pushed below 15% even in high tax jurisdictions, particularly where there are other factors in play (such as non-taxable income or tax incentives in the form of additional deductions).
Modelling conducted by KPMG for a tax regime following IFRS Standards shows that the BEPS ETR is sensitive to the size of the loss recognized at transition and whether or not the transition is spread for current tax purposes. Furthermore, the deviation from the statutory rate in the year of adoption of IFRS 17 is compensated for by deviations in the opposite direction in later years. Therefore, a one-year delay to the BEPS rules may cause that first year to fall out of account and give rise to a different ETR profile.
Deferred tax – timing of reversal
Under BEPS rules, deferred tax balances are generally tested to see if they reverse within 5 years. Importantly, there is an exclusion from this rule for insurance reserves, insurance policy deferred acquisition costs,and any additional amounts accrued as a result of accounting principal changes with respect to those items.
This is a welcome relief and potentially applies to most or all deferred taxes arising as a result of adopting IFRS 17. However, some attention will need to be given to local implementation and interpretation. “Insurance reserves” is not a defined term and its meaning may not be identical to insurance contract liabilities under IFRS 17. Where deferred tax balances exist in respect of deferred profits (specifically the IFRS 17 contractual service margin) their treatment under the BEPS rules may need to be considered.
Many insurers are modelling the impact of BEPS 2.0. Where past data is used, some overlay to take account of the IFRS 17 transition and the future release of the contractual service margin is recommended. Some insurers may be sensitive to whether or not BEPS 2.0 and IFRS 17 take effect in the same accounting period.
For many insurance groups, BEPS 2.0 presents a significant compliance challenge even if there is limited exposure to top-up tax. The BEPS rules for deferred tax adjustments are complex and the amounts used for the purposes of determining the ETR may differ from that shown in the financial statements prepared under IFRS Standards. It is essential that an entity has a good understanding of both IFRS 17 and BEPS 2.0 when integrating the two new sets of requirements.