Annex 1: Minor changes in the law made by the Act: Change 118: Exempt income: purchased life annuity payments: method of calculating exempt part of purchased life annuity: section 719
This change alters the method of calculating the exempt part of an annuity payment where both the term of the annuity and the amount of the annuity payment depend on some contingency other than the duration of human life, and gives statutory effect to ESC A46.
Section 656(1) of ICTA provides for a part of an annuity payment made under a purchased life annuity to be treated as capital (the “capital element”). The effect is that, so far as it consists of the capital element, the annuity payment is exempt from income tax.
The way in which that exempt part is calculated varies according to the type of annuity involved, but the legislation is very jumbled and does not distinguish the different types very clearly.
By definition (see section 657(1) of ICTA) the term of a purchased life annuity is always dependent on the duration of a human life. The amount of the annuity payment might also be dependent on the duration of a human life. And the term or the amount (or both) might also be dependent on some other contingency (a “non-life contingency”).
There are two basic approaches to the calculation of how much of any annuity payment is exempt. Which approach applies is, in general, determined by whether or not the amount of the annuity payment depends on some non-life contingency. Where the amount does depend on a non-life contingency, a constant sum is exempt (assuming the period covered by each payment is the same) - see section 656(2) of ICTA. But where the amount of the payment does not depend on a non-life contingency, a constant proportion of each payment is exempt - see section 656(3)(a) to (c) of ICTA.
Where not only the amount of the annuity payment but also the term of the annuity (in addition to depending on the duration of human life) depends on a non-life contingency, section 656(3)(b) and (e) of ICTA provide for the exempt part of each payment to be computed as a constant proportion. “[T]hat proportion shall be such as may be just, having regard to subsection (2) above and to the contingencies affecting the annuity.”
As section 656(2) of ICTA recognises, actuarial techniques do not provide any mechanism for calculating the (exempt) capital element as a constant proportion of an annuity where the amount of the annuity is dependent on a non-life contingency. So the calculation envisaged by section 656(3)(b) and (e) of ICTA is not possible. Actuarial techniques do, however, provide a route to calculating a capital element as a constant monetary sum. It is possible, therefore, where both the amount and the term depend on a non-life contingency, to calculate the (exempt) capital element as a constant monetary sum (rather than as a constant proportion). Accordingly, section 719(4) provides for the constant sum method to apply in this case.
If the exempt capital element is so calculated, it is then possible for the amount of the exempt part to exceed the amount of a particular annuity payment. (See Change 119 in Annex 1.) To cover that situation the carry forward of excess exempt amounts allowed by ESC A46 has been extended to annuities of this sort. The result is that the excess may be carried forward and added to the exempt part of the next payment. (See section 719(5).)
This change is adverse to some taxpayers and favourable to others in principle. If the amount of the annuity payment increases at a rate greater than that assumed for the purpose of calculating the capital element, the constant proportion approach favours the taxpayer. If the rate of increase falls below that predicted, the constant sum approach is to the taxpayer’s advantage. In practice, it is expected to have no effect because this type of annuity has not been met in practice and remains no more than a hypothetical possibility.