Readers' forum - IFA clawbacks

My client was a self-employed independent financial adviser who worked under an FSA regulated company. Unfortunately, he died in August 2004. Much of his work was selling term insurance for which he received commission. If the insurance is cancelled within four years, there is a clawback of commission by the insurance company. Therefore it is highly likely that in the years after death the estate will have liabilities in the form of clawbacks, without there being any commission against which to offset these payments. This will cause overall losses.
Two possible situations then arise.
First, the FSA company (who initially received the commission and the claims for clawback) may settle for a single payment of the estimated liabilities from the estate, so the matter can then be finalised before the tax return deadline of 31 January 2006 for 2004-05. In this case, can the arising losses be allowed under the terminal loss rules?
Secondly, where there is no agreement, the claims will be continually made against the estate for the next four years. In this case, can the losses be claimed and how may this be done?
Query T16,677                                               — Cricket.

Reply by Penny Bates, Tax Partner Menzies:

The starting point to this query is to look at the accounting treatment. General accountancy principles in FRS12 state that a provision should be recognised where an entity has a present obligation (legal or constructive) as a result of a past event. It is probable that a transfer of economic benefits will be required to settle the obligation, and a reliable estimate can be made of the amount of the obligation.
How does this apply to the IFA concerned? Is there a present obligation as a result of a past obligating event? Yes, I think so. This applies to the financial adviser as he is obliged to return commissions where policies are cancelled within the initial four-year period.
Is there a transfer of economic benefits in settlement? Probably, as history will undoubtedly show that a number of policies are cancelled early each year. It is likely that a pattern can be established as presumably the adviser has dealt with this type of client for many years.
The conclusion I reach from this is that it is therefore correct to include a provision in the accounts, but of course this leads on to the question of whether this provision will be allowable for tax purposes.
HMRC's Business Income Manual at BIM40705 refers specifically to repayable insurance commission:

'Where commission receivable on indemnity terms is recognised for Case I purposes when it becomes due, a provision may in principle be allowed for any part of that commission which, on a reasonable estimate, may eventually become repayable (because of early policy lapses).'

It goes on to say:

'In practice you should take a broad view of what constitutes an acceptable provision for the repayment of indemnity terms commission, in particular in considering whether a figure is sufficiently reliable for tax. Most agents will have some experience of the pattern of policy lapses or may have access to data from insurers. There may even be industry-wide data.'

It must be assumed that in scenario one (the insurance company settles for a lump sum) that they would only be prepared to do so on the basis of a reasonable estimate based on prior years' clawbacks for the adviser concerned; i.e. on a similar basis to that outlined in FRS12. In this event the deduction should be allowable in full and any loss arising as a result should be allowed by HMRC under normal trading loss rules. The executors will then have certainty and will be able to successfully deal with the administration of the estate and then wind it up at an early date.
Scenario two suggests that the estate will settle clawbacks called by the insurance companies concerned as they arise in the four years following death. From an accounting and tax point of view I feel that a provision should still be included in the accounts and allowed as suggested by BIM40705 and FRS12. The downside to this approach is that the estate cannot be wound up until all the potential claims have been settled, as the executors are unable to quantify them. Additionally if the provision proves to be wrong, there is the possibility of post-cessation adjustments to consider. 

Reply by Edmund:

The situation described by Cricket is not unusual. Every commission agent must prepare accounts which form the basis for calculating his tax liability, and these accounts must conform to 'generally accepted accounting practice' (FA 1998, s 42). This would include making adequate provision for the commissions that have been earned, but which may be clawed back in the future if the policy is cancelled in accordance with the terms of the commission agreement. The relevant accounting practice here is FRS12, which allows such a provision if certain conditions are met, as seems to be the case here.
HMRC guidance on FRS12 can be found in the Business Income Manual at BIM46520. Under FRS12, provisions should be made in the accounts when and only when:

• at the balance sheet date, the business is under a present legal or constructive obligation;
• the obligation is as a result of a past event;
• it is probable that there will be a 'transfer of economic benefits' arising from the obligation; and
• a reliable estimate of the amount of the provision can be made.

Here, there is a legal obligation to refund the commission if the client cancels the policy in certain circumstances. Crucially, it should be possible to arrive at a reliable estimate of the potential liability by looking at the pattern of such clawbacks in the past. Indeed, if this accounting policy has been adopted in previous years, it is only the movement in this provision from one year to the next which is taxable or relievable.
In Cricket's case, his client has died and therefore accounts for the final period will need to be prepared. If the FSA company who provided his income can be persuaded to make a once and for all settlement of outstanding commission, then this will be brought into the final accounts. Otherwise, a provision for future commission and clawback will need to be made.
This provision will inevitably be an estimate until the run-off time has expired, but this should not delay the finalisation of the accounts. The fact of the estimate should be disclosed in the white spaces on the tax return. Any material adjustment necessary as a result of future events should then be treated as a post-cessation receipt or expense and taxed accordingly.
Cricket suggests that a terminal loss claim is in point. He should ensure that any provision in the final accounts (as opposed to an actual negotiated final payment) is realistic and not excessive.  

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