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whole orange

Life assurance investment bonds are often used by financial planners as a method of growing an investment while allowing the investor to withdraw some of the growth annually without suffering an immediate tax charge.

Qualifying and non-qualifying Policies

An investment bond is usually a single lump sum and an investment policy or plan is usually regular payments of premiums. 

There are qualifying and non-qualifying policies. Qualifying policies have a £3,600 limit on the premium which can be invested and so are seldom used now by financial planners. 

For non-qualifying policies the investor can withdraw up to 5% of the amount invested each year without triggering an immediate tax charge.  Technically the withdrawal could reflect the growth, if the original investment remains intact, but the Income Tax liability only arises when the policy matures or is surrendered.

The 5% per annum is cumulative and any unused part of the 5% can be carried forward and used in future years however, the cumulative 5%s cannot exceed 100% of the amount paid into the bond.

A gain on a non-qualifying policy is potentially subject to higher and additional rates of Income Tax not Capital Gains Tax!  CGT and IT at the basic rate are treated as being paid via UK Life Fund taxation paid by the insurance company from the funds, but being notional it cannot be repaid.

To make the partial surrenders possible the investor usually, purchases their bonds or policies in a number of identical segments.  Let’s think of an investment as an orange with 10 segments.   Eating part of the orange can be done by choosing to eat one whole segment, Segment

alternatively the orange can be cut into 10 equal slices and one slice eaten. Slices

Whichever way is chosen, part of the orange is eaten, but when eating a whole segment, 9 whole segments remain whereas when eating a slice, 90% of the whole orange remains.

It’s a similar concept when making withdrawals from life assurance policies.  The chosen method of surrender of a part of an investment bond has very different tax consequences!

A subtle difference with huge tax consequences

Surrendering a segment

A full encashment of a number of individual whole segments will result in no chargeable event gain as the proceeds and the cost are identical.

Surrendering a slice

A partial surrender across all segments results in a chargeable event gain being calculated on the excess of the proceeds over the annual 5% limit.

Example

Say 100 bonds were purchased for £100,000 and 2 years later the owner wants to take out £40,000.  For ease of calculation imagine there has been no growth on the investment in the 2 year period.  The investor has 2 choices:-

Surrendering 40 whole identical bonds - Segments

Proceeds                        £40,000

Cost                                 £40,000

Chargeable event       £   NIL   

Surrendering 40% of the whole investment - Slices

Proceeds                         £40,000

2 years at 5%                 £10,000

Chargeable event         £30,000

The proceeds are the same under both methods i.e. £40,000 and as there has been no growth, the £40,000 withdrawn can only equate to the £40,000 invested however only 5% per annum can be withdrawn with no immediate tax consequence with the remainder is subject to IT at higher and additional rates if applicable to the taxpayer!

The way the investment is withdrawn is vital to the way it is taxed. 

The case which highlighted this

Mr Joost Lobler placed his capital in several life insurance bonds but later wanted to withdraw an amount for personal reasons.

He withdrew cash which included a small amount of growth on the amount invested.  He selected the slice method of withdrawal (the partial surrender across the whole investment).

Unexpected consequences  

He made £66,000 profit but his tax liability was £560,000!  A tax liability at an effective rate of almost 800% on the actual income generated by the policy.

Mr Lobler appealed against the injustice of this. However the First Tier Tribunal upheld HMRC’s intention to charge the tax, saying Mr Lobler could have taken financial advice before making the withdrawal.  Sanity prevailed with the Upper Tribunal ruling the charge was “wholly disproportionate to the material gain made” and the taxpayer had a right to “expect to withdraw money invested with no tax consequences”.

Other Consequences

In addition to the obvious consequence of a chargeable event gain pushing a Basic Rate taxpayer into Higher Rates or potentially Additional Rates of tax, there are other potential consequences.

For an individual with children, once the gain pushes an individual’s income over £50,000 the higher child benefit charge would be triggered and if it pushes an individual’s income over £100,000 the individuals entitlement to personal allowances diminishes.

Because the income from a chargeable event gain is savings income the rates used for the gains are the same for Scottish and Welsh taxpayers as those which apply to the rest of the UK.

Attempts to fix this.

The Finance Act (2) 2017 offers an appeals mechanism for those taxpayers caught by the legislative anomalies where they have inadvertently triggered a chargeable event gain. In plain English, they have “ticked the wrong box” when requesting a withdrawal from their bond which is in excess of the cumulative 5% allowed.

  • The appeal must be made in writing.
  • It’s an application to have the charge reviewed by an officer of HMRC.
  • This review will not be carried out automatically.
  • There is no guarantee this will be successful.

The officer of HM Revenue and Customs will review of the calculation and assess if the tax charged is wholly disproportionate and only if the officer considers the gain to be wholly disproportionate will it be recalculated on a just and reasonable basis.

This new “fix” does nothing to alleviate the complexities of this tax legislation for taxpayers or the uncertainty around any appeal’s potential for success.

It leaves the decision to recalculate in the hands of individual officers and there is no statutory definition of what is wholly disproportionate nor what is just and reasonable and does nothing to help a client who has inadvertently chosen slices as opposed to segments!

As always awareness of this subject and its potential for devastating tax consequences is vital for tax professionals and so I am delivering a webinar on this subject on Wednesday 24th October 2018 at 10am, 12pm and 2pm.  To register click here https://events.genndi.com/register/169105139238452332/a7388896bb

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Debra Lowndes

Tax Specialist 

Email: [email protected]

Tele: 01246 488 200

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