Top slicing relief piles up more trouble
HMRC has tweaked the top slicing relief rules that have been applied to the taxpayer’s disadvantage since 2010. But the result is still not fair for some individuals.
Top slicing relief (TSR) is used when an individual cashes in non-qualifying life assurance policies (commonly called bonds) to create a chargeable event gain.
Why do we need TSR?
TSR is needed because when a bond matures, a substantial event gain (a lump sum chargeable to income tax) accrues which is all taxable in the year of maturity. Frequently the gain is sufficient to shift the taxpayer’s marginal tax rate from the 20% basic rate to the 40% or even the 45% bands.
However, owing to the structure of these policies, some or even all of the gain may have resulted from earlier “tax-deferred” cash withdrawals from the bond, over anything up to 20 years. If the overall gain had been taxed gradually each year, the policyholder might well have remained at lower marginal tax rates throughout.
TSR was designed to give some relief for this. The idea is that an alternative, hypothetical tax liability should be calculated on the assumption that the gain accrued – and should be taxed – evenly over the years. For example, rather than calculating one year’s tax on a £100,000 gain, we might be computing the tax on twenty gains of £5,000.
For each slice of the gain, we treat it as the top slice of the taxpayer’s total income, and give credit for either the notional basic rate tax which has been suffered (on a UK policy) or the actual basic rate tax which will be payable (on an offshore policy).
Alex has pension income which uses up his personal allowance and all but £4,000 of his basic rate band. He encashes a UK bond with a chargeable event gain of £45,000 which accrued over five years.
Simple example: A £45,000 bond
Without TSR, £41,000 of the gain would be chargeable at the higher rate. His tax bill on the gain would be £41,000 @ (40% - 20%) = £8,200.
Applying TSR, the gain is sliced into five tranches of £9,000. Out of each tranche, only £5,000 is exposed to the higher rate. That would give a hypothetical tax liability on the whole gain of 5 x £5,000 @ (40% - 20%) = £5,000.
Alex is entitled to TSR of the difference between these two calculations: £3,200.
What went wrong?
When TSR was introduced, treating something as the top slice of someone’s income was relatively straightforward, as personal allowances and savings reliefs were not tapered down according to total income levels.
However, since 2010 where adjusted net income exceeds £100,000, the personal allowance is reduced by £1 for every £2 of excess (until it falls to zero at income of £125,000). Also, the savings allowance varies according to total income from £1,000 for a basic rate taxpayer, to £500 for a higher rate taxpayer, and zero for additional rate taxpayer.
Consider an individual with income of £90,000 who realises a chargeable event gain of £100,000, accrued over 10 years. Adding the chargeable event gain to the income of £90,000 wipes out the personal allowance.
How would you calculate the hypothetical income for TSR purposes?
The legislation (ITTOIA 2005 s536) told us to “calculate the individual's liability (if any) to income tax on the annual equivalent, on the basis that the gain from the chargeable event is limited to the amount of the annual equivalent”.
Most people would view the annual equivalent of the chargeable event gain as £10,000, so adding that to income for the year, the adjusted net income would not exceed £100,000, saving the full personal allowance.
Sadly, HMRC is not most people. Its view was that this individual had no personal allowance available, and that this lack of allowance extended to working out any TSR. It took a tribunal defeat in the case of Marina Silver (TC07013) to convince HMRC of its error.
Dogs in mangers
Section 37 of Finance Act 2020 represents HMRC’s response to the Silver judgment. It acknowledges that slicing the gain does mean that the annual slice is used to check whether the personal allowance is available when calculating TSR.
However, in what comes over as a rather mean-spirited move, it removes for the purposes of TSR the usual provision requiring personal allowance to be applied in the way which results in the greatest reduction in an individual’s tax liability, and says that the allowance can only be applied against the chargeable event gain if it is impossible to utilise it elsewhere.
In simple terms: you can have your personal allowance, but we’ll limit how much good you’ll get from it.
Is the problem fixed now?
No, following the new provisions in FA 2020, TSR is still a nightmare.
Open appeals relating to returns back to 2018/19 will be settled on Silver terms, but HMRC will resist any attempts to open fresh (late) appeals against cases which had been settled on HMRC’s incorrect basis.
The issue of how to utilise the savings allowance, or the savings rate band, when applying TSR has still not been resolved.
Black box syndrome
Most tax practitioners use commercial software to calculate TSR. For many accountants that software is a “black box” which produces numbers without providing any understanding of how those figures were calculated.
Until now much commercial software has used the HMRC approach for TSR. Can we be sure that going forward the TSR calculations are always correct and in line with the new legislation?
The Chartered Institute of Taxation has drawn attention to the problem that there is no effective audit of the tax calculations embedded within software products. As the MTD initiative grinds onwards there is ever increased risk that tax software will produce outputs which are not in line with the tax law.