Taxation of life assurance policies
Legal, accountancy and investment professionals will be familiar with the tax regime applying to life assurance policies and capital redemption policies – colloquially known as investment bonds. These offer many useful features: an income tax deferral, the ability to withdraw up to 5 per cent of the premium each year until the premium value has been exhausted, an effective basic rate credit where the policy has been issued by a UK assurer, top-slicing relief to spread the investment gain over the period of ownership in certain circumstances, the ability to assign ownership without adverse tax consequences and the availability of time apportionment relief. However, there is no such thing as the perfect investment. The life assurance bond has its tax downsides, although many of these can be avoided with careful planning. Unfortunately, clients acting on their own initiative are often unaware of the downsides and the triggering of unexpected and unwelcome bond gains with accompanying tax charges happens all too frequently.
With heavy hearts we dismiss the appeal
Joost Lobler and his family moved to England in 2004. In 2005 they sold their house in Holland and invested the proceeds in a life insurance bond with Zurich Life, based in the Isle of Man.1
The bond premium was supplemented with a loan from HSBC of USD700,000, resulting in a total investment of USD1,406,000. This investment had been arranged for Lobler by HSBC Private Banking. Lobler had told HSBC about his plans and assumed that he did not need any further independent advice. He took no advice before taking withdrawals from the bond.
In 2006, Lobler bought a house in England. He withdrew USD746,485 from the bond on 28 February 2007 and used this to repay the loan from HSBC. On 29 February 2008, he withdrew a further USD690,171 to pay for his house. Withdrawals were executed by completing a form provided by Zurich. This offered four surrender options: full surrender, partial surrender across all policies and funds, partial surrender across all policies from specific funds, and full surrender of individual policy segments. Lobler put an ‘X’ in the box opposite the words ‘partial surrender across all policies from specific funds’; he put the amount he wished to raise in the next box and selected the funds from which the withdrawal should be made. He stated that the reason for the withdrawals was that he was buying a property.
Lobler (mistakenly) assumed that because he had withdrawn no more than he had paid for the bond, no taxable gain would arise. The withdrawals were not mentioned in his self-assessment returns. Zurich provided HMRC and Lobler with chargeable event certificates showing gains of USD676,184 in respect of the 28 February 2007 withdrawal and USD619,871 in respect of the 29 February 2008 withdrawal.
HMRC opened enquiries and eventually included the above amounts as taxable income. This was appealed.
The Tribunal summarised the relevant legislation, which: ‘… provides for a calculation to determine whether a gain arises, and to calculate a gain if rights under a policy have been surrendered. The calculation requires that the gain is equal to the excess of the value of the any part of the policy surrendered over 5 per cent of the premiums paid for the policy. The calculations are performed annually on a cumulative basis… If a share in the rights conferred by a policy is surrendered the value of that share… is the amount or value payable because of the surrender.’
That process gave the gains calculated by Zurich and notified to HMRC and to Lobler. The Tribunal stated that: ‘… though we have struggled so to do, we can find no way to give a different interpretation to the legislation.’ And concluded: ‘Thus with heavy hearts we dismiss the appeal.’
The Tribunal also noted that: ‘A remarkably unfair result arises as a result of a combination of prescriptive legislation and Lobler’s ill-advised actions,’ and pointed out that: ‘The appeal takes place at a time when there is great media and political comment about a fair tax system. That interest focuses on the avoidance of tax by those who have substantial income, but to our minds it is more repugnant to common fairness to extract tax in Lobler’s circumstances than to permit other taxpayers to avoid tax on undoubted income.’
On a more positive note, the recent UK Budget contained a significant change to the taxation of life assurance policies.
Time apportioned reductions
The chargeable event gain regime taxes gains realised by individuals on life assurance and capital redemption policies. The current regime ensures that the chargeable event gains arising on policies issued by non-UK assurers are reduced in proportion to the policyholder’s period of residence outside the UK during the life of the policy. This means, in broad terms, that policy gains accruing during residence outside the UK are excluded from the UK tax charge. Reductions are not available for policies issued by UK assurers, even though policyholders may have periods resident outside the UK.
The Finance Bill 2013 amended the provisions for time apportioned reductions in gains made on life assurance policies for periods when the policyholder is resident outside the UK. It is proposed that time apportioned reductions will be available for policies issued by UK assurers. In addition, the current rules can provide inappropriate outcomes. Relief is generally given by reference to the residence history of the legal owner (the policyholder) rather than the individual on whom the tax charge falls.
Time apportioned reductions are an important development in the taxation of life assurance policies
The Finance Bill proposals flow from a consultation paper issued in August 2012 and the responses to it. There are three aspects to the proposals:
- Time apportioned reductions will be available for policies issued by UK assurers.
- From 6 April 2013, reductions will be calculated by reference to the residence history of the individual or person liable to income tax on the gains.
- Tax residence will be determined according to the new statutory test.
The changes affect policies issued on or after 6 April 2013. Those issued earlier are also affected if (on or after 6 April 2013):
- the policy is varied, resulting in an increase in benefits;
- there is an assignment of policy rights (including a share of rights) to an individual; or
- rights become held as security for a debt of an individual.
The draft legislation introduces the ‘material interest period’. This is basically the period in which an individual would be subject to tax on policy gains, either as a beneficial owner or the settlor of a trust.
The computation is based on days of non-UK residence rather than years. The concept of a day of non- UK residence seems anachronistic – perhaps a throwback to the days of foreign earnings deductions! The draft legislation approaches this by providing that a day will be taken into account in the computation only if the individual is not resident in the UK for the whole of the relevant tax year, or the year is split between a UK-resident part and an overseas-resident part.
The gain on which tax is charged is reduced by the ‘appropriate fraction’. This fraction is A/B, where A is the number of non-UK-resident days in the material interest period, and B is the number of days in that period. See the example below for more details.
A chargeable event gain is taxed in one year even though it may have accrued over many years. The gain may push the individual into the higher or additional rate tax band. Top-slicing relief can help in this situation by spreading or averaging of the gain over the period of ownership. Effectively, the gain is taxed as if it accrued over the years of ownership. An individual can qualify for both top-slicing relief and a time apportioned reduction. To prevent double relief in computing top-slicing relief, the number of complete years for which the policy has run before the chargeable event gain arises will be reduced by the number of complete years of the material interest period for which the individual was non-UK-resident.
The availability of time apportioned reductions is an important development in the taxation of life assurance policies and may increase their use by the internationally mobile.
Finally, the new statutory residence rules contain an anti-avoidance provision taxing (in certain circumstances) chargeable event gains arising in a period of ‘temporary non-residence’ (a period of five years or less). The gain is charged to income tax in the year UK residence is resumed. The gain must have been chargeable had the individual been resident in the year in which the gain arose. Gains arising on a death are excluded. The aim is to prevent avoidance strategies whereby individuals become non-resident, realise gains, then resume UK residence. Similar provisions attack strategies intended to avoid UK tax on payments under pension schemes, distributions to participators in close companies and capital gains.
- 1. Lobler v HMRC  UKFTT 141
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