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What next for the 5% allowance rule?


One helpful feature of the taxation of investment bonds is the ability for the client to take partial withdrawals each year of up to 5 per cent of the amount invested, for at least 20 years, without triggering an immediate tax liability. Used properly, this facility can give access to regular or one-off payments with minimum admin, as such payments do not have to be declared on the policyholder’s self-assessment tax return.

Used improperly, however, this simplification measure can create wholly artificial gains that do not exist in the real world. This is illustrated in the following case study.

Case study

George took out an international investment bond for £100,000 on 1 July 2014.  On 1 September 2015 the value had increased to £110,000 and George decided he would like to withdraw £90,000, leaving £20,000 invested. The chargeable event triggered by this withdrawal occurred at the end of the policy year, on 30 June 2016, which meant George had a total tax-deferred allowance of 2 x 5 per cent x £100,000 = £10,000.

Since he had withdrawn more than this, the excess – £80,000 – was a chargeable gain assessable to income tax at his marginal rate, even though the value of the investment bond had actually grown by much less than this. Additionally, as the gain plus his other income exceeded £100,000 by more than £22,000, his entitlement to the £11,000 personal allowance was reduced to zero.

Of course, George could have avoided this result by taking full encashments from some of the bond segments. However, he was not aware of this and simply requested a partial withdrawal without the benefit of professional advice.

At Budget 2016, the Government announced its intention to change the tax rules so that disproportionate gains cannot arise in the future and in April 2016 HM Revenue & Customs issued a consultation document inviting views on three options for change. These are briefly described below.

Option one

The 5 per cent allowance would be retained but, if a partial withdrawal exceeded the allowance, the economic gain actually realised would be calculated. This would utilise the formula A/(A+B) to calculate how much of the premium should be deducted from the withdrawal, where A is the amount withdrawn and B is the bond value after the withdrawal. This will be a familiar approach to anyone dealing with capital gains calculations for a partial withdrawal from an investment subject to capital gains tax.

Had this option been in force at the time of George’s £90,000 withdrawal the gain would have been:

£90,000 – (£100,000 x £90,000/(£90,000 + £20,000))

= £90,000 – £81,818

= £8,182

This would be assessable at George’s marginal rate of income tax and, if the gain plus his other income did not exceed £100,000, he would retain the full benefit of his £11,000 personal allowance. If George made any future withdrawal that exceeded the 5 per cent allowance, the A/(A+B) formula would again be used but based on a premium of £100,000 – £81,818 = £18,182.

Option two

The 5 per cent allowance would be replaced by a 100 per cent allowance, which would be available throughout the lifetime of the investment bond. In other words, policyholders would be able to make partial withdrawals of whatever amounts they wanted, whenever they wanted, and no chargeable gain would arise until the total amount withdrawn from the bond exceeded the total amount paid into the bond.

Had this option been in force at the time of George’s £90,000 withdrawal, there would have been no chargeable gain and no immediate tax liability.

Option three

The 5 per cent allowance would be retained and any partial withdrawals that exceeded it would result in a chargeable gain equal to the excess but subject to a pre-determined ceiling. The consultation document suggests this ceiling might be, say, 3 per cent each year, but it could be higher or lower than this if option three is implemented. Any partial withdrawal that exceeded the 5 per cent allowance plus the ceiling would result in a chargeable gain that would be deferred until the next chargeable event.

Had this option been in force at the time of George’s £90,000 withdrawal, there would have been an £80,000 chargeable gain as under the current tax rules.  However, since the gain exceeds the 2 x 5 per cent allowance plus the 2 x 3 per cent ceiling, the immediate gain would be limited to 2 x 3 per cent x £100,000 = £6,000.

The remaining £74,000 of gain would then be deferred to be brought into account at the next chargeable event.

Each of the options will indeed achieve the main objective of preventing large artificial chargeable gains, while preserving the benefits of the existing 5 per cent tax-deferred allowance. Some, however, are easier to understand and administer than others. The consultation, which has now closed, made no reference to the application of any of the options to existing investment bonds. How these will be catered for will hopefully be addressed in the Government’s response to representations received, which is expected to be published about the beginning of October.

Paul Thompson is tax and estate planning consultant at Canada Life



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There are 5 comments at the moment, we would love to hear your opinion too.

  1. George would have done far better leaving the money under the bed!
    No mention of the commissions and charges in these hypothetical examples
    Bonds are so 1980’s

  2. If he had left 20% invested he would be saddled with equivalent 7% + charges per year
    For the next 5 years so no worries about tax because not likely to be any profit other than for insurer and ‘adviser’

  3. Anyone giving financial advice would (or should) have fully checked George’s objectives beforehand. A reasonable chance of wanting to make such a massive short-term withdrawal would have then been identified.

    In the suitability report, sufficient risk warnings about the potential perils of partial encashments would (or should) have been given.

    Even if the partial withdrawal could not have been reasonably envisaged, and notwithstanding suitable risk warnings, it beggars belief that George would not have consulted his adviser before making such a withdrawal. A full blown encashment may have been recommended on the grounds of lower policy, fund and tax penalities.

    The example given is possible, but only by negligence on the part of George, and possibly his adviser,

    Such draconian rules punish inappropriate short term investment and actions. Surely, that is what we want, in a bid to encourage the nation to save more for the longer term?

  4. At least he had an offshore bond, I have seen a situation where almost every client of a firm had an onshore bond, in their SIPPs as well, the smoke and mirrors charging structure being a safe refuge for a commission hungry salesman who has made a good living out of churning. And yes, money earmarked for a tax bill the next year was invested just before the Credit Crunch, earning 4.5% initial. No taxable gain there then.

    The 100% of initial capital invested would seem to be a sensible solution, and easier to calculate. Which means it will not happen! Also be careful as initial charges deducted reduce the investment to a net figure.

  5. Interesting comments. Thanks for the article Paul purpose of which is to demonstrate the potential changes on offer after this consultation. Just to enter into this interesting debate above, the bond was written post RDR so I’m sure George would not have been inadvertently affected by high commissions. Secondly, as for a place for bonds in financial planning absolutely they play a part, both offshore and onshore. For instance, they can be useful for IHT planning, low earners, those with tax positions that may change in the future, micro entity businesses etc etc etc. Diversify product wrappers in addition to diversifying asset classes (dependant of course on the clients circumstances)

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