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Act gives definition to capital bonds

Several offshore insurers now offer unit-linked capital redemption bonds, generally with a term of 99 years. The maturity value is usually described as being a guaranteed amount or the value of units, if greater.

Companies, trustees or other investors who do not want to have to specify an individual life assured typically use these contracts. In addition, some investors do not have a favourable outlook on life insurance or, indeed, are prohibited from effecting insurance contracts on religious grounds. Capital redemption bonds are a helpful tool for advisers wishing to promote a tax-efficient investment to these classes of investors.

Historically, companies used capital redemption contracts or sinking funds as a way of funding future capital outlay. Typically, a manufacturing company would need to save for the time when it would need to replace plant or machinery when it became obsolete in the future. In return for a premium or premiums of a fixed amount, the insurer undertook to pay the investor a guaranteed sum on maturity of the contract. Generally, contracts were for terms of between five and 15 years.

Clearly, such contracts are not life insurance contracts as they do not depend on human life. The judgment in Fuji



Aetna Life Insurance Company supports this view. Equally, it is difficult to view these contracts as insurance in the ordinary sense. This is because the happening of the specified event, on which the insurer will pay, does not involve uncertainty about whether it will occur at all or, as with life insurance, about its timing.

Nonetheless, it does seem that, by long use and custom, capital redemption contracts have been considered as insurance business. Thus, they are included within the permitted classes of long-term business that a life insurer is allowed to write under Part II Financial Services and Markets Act 2000 (Regulated Activities) Order 2001.

However, how are gains produced by such contracts treated for UK tax purposes?

When Parliament introduced the present regime for policyholder taxation in 1968, it made no attempt to distinguish capital redemption contracts from any other type of long-term business. Thus, the policyholder tax legislation in what is now SS539-554 ICTA 1988 applies “in connection with policies of life insurance, contracts for life annuities and capital redemption policies”.

S539(3) defines a capital redemption policy as being “any insurance effected in the course of capital redemption business as defined in S458(3)”.

S458(3) used to define capital redemption business as “business (not being life insurance business) of effecting and carrying out contracts of insurance, whereby, in return for one or more premiums paid to the insurer, a sum or a series of sums is to become payable to the insured in the future”. However, the Finance Act 1996 amended the definition of capital redemption business in important ways. The change applied to insurance company accounting periods that ended on or after July 1, 1999.

Capital redemption business is now defined as “any business in so far as it consists of the effecting on the basis of actuarial calculations, and the carrying out, of contracts of insurance under which, in return for one or more fixed payments, a sum or series of sums of a specified amount become payable at a future time or over a period, and is not life insurance business”.

It would appear that the specified amount (usually twice the premiums paid) offered by these offshore insurers could be such a sum. Leading English tax counsel believe that these offshore capital redemption bonds are subject to tax under the same special rules that apply to offshore life insurance bonds. These appear in S553 ICTA 1988.

The key result of the change to the definition of capital redemption business in Finance Act 1996 is that it brings certainty. A unit-linked capital redemption policy, providing a real specified amount at maturity, can clearly satisfy the definition and will be subject to income tax under the policyholder tax rules.

In summary, therefore, I believe the unit-linked capital redemption bond will provide an extremely valuable tax-planning tool in the hands of many UK-resident investors, as well as those non-resident investors who nevertheless have strong UK connections.

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