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Artificial light

The tax strategy to follow when a big part encashment has been made from an investment bond

I have been reviewing the First-tier Tribunal (Tax) case of Shanthiratnam v Revenue & Customs (2011) which illustrated that great care needs to be taken when withdrawing substantial funds from an investment bond (UK or offshore).

The artificial gain that can be created when a big part encashment is made (especially only a short way into the policy term and when there has been no economic gain on the policy) can be substantial.

The investor’s sense of injustice when such an event occurs (followed by the inevitable chargeable-event certificate and assessment to tax) would be understand-ably exacerbated if the investment was standing at an economic loss which would have been realised if the policy had been fully encashed.

If such a big part encashment with adverse tax consequences is discovered, then remedial action may be possible if the error is discovered in time. Preferably, the encashment would be carried out in the right way in the first place.

For big part encashments (in excess of the available 5 per cent annual allowances), the preferred course of action will usually be to encash a sufficient number of whole policies. This will usually be possible as most investment bonds are issued as a big number of small, identical but genuinely separate policies all capable of being dealt with separately.

Ahead of the encashment, it will always be worth carrying out a comparison of the best way to proceed based on the facts, identifying all the numeric/economic and non-economic aspects of the case. In many cases, a full policy or segment surrender will yield a lower tax bill and this should always be considered and a comparison between the two methods of taking withdrawals made.

Before considering what can be done about an “artificial gain” once triggered, let us just remind ourselves of the reporting process. Bearing in mind that the chargeable event on part encashment occurs on the last day of the insurance (policy) year, if a chargeable-event gain arises, it has to be reported by the insurance company to HMRC not later than three months after the end of the year of assessment in which the chargeable event occurs. For example, for a policy which commenced on July 1, a partial encashment which takes place on, say, September 9, 2011 would give rise to a chargeable event on June 30, 2012, meaning the chargeableevent gain would need to be reported to HMRC no later than July 5, 2013, that is, no later than three months after the end of the year of assessment (2012/13) in which the chargeable event occurs.

As far as the policyholder is concerned, the chargeableevent certificate has to be issued to him within the period of three months following the happening of the chargeable event, that is, by September 29, 2012 in our example as the chargeable event occurs on June 30, 2012.

Where a big part encashment has been made, then the following strategy would help avoid the tax charge on the “artificial gain”.

A full surrender of the policy would be made in the same tax year as that in which the chargeable event on the big part encashment occurs. In these circumstances, the final insurance year and the preceding insurance year are treated as being one insurance year. This artificial “one insurance year” will be the final year.

Using the above example, if the partial encashment on September 9, 2011 gives rise to a chargeable-event gain, then a full surrender before April 6, 2013 would negate the effect of the partial encashment. This is because the last insurance year July 1, 2012 to the date of full surrender, say, December 12, 2012 begins and ends in the same tax year (2012/13) which means that it and the preceding insurance year (July 1, 2011 to June 30, 2012) are treated as one year. The result of this is that a full surrender of the policy occurs, with the proceeds of the surrender being the total of the proceeds on the partial encashment plus the proceeds on full encashment.

Putting some figures to the example, the position could look like this:
Policy commencement date: July 1, 2009
Purchase price: £100,000: 5% allowance £5,000
First withdrawal by part encashment on September 9, 2011 for £60,000
Date of chargeable event: June 30, 2012
Calculation of chargeableevent gain:
Part surrender proceeds: £60,000
Less 3 x 5% allowances: £15,000
Chargeable event gain: £45,000

Assuming a full surrender on May 30, 2014 when the policy is worth £35,000, the chargeable event position would be as follows:
Gain/deficiency = surrender value (£35,000) plus previous withdrawals (£60,000) less premium (£100,000) plus previous chargeable event gains (£45,000) = deficiency of £50,000.

Overall, the policyholder will have received benefits of £95,000, so incurring an economic loss of £5,000, and been potentially liable to income tax at rates of 20 to 50 per cent, depending on personal circumstances and whether the policy is a UK or non-UK policy. £45,000 of the deficiency could be set against income subject to higher-rate tax, if any, in the tax year of full surrender with relief at 20 per cent (for both a UK or non-UK policy).

In contrast, if following the partial encashment (and being aware of the tax problems, it produced) a full encashment took place on, say, December 12, 2012, that is, before April 6, 2013 for £35,000, then in the final insurance year, running from July 1, 2011 to December 12, 2012, the total surrender proceeds are £95,000, from which the premium is deducted to produce a loss of £5,000, which does not qualify for deficiency relief in the absence of any previous excesses.

However, even though a £5,000 loss (for which there is no tax relief) has occurred, a tax charge on a chargeable event gain of £45,000 has been avoided.

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