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Case study: The danger of breaching investment bond income rules

The problem: A client with a substantial amount invested in an investment bond wants to manage the withdrawals himself. What are the potential pitfalls.

The answer: Life assurance bonds offer many useful features, including income tax deferral, the ability to withdraw up to 5 per cent of the premium each year, top slicing relief to spread the investment gain over the period of ownership, the ability to assign ownership without adverse tax consequences and, following this year’s Budget, the availability of time apportionment relief for both UK and “offshore” bonds.

However not everything in the garden is rosy.

Life assurance bonds have their tax downsides and while many of these can be avoided with careful planning, clients acting on their own initiatives are often unaware of the downsides and the triggering of unexpected and unwelcome bond gains with accompanying tax charges happens all too frequently.

A recent case illustrates the potential problems.

The Lobler family moved to the UK and became tax resident in 2004. They invested the sale proceeds of their previous house in a life insurance bond issued by an Isle of Man-based life company.

The premium was supplemented with a loan from the private bank which had arranged the investment. The bank’s in-house adviser had been told about the family’s plans. Mr Lobler assumed that he did not need any further advice.

In February 2007, Mr Lobler withdrew approximately half the value of the bond to repay the bank loan. In February 2008 he withdrew most, but not all, of the remaining value to pay for a house.

These withdrawals were actioned by completing a standard form supplied by the life office. This provided 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.

Mr Lobler put an “X” in the box opposite the words “partial surrender across all policies from specific funds”. He stated the amount of his desired withdrawal on the form and indicated the specific funds from which he wanted the withdrawals made.

He advised that the reason for the withdrawals was that he was buying a property.

Mr Lobler assumed that because he had withdrawn no more than he had paid for the bond, there would be no tax implications. He did not realise that he had breached the “5 per cent limit” and breached it to a very substantial degree.

He did not include details of the withdrawals in his self assessment tax returns for the relevant years. The life office provided HMRC (and Mr Lobler) with chargeable event certificates showing substantial gains in respect of both withdrawals. It was then too late to take remedial action.

Inevitably, HMRC opened an enquiry into the self assessment returns and ultimately included the above amounts as taxable income. Mr Lobler appealed to the Tax Tribunal.

The Tribunal considered the relevant legislation. In Mr Lobler’s case the legislative computation compared a withdrawal of nearly half the fund value against in one case 5 per cent of the premium, and in the second 10 per cent of the premium, despite the fact that there was no investment gain!

This legislative process resulted in the gains calculated by the life office and notified both to HMRC and to Mr Lobler. It was an open and shut case although one which left Lobler liable for a tax bill of $560,000 on an investment of $1.4m.

The Tribunal concluded that, “… though we have struggled so to do, we can find no way to give a different interpretation to the legislation.” They stated that “… to our minds it is more repugnant to common fairness to extract tax in Mr Lobler’s circumstances than to permit other taxpayers to avoid tax on undoubted income.”

However, they had to conclude reluctantly that the HMRC analysis was correct noting that “a remarkably unfair result arises as a result of a combination of prescriptive legislation and Mr. Lobler’s ill-advised actions”.

Gerry Brown is technical manager at Prudential


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