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# Case study: The danger of ill-considered bond surrenders

The Problem: In the course of preparing for an annual review you become aware that one of your client’s long-held onshore investment bonds has been cashed in, but the client appears unaware of the tax consequences.

The solution: Most professionals are aware that dividing the full gain by the number of complete years that the bond is held leaves the ‘slice’, and if the slice falls fully in the basic rate band there is no further tax due – the ‘notional tax paid’ and top slicing relief take care of the tax liability on the full gain.

Where the slice falls wholly above the higher rate threshold, 20-30 per cent tax is payable on the full gain.

However, the slice is only used in computing the tax liability on the total gain. For personal and age-related allowance purposes, the key measure is the ‘adjusted net income’, which uses the full gain.

Losing personal allowance increases your tax bill – it makes the tax bands start at a lower amount.

For example, in 2012-13 the higher-rate band starts at income over £42,475, but with full loss of personal allowance it starts at £34,370.

The client in this is a UK resident with earnings for 2012-13 of £37,475.

The bond has been fully surrendered and, based on the full gain over 15 years of £72,525, the slice is £4,835.

On an income of £37,475, less the personal allowance of £8,105, the client has taxable income of £29,370. With basic rate income tax at 20 per cent, this results in income tax due of £5,874. As the slice falls within the remaining basic rate allowance of £34,370, the client assumed there was no further tax to pay.

But based on adjusted net income the true position is as follows:

• Earnings: £37,475
• Plus the full gain: £72,525
• Personal allowance threshold: £100,000
• Excess over threshold: £10,000
• The personal allowance is reduced by £1 for every £2 over threshold, so the allowance is reduced by £10,000/2 = £5,000
• Income: £37,475
• Less personal allowance: £3,105
• Taxable income: £34,370

Tax

• £34,370 @ 20 per cent = £6,874
• 20 per cent band remaining: £0
• Slice of £4,835 fully within the 40 per cent band: 20 per cent tax due
• £72,525 @ 20 per cent: £14,505
• Total tax due: £21,379
• This results in additional income tax of £15,505.

The problem has been caused by the lost personal allowance lowering the higher-rate tax threshold.

There are two ‘mainstream’ solutions. As the gross value of pension contributions or gift aid payments is deducted when arriving at ‘adjusted net income’, so where the problem is identified in the same tax year as the surrender a lump sum contribution or gift to charity can be used to restore the personal allowance and bring the slice back within the basic rate band.

The solution

• Earnings: £37,475
• Plus the full gain: £72,525
• Less gift aid/pension (£8,000 net): £10,000
• Threshold: £100,000
• Excess over threshold: £0
• Personal allowance restored
• Income: £37,475
• Less personal allowance: £8,105
• Taxable income: £29,370

Tax

• £29,370 @ 20 per cent: £ 5,874
• 20 per cent band remaining: £5,000
• Slice of £4,835 within basic rate band, no further tax
• Tax to pay: £5,874 (£2,000 of which is recovered by pension/charity).

A cheque for £8,000 saves tax of £15,505. The client has a fuzzy glow from their charitable deed or a £10,000 pension.

If the client misses the tax year-end, all is not lost. Carry-back of pension contributions is no longer allowed; however, gift aid contributions may be carried back for one year. This needs to be done prior to submission of tax returns or the self-assessment deadlines if earlier.

Les Cameron is a technical manager at Prudential

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