The Inland Revenue issued a press release on March 3 which announced a change to the taxation of life policies. It removes one planning opportunity that has existed since 1975 but leaves others unaffected.
In a dawn raid, Paymaster General Dawn Primarolo announced an attack on “schemes which create deficiency relief for individuals in connection with life insurance policies to set against their income liable to tax at the higher rate”.
She said the Government “has acted quickly to stop these schemes, which depend on wholly uncommercial transactions involving life insurance policies to facilitate the avoidance of higher-rate tax by very high-net-worth individuals”.
What is deficiency relief? S540(1)(a)(v) and S545(1)(d) Income and Corporation Taxes Act 1988 provide that a partial surrender of a life or capital redemption policy of more than the cumulative 5 per cent withdrawal allowance is a chargeable event. S541(1)(d) and S545(3) provide that the gain is equal to this excess. Because of this, taxable gains can arise even where there is no investment gain.
As a result, it is necessary to have a sweep-up calculation when the policy ends to ensure that tax has been charged on the true investment return only. Where previous gains exceed the true investment return, then higher-rate relief is available on the excess. This so-called deficiency relief is given by s549 ICTA 1988.
What does the latest announcement mean? Consider a bond effected by Cherie for £100,000. She takes withdrawals of £10,000 each year for 10 years and then gives the bond to her husband Anthony. He fully surrenderes the bond when it is worth £45,000.
Each year, Cherie will have realised a gain of £5,000. On final surrender, Anthony will have realised a deficiency of £5,000, which he can then set against any income subject to higher-rate tax.
The recent announcement means that deficiency relief will still be available to policies issued from March 3, 2004. However, it will only be available up to the value of any earlier gains which formed part of that same individual's income.
Deficiency relief will also continue to be available to all existing policies. But this will only apply provided they are not assigned (either by gift or for consideration), become used as a security for a debt or have further premiums paid from March 3, 2004.
Thus, in the above example, Anthony may no longer be able to claim any relief for gains realised by Cherie.
It is important to be aware of what has not changed in calculating deficiency relief. The relief will continue to be available where there is a deficiency when a policy or contract ends and all gains made over the life of the policy have been made by the individual entitled to the deficiency.
So, what opportunities rem-ain? If a policy has changed ownership before March 3, 2004, then deficiency relief is still available.
Also, relief is still available where the policy has never changed ownership. This could arise in the circumstances set out in my column of February 14, 2002, where the policyholder was non-resident while the gains occurred but became a UK-resident higher-rate taxpayer before the deficiency arose.
Relief is also available where the gains were realised when the policyholder was a basic-rate or non-taxpayer and the deficiency is realised when they are a higher-rate taxpayer. This could arise where the policyholder is receiving pension income drawdown and, thus, is able to vary their income to achieve this.
While it is understandable that the Inland Revenue has moved to prevent misuse of this relief, the measure is not as targeted as it should be.
As the Finance Bill is drafted, all changes of ownership would prevent deficiency relief from being given, even where it occurs on the death of the policyholder. This is unduly harsh, as even the Inland Revenue has accepted that no taxpayer dies for taxavoidance purposes.
The financial services industry has lobbied the Inland Revenue for the relief to continue to be available where ownership has changed because of death but to no avail.
In conclusion, therefore, deficiency relief still provides a planning opportunity using life and capital redemption bonds but in a more limited way than before.