Wouldn't it be great if you could avoid income and capital gains tax on your investment gains? Well, that is exactly what you can achieve with some relatively simple planning using life insurance policies.
The current level of Government spending has forced the Chancellor to increase the tax yield. This has led the financial services industry back towards the focus that was pervasive in the 1970s. This is that tax planning is a key part of the advice process and an area where you can add significant value to client relationships.
In these times of ever-increasing focus on tax planning, you should consider all opportunities. Sometimes, these opportunities have been around for many years but have simply not been used very often, as they are not well known. The ability to realise gains without liability to tax is one of these.
How does it work? Capital payments arising under life assurance policies are subject to tax under the special rules contained in sections 539-554 Income and Corporation Taxes Act 1988.
Such payments are taxable only when a chargeable event occurs. Chargeable events, as defined in S540, are broadly: death giving rise to benefits, assignment for consideration, maturity, full surrender and part-surrender realising a sum of more than the 5 per cent allowances.
In this article, I am going to focus on the chargeable event on death and the planning opportunity that can arise in this area.
Most single-premium insurance bonds provide that the insurer will pay a benefit on the death of the life assured or of the last of them to die, if there are more than one. This benefit is usually equal to 101 per cent of the surrender value of the policy.
With unit-linked policies, it is common for the death benefit to be calculated by referring to the date on which the insurer received written notification of the death. It is not usual for the reference date to be the date of death of the life assured. This is to protect the insurer from negative market movements between death and notification of it and to give the benefit of positive market movements to the policy's owner.
The tax-planning opportunity arises because the tax regime for life policies does not give relief for any negative movements in the period between death and notification. Nor does it tax any positive movements in this period. Instead, the chargeable event gain is calculated by reference to the surrender value immediately before the death of the life assured. This applies equally to policies issued by offshore as well as onshore life offices.
Let us consider an example to explain the opportunity. Suppose that Anthony, a higher-rate taxpayer aged 50, effected an offshore single premium investment bond on his sole life for a premium of £100,000. To avoid probate and to mitigate UK inheritance tax, he transferred the bond to a trust.
Ten years later, Anthony dies suddenly from a previously unsuspected heart condition. By now the value of the bond is, say, £200,000. If the trustees were to notify the insurer of Anthony's death, then the insurer would pay the death benefit of £202,000 to them.
S541(1)(a) ICTA 1988 provides that the gain at this time would be the difference between the surrender value immediately before the death (£200,000) and the premium paid (£100,000). Therefore the taxable gain would be £100,000. The extra £2,000 gain would be tax-free. This seems favourable, but it can be improved still.
If the trustees were not aware of Anthony's death (perhaps because Anthony had moved abroad) then they would simply continue to manage the bond investment in the normal way. If, some 15 years later, when the bond was worth, say, £500,000, the trustees became aware of Anthony's death, then they would notify the insurer accordingly. The insurer would then pay the death benefit of £505,000 to the trustees.
Logically, you might expect the taxable gain to be calculated at £400,000, but you do not need to be reminded that “logic” and “tax” rarely go together.
The process prescribed by S541(1)(a) provides that the gain would remain unchanged at £100,000 because the surrender value immediately before the death has not changed over the intervening 15 years. Therefore, the trustees have realised a gain of £305,000 without any liability to taxation.