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Tony Wickenden: The best advice for part surrenders

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The summary of responses to the consultation on part surrenders and part assignments of life assurance policies, and the supporting 2017 Finance Bill draft clauses, appear to have brought to a close the uncertainty over the future of the rules dealing with these events.

The Joost Lobler case brought to the attention of HM Revenue & Customs the difficulties the other side of the 5 per cent withdrawal coin could bring in respect of disproportionately high tax liabilities. It has to be said, though, that these “difficulties” would only arise for those who did not seek and act on informed advice.

The latest developments remind us just how favourable and beneficial the 5 per cent rule is. Simply put, regardless of the amount of commercial/economic gain standing in the policy, the investor could withdraw up to 5 per cent of the value of the initial investment for each full year (subject to a maximum of 20 years) the policy has been in force (to the extent a 5 per cent allowance had not been used in a previous policy year) and it will be treated as a return of capital, so not taxable at that time.

And the 5 per cent per annum allowance is cumulative, which means if you do not use it one year you can carry it forward to the next, and so on.

A case study

Take this example: an individual could invest £100,000 in a UK or offshore bond that could grow to be worth £120,000 after, say, four years. The investor would not have borne any tax year-on-year as all gains and income arising on the investment would have done so to the life company not the investor. If the life company was a UK resident company there would be no tax on dividends received, (broadly) 20 per cent tax on interest and a reserve made for tax on capital gains – but after applying (RPI-based) indexation allowance. Not bad.

Under the 5 per cent rule the investor could withdraw 4 x £5,000 (£20,000) at that point. Of course, the amount withdrawn would need to be added back to the amount actually received on final encashment to work out the final gain.  That is what is meant by the 5 per cent withdrawal being described as “tax-deferred”.

Given this reality, one could argue that a gain arising if you part surrender for an amount that exceeds the cumulative 5 per cent allowances at that time should be taxed. And this should be so even if the amount subject to charge is way more than the economic gain standing in the policy at the time – if you follow that logic. These situations can arise especially in bonds where there has been little or no real economic growth at the time of encashment and this could well be relatively early in the investment’s life.

The “mistake”, then, is for the investor to take the amount required by a part surrender across the whole investment, as opposed to encashing whole policy segments – a facility available to most bonds.

Cashing out early

So why take large amounts out early in the life of a bond? Well, you never know when you might need money and, in some cases, the investor may even have misunderstood the true nature of the investment, thinking of it as something like an “account” from which withdrawals could be made when needed. Regardless of this, the fact remains that withdrawals have been made in a way that gave rise to a gain under the chargeable events legislation that substantially exceeded the economic gain.

As those with experience of advising on the optimum way to take funds from an investment bond will know, particularly when the amount being taken exceeds the cumulative 5 per cent allowances, it is always advisable (a responsibility even) to model the taking of funds by way of part surrender or encashment of whole policies.

Given this, some expressed surprise that HMRC commenced the consultation process to change the law to prevent the detrimental outcome from part surrenders and part assignments. But it did. And even though it has decided not to proceed with any fundamental reform of the rules on taxing part surrenders, it has proposed a “safety net” provision (available on application) for it to apply an alternative “just and reasonable” calculation in substitution for the strict basis where a “wholly disproportionate” chargeable event gain would otherwise arise.

More on the detail of this in my next two columns.

Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn


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There are 2 comments at the moment, we would love to hear your opinion too.

  1. I’m showing my age by admitting that I remember queuing for the 1974 Finance Bill (new Labour government, lots of changes including the replacement of Estate Duty by Capital Transfer Tax) at HMSO in Holborn and already being depressed by what I had read on the bus even before I got back to the office (Canada Life in those days). Unit linking was a new line of business already accounting for the majority of new business so bonds were important and here they were seemingly dead. Who would buy something where you would basically be taxed on the amount withdrawn (even if there was no profit) unless you cashed it all in? Surely that was unsalable? At the next product development meeting the optimists (sales and marketing) said; let’s concentrate on the plus side – tax free ‘income’. I said; “not true, only tax deferred, only 20 years and only 5% (bank base rates higher than that then)”. About a week later one of my actuarial colleagues suggested issuing several equal policies rather than one so that whole ‘segments’ could be surrender if a large ‘partial’ withdrawal was required. I suggested that would be confusing. Lots of life companies shared the same ideas in a bid to ‘save’ unit linked bonds, segmentation survived several tax threats and the rest, as they say, is history. Life Company Bond sales dwarfed mutual funds sales for decades and even now I suspect the legacy rump of business is bigger. For over 40 years the tax man showed absolutely no interest in the plight of those caught in the bond large partial withdrawal tax trap, despite frequent publicity of ‘hard luck’ cases. Only when Bond sales had dwindled drastically post RDR and Post the investment platform revolution did the tax man suddenly show some interest in the subject – hence the surprise mentioned by Tony. Bonds have survived and still have considerable benefit in the right circumstances.

  2. peter mulholland 20th January 2017 at 9:45 pm

    My eyes glaze over on this subject I just can’t stay awake!
    It’s like a slow motion Ivan the terrible Billy Connolly moment when technical people marvel at life bonds.
    For me the kicker and feeling it’s of no use to me is when anyone tells me – 5% tax free
    I mean how on earth is that good ? It’s a return of your intitial capital and later you pay unless you drop into poverty and wow hello!
    There are much simpler ways of investing without the actuaries getting involved because believe me they do the clients no favours what so ever given half a chance. You only have to look at the carnage caused in the offshore market by our ‘heroic’ uk life company offshore subdivisions.

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