Wouldn't it be great if you could avoid income and capital gains tax on 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, which is that tax planning is a key part of the advice process and one 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 insurance 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. S540 defines a chargeable event. These are, broadly, death giving rise to benefits, assignment for consideration, maturity, full surrender, part surrender realising a sum more than the 5 per cent allowances. In this article, I want to focus on the chargeable event on death and the planning opportunity which arises 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 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 reference to the date of receipt by the insurer of 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 and to give the benefit of positive market movements to the owner of the policy.
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. Suppose Anthony, a higher-rate taxpayer aged 50, effected an offshore single-premium investment bond on his life for a premium of £100,000.
To avoid probate and to mitigate UK inheritance tax, he then transferred the bond to a trust. Some 10 years later, Anthony dies suddenly from a previously unsuspected heart condition, when 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 the trustee.
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). Thus, the taxable gain would be £100,000. The extra £2,000 gain would be tax-free. This seems favour-able but it can be better still.
If the trustees were unaware of Anthony's death (perhaps because he 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, 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 £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 death has not changed over the intervening 15 years. Therefore, the trustees have realised a gain of £305,000 without any liability to taxation.