A recent tribunal case sheds some light on how top-slicing relief works, but the topic is still subject to debate
There has been some recent confusion in the market over how the personal allowance, personal savings allowance and the starting rate of tax interact with bond gains and, in particular, top-slicing relief. This confusion came to a head when HM Revenue & Customs was accused of not granting the relief when it should have done.
How top-slicing works
Chargeable event gains on investment bonds are added to other taxable income in a tax year, which means a client could be taken to a higher tax band than they would usually pay. These gains build up as years go by, which can make it unfair to add all the gains to other income in one tax year.
Top-slicing relief allows clients to annualise the gain made on an investment bond so that the rate of tax applicable is calculated as if an element of the profit had been made each year the bond was held.
Top-slicing works by taking the gain and dividing it by the complete years the bond has been in place, which creates a “slice”. The slice is then added to the individual’s income for the tax year, to calculate the appropriate rate of tax on it.
The First-Tier Tax Tribunal recently granted top-slicing relief to a taxpayer who bought a life insurance bond in 1993 for £55,000, withdrew approximately £2,200 a year from it for the next 21 years, and cashed it in during May 2015 for £119,000.
In the case, Mrs Silver surrendered a life insurance bond in May 2015. She and her husband did not believe she had any tax liability in respect of the surrender and Mr Silver, acting on behalf of his wife, did not include it in Mrs Silver’s tax return for 2015/16.
However, a year later, HMRC wrote to Mrs Silver, opening an enquiry into that return, on the basis that it believed she owed additional tax of £21,391. HMRC closed the enquiry on 28 December 2017, amending Mrs Silver’s return to show a tax liability of £26,818.33 (around £4,059.20 having been shown in the original return as owing in respect of declared income).
HMRC’s case was that Mrs Silver’s adjusted net income for 2015/16 exceeded £122,000, which meant she had no personal allowance. It considered her adjusted net income to be £31,101 (her other income), plus £110,721.93 (the chargeable event gain), making £141,822 in total.
However, the couple claimed Mrs Silver was entitled to top-slicing relief, despite HMRC making it clear that this was only available to those who were entitled to a personal allowance.
Both parties agreed on the “annual equivalent”, which is calculated by dividing the gain by “N” (this denotes the number of complete years a bond has been held for; 21 in this case).
Next, it was necessary to calculate Mrs Silver’s (hypothetical) liability to income tax on the annual equivalent.
This was done on the assumption that the single annual equivalent was the entire gain and that it was the highest part of her income to be taxed. She was also to be given credit for basic rate tax.
The dispute was around step three (whether Mrs Silver was entitled to a personal allowance) of the top-slicing calculation (multiplying the relieved liability on the annual equivalent by N). Mrs Silver’s (hypothetical) income under this calculation was £31,101, plus £5,272.43 (the annual equivalent), leaving a total income
Mr Silver’s point was that this was a hypothetical calculation and as Mrs Silver’s hypothetical income was £36,373, it did not exceed £100,000 and was therefore entitled to a personal allowance.
The First-Tier Tribunal preferred Mr Silver’s interpretation of the legislation. The tribunal believed that the calculation for finding out the top-slicing relief liability for one chargeable event directed there to be a hypothetical tax calculation carried out, using certain assumptions.
The tribunal felt that as a result, it would be wrong to carry out the calculation without using these assumptions consistently.
And consistently applying the assumption that Mrs Silver’s income was only £36,373.43 meant that she was (in this hypothetical scenario) entitled to a personal allowance in this calculation.
What happened next?
The result was her liability to tax on the annual equivalent was nil. This is because deducting her hypothetical personal allowance of £11,000 resulted in her total hypothetical taxable income being £26,373.43. This was below the basic rate limit of £32,000 (for tax year 2015/16), which also meant that the annual equivalent of £5,272.43 would have been taxable only at the basic rate. As Mrs Silver was given credit for the basic rate, her relieved (i.e. hypothetical) liability would be £0.
This topic is currently subject to debate and ongoing discussion, therefore caution should be applied in such circumstances.
Rachael Griffin is tax and financial planning expert at Quilter