When a chargeable-event gain calculation on the final encashment of a life insurance policy gives rise to a deficiency (loss), that deficiency can be attributed to income of the policyholder that has suffered higher-rate income tax in the same tax year.
The amount of the deficiency that can be so attributed is restricted to an amount not exceeding previous chargeable-event gains under the same policy (regardless of whether any tax was actually paid on those previous chargeable-event gains) that have arisen to the person who is now being assessed to tax on the encashment of the policy.
Deficiency relief is given by way of a tax reduction but is not available for policies owned by companies, those held in a trust created by a company or ones held in trust where the tax liability falls on the trustees.
As stated above, where the relief applies, the deficiency can reduce the higher-rate income tax the investor pays on other income that will suffer higher-rate tax. Of course, the rate of higher-rate tax that income will suffer depends on the type of income, namely whether it is dividend income or not.
For tax year 2009/10, to calculate the tax reduction, the deficiency is attributed first to income subject to the dividend upper rate of 32.5 per cent, then income subject to the 40 per cent higher rate.
The amount of tax due on this income is then compared with the amount of tax on that income calculated at the dividend ordinary rate or basic rate, as appropriate. The excess is the tax reduction available.
The example on this page sets out how deficiency relief currently works.
The rules apply in the same way to those who own non-UK policies, even though they will not have been entitled to the 20 per cent tax credit (see example).
From April 6, 2010, for taxable income that exceeds £150,000 the top rate of income tax has increased to 42.5 per cent on dividend income and to 50 per cent on other income.
In the April Budget, the Labour Government sought to deal with the issue of bond losses for people who pay income tax at the additional rate by introducing rules to attribute the bond loss to different types of income.
The intention was that if a deficiency arose on a chargeable event on the final encashment of a bond that occurs on or after April 6, 2010, the deficiency would be attributed to income in the following order:
1: Income subject to the 42.5 per cent dividend additional rate.
2: Income subject to the 50 per cent additional rate
3: Income subject to the 32.5 per cent dividend upper rate.
4: Income subject to the 40 per cent higher rate.
The amount of tax due on this income would then be compared to the amount of tax on that income calculated at the dividend ordinary rate or basic rate, as appropriate. The excess would be the tax reduction available.
However, in its first Budget, the coalition Government sought to restrict this extra relief when it confirmed that relief for deficiencies on single-premium bonds would not be extended to the additional rate of income tax.
This announcement was tucked away in the Treasury Red Book, which stated: “The Government will not extend life insurance deficiency relief to the additional rates of tax. Instead, the deficiency relief rules will continue as at present and will reduce tax due on income subject to the higher rate and dividend upper rate of tax only.”
Of course, because of the intervening general election, the original Labour proposal was never implemented into legislation. Therefore, there is no necessity for the present Government to introduce amending legislation because the original (pre-Labour) provisions still exist.
Another area the Labour Government touched on in its April Budget was the announcement that it intended to introduce specific anti-avoidance legislation targeted at bond losses. This was intended to be effective for termination chargeable events occurring on or after April 6, 2010 that give rise to a deficiency.
The aim was that the provision would apply where the main purpose, or one of the main purposes, of arrangements made on or after April 22, 2009 was to secure a tax advantage. In particular:
- Such a tax advantage would be secured where there is a deficiency and the amount of the tax reduction would exceed the “related income tax liability”. The related income tax liability is the tax liability on all previous chargeable event gains under the same policy less any basic rate tax credits that were available.
- Where this provision applies, deficiency relief would not be given at the additional rates but would be restricted to the tax due on previous gains, that is, the related income tax liability.
- The provision would not apply where any gain included in the total amount of all previous chargeable-event gains arose on a chargeable event more than five years before the termination event.
The coalition did not make any announcement on these measures in its June Budget and so we will have to wait and see whether any action is taken to introduce this targeted anti-avoidance measure.
There is no reference to these measures in the Finance (no 2) Act 2010 published after the June election. Measures could be included in finance (no. 3) act scheduled for this autumn, or next year’s Finance Act.
If such a measure is introduced, to guarantee relief under the bond deficiency rules, there will need to be at least a five-year period between the encashment of the bond and the matching chargeableevent gain that gives rise to the deficiency.