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 Of course, the amount withdrawn would need to be added back to the amount actually received on final encashment to work out the final gain.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