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Trigger points

How advisers can help investors wanting to withdraw funds from an investment bond avoid an unnecessary tax charge

II came across a Firsttier Tribunal (Tax) case recently that reminded me how easy it is to trigger a tax charge when there need not be one when withdrawing funds from an investment bond – UK or offshore.

There are two ways to get at your money in an investment bond when you are not looking to cash in the entire investment – by withdrawal (part encashment of) from a policy or policies or by cashing in whole policies.

The latter offers a way to get some of your funds from your investment by splitting it into a number of individual identical policies or segments, meaning a £100,000 investment would be represented by, say, 100 individual policies of £1,000 each.

It is worth noting in this context that to be treated as an individual policy for tax purposes, each of these mini policies must be capable of being dealt with, for example, assigned/ encashed on its own.

In relation to the part encashment/withdrawal, there is the well known 5 per cent allowance. Broadly speaking, it is a per cent of the amount originally invested in the policy each policy year for 20 years, with the amount withdrawn treated, for tax purposes, as a return of capital.

Everyone is familiar with this so-called tax-free income facility, which, of course, it is not. It is not income and is tax-deferred. There is also the ability to carry forward unused allowances from one year to the next so that after, say, 10 years of no withdrawals, an amount of up to 50 per cent of the original investment (10 times 5 per cent) could be taken free of tax at that time.

It is tax deferment and not tax freedom because any such amounts withdrawn have to be added back when calculating the final gain under the policies from which the withdrawals are taken.

This is relevant background to the recent case I referred to at the beginning of the article. It illustrates the big difference in tax outcome dependent on how you take benefits from an investment bond. The case I refer to is Chandraprakash Shanthiratnam v the Commissioners for HM Revenue & Customs, which was heard in September 2010.

This case involved a partial surrender of approximately one-third of the rights attaching to each of the 50 policies in a cluster of offshore life policies. On account of the rules concerning the calculation of the chargeable event gain (the gain being charged to tax as income), on the occasion of partial surrenders, the appellant suffered the extraordinary result that partly because the policies had subsisted only for one year and regardless of the fact that the total policies were probably worth less at the time of the partial surrender than the premium paid, 85 per cent of the amount received on the surrender (£42,500 out of the £50,000) was treated as his taxable income.

The appellant advanced three contentions as to why this result was incorrect. Regrettably, none of those three contentions proved to be sustainable.

I will look at the case in detail in the coming weeks and ask how the circumstances could have been avoided and what could be done about it after the event.

The role of the adviser in helping an investor to take the right action so as to secure the most favourable outcome is critical. In most cases, the choice will be easy and in some cases a simple comparison will be necessary to determine whether to take benefits from an investment bond by a part encashment or by the encashment of whole mini policies.

When the amount to be taken exceeds the cumulative unused 5 per cent allowances then it will usually be more tax-efficient to take the amount required by whole policy encashments.

Without advice it would be easy for a request to take a large encashment from a policy to manifest itself as a formal instruction to take a part surrender. And that, as the case referred to illustrates, is when HMRC becomes interested if the amount taken triggers a chargeable event (and a chargeable event certificate) by virtue of an excess over the allowable 5 per cent allowances arising.

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