An investment bond is a tax wrapper within which collective investments can be purchased. As the legal owner of the underlying assets, the life company is responsible for the tax on the income and gains. The policyholder only becomes potentially liable for any tax on a chargeable event such as a withdrawal.
The life company taxation of a UK policy is deemed to cover any policyholder liability to basic rate tax. An offshore policy does not come with this tax credit, as it has not incurred any UK taxes, although it may have been subject to withholding taxes.
The 5 per cent allowance
Each year a policyholder can withdraw up to 5 per cent of the original investment and defer any personal tax until a chargeable event occurs. These chargeable events include:
• Maturity or full surrender.
• Partial withdrawal in excess of the accrued 5 per cent allowance.
• Assignment for money or money’s worth.
• Death of the last life assured.
If the 5 per cent allowance is not fully used in one year then any remainder can be rolled forward to subsequent years. The maximum that can be withdrawn in this way is 100 per cent of the original investment, over a minimum of 20 years. It is also possible to withdraw a smaller annual amount over a longer time, for example 2.5 per cent over 40 years.
Maturity or full surrender
On maturity, the chargeable gain is the current value plus previous withdrawals, less the initial investment less previous withdrawals in excess of the cumulative 5 per cent allowance.
This gain is immediately taxable, although top-slicing relief (see below) may be available if the gain pushes the policyholder into a higher rate.
Partial withdrawal
There is no chargeable gain provided that the withdrawal is within the cumulative 5 per cent allowance. Where the excess is above 5 per cent, the whole of that excess is taxable. Again, top-slicing relief may be available.
Unlike a maturity, the gain is taxed at the end of the policy year. The tax due for multiple excess withdrawals then only has to be calculated once a year – potentially in the tax year after that in which the chargeable gain arose.
Top-slicing relief
Taxing a gain in a single year when it has arisen over several may cause a policyholder to pay a higher rate than they otherwise would. Top-slicing relief is designed to address this disadvantage.
The total gain is first divided by the number of whole years for which the policy has been in force. For a partial withdrawal, it is the number of whole years since the last partial withdrawal in excess of 5 per cent.
Then the top-sliced amount is added to the policyholder’s income in the year the gain arose. Any of this gain that falls into the higher-rate band is subject to 20 per cent tax, or 25 per cent tax if it is in the additional-rate band (40 per cent and 45 per cent for offshore bonds). This tax amount is multiplied by the number of years by which the gain was divided to give the total tax payable.
When completing a self-assessment tax return, it is necessary to include both the gain before top-slicing and also the top-sliced relief, not just the top-sliced gain.
Segmentation
An investment bond can be set up as a number of equal segments to allow more flexibility. This could minimise tax charges by allowing partial surrenders from all segments or full surrenders from some of the segments or a combination (see the example box).
An extreme example of partial withdrawals and segmentation was highlighted in the case of Mr Joost Lobler and HM Revenue & Customs in the Upper Tribunal.
In March 2006, Mr Lobler invested approximately $1,406,000 (then around £700,000) in 100 life insurance policies. In February 2007, he withdrew $746,485, and then a further $690,171 in February 2008. In July 2008, the policies were terminated and he received approximately $35,000. In total he had an investment gain of $65,656.
If Mr Lobler had chosen to fully withdraw some of his segments he would have had a chargeable gain broadly equivalent to his investment gain. Instead he chose partial withdrawals. Each withdrawal over $70,300 (5 per cent of $1,406,000) was a chargeable gain. He then had chargeable gains of just under $1.3 million and a tax bill of about $560,000.
The Upper Tribunal found that this mistake could be rectified.
Finance Bill 2017 should allow policyholders who have inadvertently triggered a wholly disproportionate gain to ask HMRC to recalculate the gain on a just and reasonable basis. HMRC will decide whether a gain is wholly disproportionate and, if so, the just and reasonable basis on which it should be calculated.
Planning points
Making a personal pension contribution will extend the higher- and additional-rate threshold. This can lead to more of the top-sliced gain falling within the basic-rate band and therefore increase the top-slicing relief. An occupational pension contribution will achieve the same result where it decreases employment income.
Although assigning a bond for money or money’s worth is in itself a chargeable event, this does not apply if the bond is assigned as a gift. It is therefore possible for a higher-rate taxpayer to assign the bond to their basic-rate taxpaying spouse before the withdrawal.
As a full withdrawal is immediately taxable, and a partial withdrawal is only taxable at the end of the policy year, it is possible to effectively cancel a partial withdrawal by making a full withdrawal before the end of the policy year. This can be particularly effective where the policy as a whole has made a loss, but the partial withdrawal has triggered a chargeable gain.
Financial advisers will still wish to ensure any investment bond withdrawals are carried out in the most tax-efficient way. While legislation to ensure that investment bonds are fairly taxed is welcome, it would be a brave adviser who relied on HMRC deciding not only that a particular gain was wholly disproportionate, but also what is just and reasonable taxation.
Phil Warner is head of technical at Hargreaves Lansdown
