It is easy to think that when a client surrenders a UK investment bond that there’s no need to worry about tax, because they’re a basic rate taxpayer.
But of course that’s not always the case; firstly, the top-slice may push them into higher rate tax and secondly, they are still duty bound to report the chargeable gain to HMRC – even though no tax may actually be payable.
There are also other ramifications for basic rate taxpayers, because the chargeable gain will be classed as unearned income and can impact negatively on the policyholder’s personal tax position.
This is because HMRC will initially add the full amount of the chargeable gain to the policyholder’s other income to ascertain their ‘adjusted net income’ – working out their tax bill based on that figure before top-slicing relief is applied.
The situation could have been avoided by keeping the client’s income plus the chargeable gain below the £100,000 limit.The message is that an investment bond is an excellent tax-efficient investment, but if a chargeable gain does occur, you should check the following situations.
1. Personal allowance
When a person’s adjusted net income exceeds £100,000 their personal allowance is reduced by £1 for every £2 over that limit.
So if they have income of £102,000 their personal allowance is reduced by £1,000 (£2,000/2) from £11,500 to £10,500. Of course, this means that they may pay more tax on their existing income and in some instances when chargeable gains arise, considerably more.
The following examples illustrate this point.
Example 1
John has PAYE income of £20,000 and he surrenders a UK bond after 20 years with a chargeable gain of £103,000. Because his adjusted net income is £123,000 for that tax year, his personal allowance is reduced from £11,500 to nil.
The top-slice is still within the basic rate tax band of £33,500 and so there is no additional tax to pay on the chargeable gain from a UK bond but he now receives a tax bill for £2,300 (20 per cent of £11,500) on some of his PAYE income as this is now taxable.
Example 2
Joanna has PAYE income of £30,000 and she surrenders a UK bond after 20 years with a chargeable gain of £300,000. Because her adjusted net income is £330,000 for that tax year, her personal allowance is also reduced from £11,500 to nil.
Like John, she also now receives a tax bill for £2,300 (20% of £11,500) but more seriously, the top-slice that was below the basic rate tax threshold of £45,000 (personal allowance of £11,500 plus basic rate tax band of £33,500) is now extending into higher rate tax.
When the top-slice of £15,000 is added to her income of £30,000 the total of £45,000 exceeds the revised basic rate tax threshold of £33,500 by £11,500. Higher rate tax is levied on this amount at 20 per cent (there is a basic rate tax credit for UK bonds) giving a tax bill of £2,300 (£11,500 x 20 per cent) for the slice of £15,000.
This amount is then multiplied back up by the complete number of years in force, giving Joanna a tax bill of £46,000 (£2,300 x 20 years) – plus £2,300 for losing her personal allowance.
In both cases, the situation could have been avoided by keeping the client’s income plus the chargeable gain below the £100,000 limit. This could be achieved by surrendering individual policies over different tax years, for example.
2. Personal savings allowance (PSA)
The adjusted net income figure also determines how much PSA a person receives. This is the amount of tax-free savings income and is £1,000 for a basic rate taxpayer, £500 for a higher rate taxpayer and zero for an additional rate taxpayer. The full chargeable gain is included in the calculation for adjusted net income.
So a basic rate taxpayer may only receive £500 PSA say, because of a chargeable gain, but not have any liability to higher rate tax.
3. Tax credits
Yet again, the adjusted net income figure determines if a person (or couple) receives tax credits such as Child Tax Credit.
This can be a quite serious situation; where a chargeable gain is more than £2,500 and they do not report it within 30 days, they could be fined up to £300 and up to £3,000 if HMRC feel that they gave wrong information carelessly or on purpose.
4. CGT
The rate of CGT on gains in excess of the annual exemption and any carried forward losses is 10 per cent for a basic rate taxpayer and 20 per cent for a higher rate taxpayer. So a person’s CGT bill could increase as a result of taxable gains coinciding with investment bond chargeable gain, in the same tax year.
This is because capital gains sit on top of a person’s income and, therefore, a chargeable gain could increase a person’s CGT bill. As for the personal allowance, the situation can be avoided by surrendering policies and other investments over separate tax years.
5. Student loan repayments
One scenario often overlooked, but encountered nowadays with a bare trust – or when assigning policies out of other types of trust – are student loan repayments.
The guidelines issued by the Student Loans Company stipulate: "If you have unearned income of more than £2,000 a year, for example interest on stocks, shares or savings, you may have to make additional student loan repayments.
"HMRC will advise you if you need to make any payments directly to them in respect of student loans once they have assessed any Self-Assessment tax return you submit to them."
Is a chargeable gain unearned income? It certainly is, so if the policyholder, or assignee if a bond has been assigned to them, has a student loan they could find that they have no tax to pay on the gain.
However, HMRC is demanding 9 per cent of that amount or, possibly, 9 per cent of the surrender value to offset against the outstanding student loan.
6. Rectification
A chargeable gain can also arise on other events of course: excess partial surrender (over the 5 per cent allowance), maturity, when death benefits become payable and assignments for money’s worth.
The first of these does have a certain notoriety, because of incidents when policyholders partially surrender large amounts, creating huge excess gains and causing a considerable tax bill to be issued.
HMRC was looking to allow ‘rectification’ of these chargeable events; however, the legislation introducing this was deferred because of June's general election but will, hopefully, be introduced before the end of this financial year.
Conclusion
Don’t just assume that because a client is a basic rate taxpayer and they have a chargeable gain under a UK bond that there will be no tax issues.
An UK investment bond can be tax efficient and provide great benefits to an investor, but as can be seen, you just have to be a bit careful that there are no knock-on effects when realising a chargeable gain.
Jeremy Pearson is technical support manager for Canada Life
