Chris Williams highlights a potential tax trap when making insurance policy surrenders.
Insurance policies and bonds remain a popular way of saving for the future or placing money for a fixed term for a safe return. They can also produce a handy return on investment, as five per cent of the investment can be withdrawn each year as a tax-free return of capital while the funds remaining undrawn accumulate income in a pretty tax-efficient environment.
But failure to take advice can have catastrophic results, as one unfortunate individual nearly found to his cost.
Onshore or offshore
Just how tax-efficient insurance bonds are depends in part on whether you go for an onshore bond (issued by a UK-resident insurer) or offshore (non-UK resident insurer). UK-resident insurers pay UK corporation tax, which reduces the amount available for reinvestment and growth, but this is partly compensated for by their income tax treatment.
Because a UK policy has suffered that tax ‘at source’ the payments out of the policy carry an effective tax credit in that they’re only subject to higher or additional rate tax, so to basic rate taxpayers the payouts often don’t suffer any further tax. Offshore bonds are treated as if they’ve paid no tax with the result that, apart from deducting the cost of the bond, all proceeds are taxable at the investor’s marginal income tax rate: all insurance savings bond payouts are subject to income tax and not capital gains tax, unless bought second hand.
There is also a form of relief, ‘top-slicing relief’ that effectively averages out the tax bill as if it accrued over the number of years the policy had been held and reduces the tax payable, but only if the policyholder isn’t already a higher rate taxpayer.
Mr Lobler’s mistake
The trap for the unwary and ill-advised comes with partial surrenders and the way they are taxed. A taxpayer (Mr Lobler) bought two blocks of policies worth together over £1.2 million, and within two years he had almost completely cashed them in, again in two tranches. These were offshore policies, so fully subject to income tax, not just higher and additional rate. On each occasion, he only surrendered 97.5% of each policy in the block. As he had held them for just one year he could only set off 5% of the cost, and was taxed on 92.5%. He finally surrendered the last 2.5% the following year and, because he could then set off the remaining 95% of the cost he made a huge loss but had no other income to set that loss against.
That loss is known as a ‘corresponding deficiency’ but it’s only available in the year that the deficiency arises. Mr Lobler couldn’t carry it back against his policy gains or forward against future income. His case is unfortunate because he financed his policy purchases partly through borrowing and partly with the sale proceeds from his former home - and had used the surrenders to buy his new home. By the time he had paid his income tax and repaid the loan he faced bankruptcy and the loss of his new home. HMRC refused to budge on insisting he pay the tax in full. He took the case through the tax tribunals where the Judges found that although the law as it stands is unreasonable, it is clear. Fortunately, the Upper Tribunal found that Mr Lobler had made a serious mistake in his decision to make partial surrenders of the policies, and allowed him to rectify that mistake.
Practical Tip:
Even if you don’t expect to have to surrender an insurance policy early, it’s a wise move to make sure the insurance isn’t a single policy, but is split into units that can be surrendered separately to maximise set-off of premiums paid should you have to surrender it. And always take professional investment and tax advice.
