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Chargeable Gains on Onshore Bonds

Chargeable gains – when they apply and to whom. This will be laid out with a general overview and then subsections dealing with each scenario. This article deals with individuals and trusts but does not cover bonds held by corporate investors.

For corporate information please look at ‘Taxing company-owned life assurance’.

What is a chargeable gain? | What events create a chargeable gain? | What events do not create a chargeable gain? | When is the gain taxed? | Who pays the Tax? | Taxation of the gain | Top slicing | 5% rule | How is the amount of the gain calculated? | Full bond encashment | Full encashment of individual policies | Partial encashment, taken across all policies | Should I surrender individual policies, or across all policies?

What is a chargeable gain?

A chargeable gain arises on certain events during the life of a life assurance contract. The gain is chargeable to income tax rather than capital gains tax.

What events create a chargeable gain?

Events that will cause a chargeable gain calculation are generally where there is a disposal of the bond which is going to involve the client (or their estate) receiving a cash value in return. Examples of this would be:

  • Death of the life assured that results in a claim.
  • Full surrender of the whole bond.
  • Part surrender across all policies within a bond which are more than the 5% cumulative annual allowance (see later heading).
  • Full surrender of some policies within the bond.
  • Maturity of the bond (if appropriate).
  • Assignment of the bond for monies worth (i.e. receiving a payment for transferring the bond) or for consideration (i.e. in anticipation of a connected transaction).
  • Substitution e.g .addition or removal of a life assured.

What events do not create a chargeable gain?

Some events mean that it is possible to take some benefits of the bond or give the bond away where there is no chargeable event. These latter events are normally where there is no exchange of a monetary value. Examples of this would be:

  • Part surrender across all policies within a bond up to the cumulative 5% annual allowance.
  • Assignment of all or part of the bond as a gift to an individual or a trust (although not a chargeable event it will create either a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfer (CLT) for inheritance tax purposes).
  • Assignment as security for a mortgage loan.

When is the gain taxed?

Any chargeable gain is taxed within the same tax year the gain arises.

Regular withdrawals and/or ad hoc partial surrenders taken across all policies within a bond in any policy year are aggregated and treated as having been taken together on the last day of that policy year. The aggregated payments will be treated as occurring in the tax year in which the last day of the policy year falls.

The chargeable event certificate will be issued within three months of the end of the policy year for any partial surrender across all policies and within three months of any final surrender of the full bond or surrender of full policies within a bond.

Who pays the Tax?

Gains on chargeable events for individuals will follow a logical route of the gain being levied on the owner of the bond at the time of the chargeable event. If the bond is jointly owned by more than one person any gain will be apportioned between them. If the bond has policies that have been assigned to another person as a gift those policies will be chargeable on their respective owner(s) and separate certificates will be required.

If the bond has been assigned into a discretionary trust, although it has been assigned into the ownership of the trustees, any chargeable gain will still fall on the settlor during their lifetime and in the tax year of their death. If the bond is encashed or creates a gain at any time after the tax year of the settlor’s death but before assignment out of the trust into the ownership of a beneficiary, the trustees will be liable for any chargeable gain created.

If the bond has been assigned into a Bare/Absolute Trust, this gives the absolute entitlement of the bond to the beneficiary and cannot be varied. As this is the case any chargeable gain will not fall on the trustees or the settlor but will be levied on the beneficiary irrespective of their age and based on their own personal allowances. However, where the trust was established by a Parent for their minor and unmarried minor child, the £100 parental settlement rule will apply. See our related article for further details.

Where a bond is owned by Trustees any chargeable event certificate will be issued to the Trustees as the legal owners but they do not need to declare the gain on their tax return unless they are liable. They can forward the certificate to the person liable for them to declare on their own tax return.

There are some exceptions to these rules, which can get quite complex and therefore specialist advice should be sought. Examples of this are:

Where the settlor is non UK resident at the point the gain arises, the gain will be paid by the trustees. If there is no trustee who is UK resident at the point of the gain then the liability will fall upon the beneficiaries. It should also be noted that if this is the case the beneficiaries cannot utilise top slicing relief, as described later in this document.

Another scenario to watch out for is where the bond was created and put under trust prior to 
17 March 1998. Where the settlor has also died before that date then there is no entity to levy the chargeable gain on and so there is nothing to pay. This will only apply where the bond has not been varied in any way or the term of a life assurance policy extended. This is known as the dead settlor rule.

These last two areas can be very complex and advice should be sought before proceeding in these circumstances.

Taxation of the gain

Any chargeable gain is subject to income tax and is added on to the income the client or trustees already have so will always attract tax at the highest marginal rate.

For individuals and bare trust beneficiaries the income tax rates are 20%, 40% and 45%. Under a bond the underlying fund is taxed as insurance company taxation (broadly equivalent to corporation tax) and this covers an individual’s liability for basic rate tax. So if any gain falls entirely into the nil or basic rate tax band there is no further liability to tax for the individual, however, they will not be able to claim any tax back if they are a nil rate tax payer. If the tax falls into the higher or additional rate tax band, the client can reduce the tax rate by 20% as this tax has already deemed to have been paid.

Example:

A client is a higher rate taxpayer and has a gain of £5,000. The tax due is 40% but 20% is deemed to have already been paid via the underlying bond taxation and therefore they only have to pay an additional 20%.

For income tax purposes Trusts have a standard rate band (SRB) of £1000 where they pay tax at 20%. Any income not covered by the SRB is liable for tax at 45%. Like an individual, the trustees can reduce their tax rate by the 20% tax that has already deemed to have been paid.

Example:

The trustees have a gain of £10,000. The first £1,000 falls within the trustees' 20% band and the tax is deemed to have been paid due to the bond underlying taxation. The remaining £9,000 is liable to tax at 45%. As 20% is deemed to have already been paid, the trustees only have to pay an additional 25%.

Where a gain falls over two tax bands, each part of the gain will be taxed at the appropriate level. This is especially significant where a client utilises top slicing relief as described in the following section.

Top slicing

Now the taxation of the gain has been described, it will need to be determined how the tax is applied to any gain.

HMRC have a system called top slicing where they allow the overall gain to be spread over the number of full policy years the bond has been held. Relief is only available if the total gain moves you into the higher rate tax bracket than you normally pay. I.e. Basic to higher, or higher to additional. To determine the revised gain you will take the overall gain and divide this figure by the number of complete policy years the bond has been running for. This will give you the ‘annualised’ amount. This amount is then added to the individual’s income to determine if this sliced gain will push their income into a higher tax bracket.

If the income stays within the nil or basic rate tax bracket after the sliced gain is added there is no further tax to pay on the whole gain (as the underlying bond taxation accounts for basic rate tax).  If the client is in the higher rate tax band after adding the sliced gain, there will be a further calculation to carry out to determine the tax due. The amount of the gain that falls into the higher rate band will be multiplied back up by the number of full policy years the bond has been running for and this amount will be the amount that is taxable as the gain.

Example:

A bond has been running for 10 full policy years and has created an overall gain of £60,000. 
The client has total income for the year in which the chargeable event falls (2016/17) of £39,000. Higher rate tax starts at £43,000 (assuming the policyholder has the standard personal allowance).

The gain is top sliced by the full number of policy years, so £60,000/10 = £6,000.

This sliced gain is now added to the client’s income to produce a total of £45,000

£4,000 of this gain falls into the basic rate tax band and the client is liable to tax on this amount. However, as the bond suffers corporation tax on the underlying funds which is equivalent to 20% the client has no further tax to pay.

However, £2,000 of the gain falls into the higher rate tax band and so is subject to further tax.

To determine the taxable element that will be charged you multiply £2,000 back up by the number of full policy years completed (10) to get a figure of £20,000.

This figure is then taxed accordingly by the difference between the 20% tax deemed to have been paid and the 40% appropriate tax rate.

The same principle will operate where the client is already a higher rate taxpayer and, when top sliced; the gain takes the client into the additional rate tax band. Remember that as the client is already a higher rate taxpayer they will be liable for 40% tax on the whole of the gain (20% deemed to be paid due to underlying corporation tax) and the top-slicing is merely to see what portion of the gain falls into additional rate tax.

Top slicing can be applied to both full surrenders and partial surrenders however, there are exceptions where it cannot be used or it is restricted as follows:

  • For partial surrenders across all policies within a bond if there has been a previous chargeable gain on those policies you can only go back as far as the last gain when calculating years used for the top slice calculation on a UK bond. However, if the bond is offshore and there has been a previous chargeable gain you are not restricted in the same way you are for an onshore bonds and top slicing can be used back to the start date of the bond.
  • Trustees are not allowed to use top slicing when calculating their gains.

It is important to note that, where the whole of the gain (before top slicing) takes the client's total income above £100,000, this will affect their personal allowance.

5% rule

You are allowed to withdraw 5% of your initial investment each year without any immediate liability to tax, or having to declare anything on your tax return up to a maximum amount of 100% of the initial investment. If you have made an additional investment at any time, the 5% allowable will then also apply to that investment on the same basis and for 100% return of that sum.

Example:

Client invests £100,000 in 2003 and takes £5,000 per year. However, in 2013 they top up this policy by an additional £100,000. They then take a total of £10,000 per year from this bond until 2023. In 2023 the initial investment of £100,000 will have been exhausted by the withdrawals and so the 5% amounts relating to this will have to stop or be subject to a chargeable gain. So from 2023 the 5% limit drops from the £10,000 to £5,000.

If the 5% withdrawal allowance is not used fully or at all in a year, the unused allowance is carried forward. There is no timescale as to how far this can be carried forward but it will always be restricted to a total of 100% of the investments made.

Example:

An investment of £100,000 is made in January 2009. £5,000 can be withdrawn during each policy year with no tax to pay at the time. If no withdrawals are made, then for example in June 2013 which is actually in the fifth policy year, 25% or £25,000 in this case can be withdrawn (5% x five years), again with no immediate liability to tax.

How is the amount of the gain calculated?

Chargeable gains are based on the amount of the investment and full bond surrender (including previous withdrawals) or amounts in excess of the tax deferred amount (5% withdrawals). The actual calculation to determine the gain can be relatively simple as long as you have all of the information needed to hand. However, in certain circumstances it can also be more complex. Under the sub-headings below we give a brief description of different gain scenarios and the calculation to work out the gain.

Full bond encashment

 Where the bond is fully encashed, the chargeable gain can be calculated as follows:

A = (bond surrender value + total partial surrenders taken across all policies within the bond)

B  = (total premiums paid to the bond + total chargeable gains created by partial surrenders across all policies)

A – B = Chargeable gain.

Example:

A client invests £100,000 into a bond. The client takes regular withdrawals of £4,000 in each of the first three years and a one-off withdrawal of £12,000 in year three. The client adds an additional £50,000 to the investment in year 7.

In year 12, the client fully surrenders the bond for £173,000.

The regular withdrawals were within the 5% tax-deferred allowance, but the one off withdrawal in year three, when added to the regular withdrawals, exceeded the cumulative allowance and gave rise to a chargeable gain of £9,000. 

Calculation:
A = (+ £173,000 + (£12,000 + £4,000 + £4,000 + £4,000)) = £197,000
B = ((£100,000 + £50,000) + £9,000) = £159,000

A (£197,000) – B(159,000) = £38,000 gain

This example shows how to work out a simple gain. In addition to this, top slicing could be applied to the calculated gain. Please refer to section on ‘Top Slicing’ above.

Full encashment of individual policies.

Most bonds are split into a number of identical policies; the number of policies is defined from outset. These policies can be surrendered individually. The calculation of the gain follows the same steps as the full bond encashment:

A = (bond surrender value + total partial surrenders taken across all policies within the bond)

B = (total premiums paid to the bond + total chargeable gains created by partial surrenders across all policies)

A – B = Chargeable gain.

However, the elements of the calculation divided by the number of policies within the bond.

Example:

£100,000 was invested in 2010 into 100 identical policies.
Two years and 11 months later this bond is now worth £120,000.
£5,000 partial surrender across all policies has been taken in the first year, but did not create a gain (within 5%).

 Now the client wishes to take £36,000.

Calculation:

Bond surrender value = £120,000 / 100 = £1,200

Previous partial surrenders taken across all policies = £5,000 / 100 = £50

Total premiums paid = £100,000 / 100 = £1,000

Gains created by partial surrenders = £0 / 100 = £0

A = (£1,200 + £50) = £1,250

B = (£1,000 + £0) = £1,000

A – B = £250 gain per policy.

How many policies should be surrendered?

Each policy was originally valued at £1,000 and is now valued at £1,200. This means that each policy has a gain of £200, so the number of policies the client will need to encash to get the sum required is £36,000 divided by £1,200 = 30.

30 x £250 = £7,500 total gain.

This example shows how to work out a simple gain. In addition to this, top slicing could be applied to the calculated gain. Please see under the heading ‘Top Slicing’.

Important: Where there has previously been a mix of encashment of individual policies partial encashment across all policies, further calculation is required. It is necessary to step through the history of the bond and establish the total partial encashment and gains applicable to the remaining policies.

Example.

100 policies from outset.

Year 1 - £5,000 surrendered as a partial encashment across all policies.

Year 2 - 10 individial policies encashed.

Year 2 - £5,000 surrendered as a partial encashment across all policies.

In year 1, the total partial encashment per policy = £5,000 / 100 = £50

In year 3, the total partial encashment per policy = £5,000 / 90 = £55.55 + £50 (from year 1)

The premium per policy is determined by dividing each premium by the number policies at the time it was made. The surrender value per policy is calculated by dividing by the number of remaining policies at the time of surrender.

Partial encashment, taken across all policies

When looking to take a partial withdrawal across all policies within the bond, this will utilise the available 5% withdrawal allowance described earlier in this article. A chargeable gain will arise where the surrender is in excess of the accumulated 5% allowance.

Note: The allowance is per policy year; where a part encashment is taken during a policy year that year's allowance can be utilised.

Example

£100,000 was invested in 2010 into 100 identical policies.
Two years and 11 months later this bond is now worth £120,000.
£5,000 partial surrender across all policies has been taken in the first year, but did not create a gain (within 5%).


The client has used the 5 % allowance for year one and has remaining two years of 5% allowance remaining (One year unused and the current policy year) =£10,000.
Any excess taken over this amount is subject to chargeable gains, so
£36,000 - £10,000= £26,000. This is the amount of the chargeable gain.

This example shows how to work out a simple gain. In addition to this, top slicing could be applied to the calculated gain. Please see under the heading ‘Top Slicing’.

Should I surrender individual policies, or across all policies?

We have used the same figures in the examples above so the outcome can be compared.  As you can see, drastically different gains are created by surrendering the same value. Although this example works in favour of full encashment of individual policies this may change significantly if, for example, the bond had been running for a longer period of time and no 5% withdrawals had ever been made. Alternatively the client may be paying a lower rate of tax at the point of encashment so the full gain will remain in the basic rate tax band. For these reasons, amongst others, it is always advisable to do both of these calculations to find the best option available for the client and their circumstances at the time.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

 

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