At the March 2016 Budget, the UK Government announced its intention to change the tax rules applicable to life assurance policy part surrenders (taking money from a policy) and part assignments (gifting or selling part of a policy) in order to prevent taxable gains arising on these events that are disproportionate to a policy’s true economic gain. Part assignments being less common, attention is likely to centre on part surrenders, which are the focus of this article.
A Consultation Document was issued on 20 April 2016 and sets out three options for consideration and comment. In our view, the UK Government’s commitment to reforming and simplifying the rules for clients reaffirms the reputation of life assurance as a resilient long-term planning tool for UK resident clients utilising the benefits (mainly that of income tax deferral on any income or gains) offered by onshore as well as offshore bonds.
Why is a change to the taxation of part surrenders necessary?
Under the current rules, investors who make large withdrawals, particularly in the early stages of their policies, can find themselves liable to pay significant amounts of income tax when they least expect it. Under current legislation, a policyholder can withdraw the equivalent of up to 5% of premiums per policy year without any immediate liability to tax, even if the policy is in gain. However, once this 5% allowance is exceeded, any part surrender is treated as crystallising a gain regardless of underlying asset performance.
Most onshore and offshore bond providers issue policies in clusters of segments (multiple policies) as a matter of course. This enables investors to totally surrender a number of whole policy segments rather than making a part surrender. The advantage to policyholders is that the chargeable event calculation for determining the taxable amount on a total surrender recognises the true economic gain as opposed to an artificial sum representing the excess over the 5% withdrawal allowance.
The distinction in tax treatment between part and total surrenders continues to catch some investors out, generating what the First-tier Tribunal of the Tax Chamber has described as “an outrageously unfair result”. As such, we welcome the current proposals.
Do the proposals remove the tax-deferred withdrawal allowance?
No. The Consultation Document describes the maintenance of a tax-deferred withdrawal allowance as a “desirable outcome”. Two of the three options preserve the existing 5% allowance, while the remaining option increases it to 100%.
What are the three options?
Option 1: Taxing the Economic Gain – this would retain the 5% tax-deferred withdrawal allowance but bring into charge a proportionate fraction of any underlying economic gain whenever an amount in excess of the 5% was withdrawn.
The method given in the Consultation Document for calculating the gain is to deduct a proportionate amount of the premium paid from the amount withdrawn. As a result, the gain arising would always be a fraction of the policy’s true economic gain and no gain would be recognised unless the policy was in profit.
A final sweep-up calculation would be made on a total surrender, as is the case under current rules, where previously charged gains would be deducted from the taxable value.
Option 2: The 100% Allowance – no gain would arise until all of the premiums were withdrawn. This would convert the current 5% tax-deferred allowance to a 100% tax-deferred allowance, and would again ensure that only true economic gains were taxed.
Once all premiums had been withdrawn from a policy, any subsequent withdrawals would be treated as gains and taxed accordingly.
Option 3: Deferral of Excessive Gains – this would maintain the current method for calculating gains but would introduce a cap so that if the gain exceeded a pre-determined amount of the premium (the Consultation Document proposes a cumulative 3% for each year since the policy commenced) then the excess would not be immediately charged to tax.
The cumulative 3% would act as a form of safety net to limit the taxable gain each policy year. The gain arising from a subsequent part surrender would be increased by the amount of the deferred gain from the earlier event. If the total gain exceeded the pre-determined amount, the excess would be deferred again.
A sweep-up calculation would occur on a total surrender, by which premiums and gains would be deducted from the total of all policy withdrawals and deferred gains would be taxed.
Which option is best?
Option 2 – the 100% allowance – is, in our view, the simplest and most attractive option for clients. Although option 1 is similar to the calculation method used in a number of European countries, both this and option 3 require more complex calculations and, as the Consultation Document acknowledges, may involve greater administrative costs for individual policyholders. All of the options retain a tax-deferred withdrawal allowance while making sure that large part surrenders do not generate artificial gains.
What are the next steps?
The 5% tax-deferred withdrawal allowance, introduced in 1975, has long been one of the most appealing features of onshore & offshore bonds to UK residents. However, there has been growing speculation as to whether the Government remains committed to maintaining it. As such, in addition to announcing much needed protection from large and potentially unexpected income tax liabilities, the Consultation Document is likely to provide welcome reassurance to prospective investors that they can continue to access the value of their investments in an efficient manner.
The consultation period closes on 13th July. The Government will then review representations and expects to publish a response within 12 weeks. Draft legislation based on the preferred option is due to appear in Finance Bill 2017.