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Chartered Insurance Institute
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Tax planning - chargeable event gains on UK investment bonds

In this article it is assumed that the reader is conversant with the general rules surrounding top-slicing relief which could apply when a UK investment bond (Bond) is encashed/surrendered.

The main points drawn out from this article are:

  • Year-end tax planning should incorporate a review of Bonds
  • Simple planning steps can greatly reduce the impact of potential tax charges

Overview

In general terms, the top-sliced gain is added to the policyholder’s other income in the tax year of (partial or full) surrender of a Bond.  For example, a chargeable event gain is made on the full surrender of a Bond that has been held for 10 complete policy years.  The total gain is £100,000 so this will mean that the top-sliced gain is £10,000.

If the policyholder has other income which utilises, for example, all of their basic rate income tax band except for £3,000 then the higher rate tax on the top-sliced gain is 20% representing £7,000 (£10,000 - £3,000 of the balance of the basic rate band), i.e. £1,400.

This will mean that the effective rate of tax on the top-sliced gain (of £10,000) is 14%.  The 14% effective rate of tax is then applied to the whole chargeable event gain, i.e. 14% of £100,000 or £14,000, to give the amount of tax due on the whole gain.  Or to put it another way £1,400 for each of the 10 completed years in force.  Top-slicing relief therefore provides a tax saving of £6,000 (ie. £10,000 at 20% less £14,000).

Planning Opportunities

There are a number of critical factors which will impact upon the amount of tax that is paid:

  • The size of the chargeable event gain
  • The number of complete policy years over which the Bond has been held, as this determines the top-slicing fraction
  • Timing over the short-term
  • The amount of the basic rate tax band available to set against the top-sliced gain

Clearly, unless the client is prepared to defer the surrender of the Bond, there is little scope for planning with these four factors, save for the last two. 

The point about timing is simply that if the planned encashment is near the beginning or the end of a tax year, it may be advisable to either consider bringing forward or deferring part of the encashment so that the gain is spread over two tax years.  The main aspect of planning, though, relates to the manipulation of the basic rate tax band that is available to set against the top-sliced gain and this is what we will concentrate on now.

There are a number ways in which this can be achieved:

(a)       An outright and unconditional assignment of the Bond, or a number of the segmented policies, to a third party who has less income than the policyholder.  So long as this assignment is not for ‘money or money’s worth’ then the assignment itself does not give rise to a chargeable event.  Thus when the Bond is surrendered the higher rate income tax liability would be less, as there is more of the basic rate tax band available to the assignee.  The top-slicing calculation carried out on the happening of a chargeable event after the assignment is based upon the full period the Bond was in force, not just the period from the date of assignment. 

Typically, this scenario will work well between spouses or registered civil partners because gifts between these couples have no inheritance tax (IHT) consequences.   

This planning will also work well where the funds being realised from the surrender of the Bond are intended to be used to make an outright gift to an adult third party and the third party has income below the higher rate tax threshold.  Let’s take the example of an adult granddaughter; rather than encashing the Bond and then making a gift of the cash to the granddaughter, the Bond could be assigned (outright and unconditionally) to the granddaughter.  The assignment will be a gift for IHT purposes, but this is no different from the tax treatment were cash gifted.  The granddaughter can then encash the Bond and any chargeable event gain will be assessed against her for tax purposes.

Example

Uncle Bruce is a higher rate taxpayer with very significant earnings.  He wishes to help his niece, Emma, who has recently graduated, put together a deposit for a flat.  Bruce has a number of UK Bonds, all of which have significant gains.  He has held them for 20 complete policy years.  If Bruce were to encash them, all the gains would be taxed at the higher rate less basic rate (40% - 20% =20%).

However, Bruce decides to assign several of the Bonds to Emma.  The total value of these Bonds is £49,000 and the chargeable event gain is £32,000.

Emma is working as a trainee solicitor and she expects to earn about £25,000 this tax year (2017/18).  Bruce assigns the Bonds to Emma.  This will give rise to a PET of £49,000 for IHT purposes (assuming Bruce has already utilised his £3,000 annual gift allowance elsewhere), but there is no income tax in respect of the assignment as it is a gift and not ‘for money or money’s worth’ .

Emma encashes the Bonds and the chargeable event gain of £32,000 is top-sliced down to £1,600 (£32,000/20 years = £1,600).  Emma will not have a higher rate tax liability as, when the top-sliced gain is added to her other income, she will not be a higher rate taxpayer.

Had uncle Bruce not been so generous and the chargeable event gain such that the addition to Emma’s income kept her below the higher rate tax threshold (currently £45,000) there would be no need to use top-slicing relief.

  • The other way to plan is for the policyholder’s income to be varied. Let’s assume the policyholder is planning in advance how best to minimise the tax consequences of the encashment.  If they are in a position to manipulate the income received in the year of encashment then this is very effective tax planning and there are a number of situations where income can be manipulated quite legitimately.  For example:
  1. Where an individual is using income withdrawals it is possible to reduce the amount of income taken in any particular tax year to as little as nil. 
  2. For a company director, he or she could take a lower level of remuneration in a particular tax year, with the balance being deferred to the following tax year.

In both these cases the action taken will reduce tax payable on the chargeable event gain as it has effectively reduced the amount of “other income” and hence freed up more of the policyholder’s basic rate tax band.

  • The last option is to utilise a personal/member’s contribution to a registered pension scheme. In this case, any contribution that is not paid by an employer or former employer of the policyholder is treated as a member contribution.  This can work for almost anyone who is UK resident and has not attained age 75.  Even if the policyholder has no relevant UK earnings, they are still able to make a contribution of up to £3,600 gross p.a. to a registered pension scheme.  Obviously if the policyholder has relevant UK earnings greater than £3,600 they can make a contribution of up to 100% of these earnings to maximise the tax relief.  Clearly, the Annual Allowance needs to be factored in including any entitlement to carry forward.

The impact of making a personal contribution to a registered pension scheme is that the individual’s basic rate tax band is extended by an amount equal to the gross pension contribution.

It is important to note that whilst this will work with a pension contribution, it will not work with a Gift Aid payment.  Whilst in most cases the gross Gift Aid payment will also increase a donor’s basic rate tax band, there is specific legislation which means this will not reduce the tax on a top-sliced chargeable event gain.

Example

Take James for example.  James has a Bond which he intends to encash.  It is standing at a gain of £50,000 and he has held it for 4 complete years.

The addition of £50,000 to James’ total income makes James a higher rate taxpayer. 

Say £40,000 of the gain falls within the higher rate tax band James will pay tax of £8,000 on the gain (top-sliced gain £10,000 x 20% x 4).

If James pays a net pension contribution of £8,000 to his own pension plan then he will be saving £8,000 tax on the chargeable event gain as the grossed-up pension contribution of £10,000 will mean the top-sliced gain will fall within the extended basic rate tax band.  In simple terms, in paying £8,000 net into his own pension he is saving £12,000 income tax (ie. £8,000 on the chargeable event gain and £4,000 on the £10,000 pension contribution).

The fact that most Bonds are issued as a number of individual segmented policies is important as it allows partial encashment or assignment of the Bond, by full encashment or assignment of whole segmented policies.  This means that the three courses of action set out above do not have to be followed in isolation, but can be utilised in any combination of two or more.