Technical - Tax. Avoiding the pitfalls

Technical Connection’s John Woolley looks at calculating income tax on chargeable event gains

Despite the continued call for UK tax rules in general to be simplified, this has not happened. Indeed, if anything, income tax – even at the lower level – has become more complicated. And nowhere is this more apparent than the calculation of income tax on chargeable event gains (CEGs) under life policies – in particular investment bonds, which are owned by hundreds and thousands of UK taxpayers.

Here, the tax complications are mindboggling, with a knowledge of the application of the personal allowance, the personal savings allowance, dividend taxation, the starting savings rate band and the convoluted top-slicing relief being an essential requirement.

This complexity has been extended still further by Section 37 Finance Act 2020, which in effect gave effect to the First-tier Tribunal decision in the Mrs Silver case. This now means that when determining a policyholder’s adjusted net income (ANI) for personal allowance purposes in the top-slicing relief calculation, the top-sliced gain will be used.

A taxpayer is, in general, entitled to offset allowances and reliefs against different sources of income in the most favourable way for income tax purposes. Unfortunately, following the enactment of Section 37(2) Finance Act 2020, this is no longer the case for CEGs under life policies. Now, such reliefs and allowances must be offset against other income in priority to CEGs.

In what follows, we look at how the current rules apply and we attempt to highlight some of the tax traps that can arise. Space does not permit us to cover all the permutations, of which there are many. Examples are based on the full encashment of life policies from which previous withdrawals have not been made – CEGs can also arise on part surrenders and assignments but these are not dealt with here. All examples assume that the policyholder is resident in England or Wales (not Scotland where tax rates and thresholds vary) and assume that the CEGs are taxed on an individual policyholder – some CEGs can be taxed on trustees. 

Fundamentals

Before looking at this area in detail, it is worth considering some fundamental points that arise, as follows:

• A liability to basic rate income tax will never arise on CEGs under UK bonds, because the funds underlying such policies will already have been taxed at source. In effect, in carrying out the tax calculation, a basic rate tax credit is given – even if a part of the gain falls within the personal savings allowance or savings starting rate band. However, no credit is given for any part of a gain that falls within the personal allowance.
• On the other hand, the CEGs under offshore bonds can be subject to income tax at all rates – basic, higher and additional.
• Policyholders who have been non-UK resident for a period during their ownership of a policy can reduce the taxable CEG by non-resident relief to reflect the period they owned the policy while they were non-UK resident. In general, for policies effected after 5 April 2013, any top-slicing period will be restricted to the period of UK residence of the policyholder (see the Insurance Policyholder Taxation Manual (IPTM) Section 3830).
• Top-slicing relief will, in general, be most beneficial to policyholders who, because of the addition of the top-sliced gain, move between tax bands. However, it may also sometimes be advantageous for those who stay in the same tax band after addition of the top-sliced gain but have the personal savings allowance (PSA) available for offset against the top-sliced gain.

The six-step process

It is generally accepted that to correctly calculate the tax on a CEG, it is necessary to use the six-step process.

In the context of calculating top-slicing relief on one CEG in a tax year, this is described as the five-step approach in IPTM Section 3840. However, it must be emphasised that the HM Revenue & Customs manual purely deals with the calculation of any top-slicing relief due. It does not deal with the calculation of income tax on the whole gain – and it is here that the tax treatment of CEGs of offshore bonds and UK bonds differs if the policyholder has dividend income. This is because offshore bond gains are generally taxed before dividend income and UK bond gains after dividend income – see example of Simon later in the article. By using the full six-step process, one can determine not only the tax on the gain but the impact that the encashment of the bond might have on the tax liability on the policyholder’s other income in that tax year.

Our six-step approach for UK bonds is set out below. In calculating top-slicing relief, it should be borne in mind that taxable redundancy pay and lease premiums are ignored.

Step 1: Calculate the total taxable income for the year and the tax thereon. This will involve determining the amount of personal allowance and PSA that is available, based on the full gain. As part of this process, identify how much of the gain falls within the starting savings rate tax band, personal savings (nil rate) allowance, basic, higher or additional rate tax bands as appropriate.

Step 2: Calculate the total tax due on the gain across all tax bands. As a separate calculation, deduct the basic rate tax treated as paid to find the individual’s higher/additional rate liability for the tax year.

Step 3: Calculate the top-sliced gain. The top-sliced gain is calculated by dividing the full gain by the number of complete years the policy has been in force – known as N (as determined in IPTM3830).

Step 4: Calculate the individual’s liability to tax on the top-sliced gain. For gains arising in tax year 2018/2019 onwards, the personal allowance is recalculated where appropriate at this stage by using the top-sliced gain as part of ANI (see IPTM3820). Deduct basic rate tax treated as paid on the top-sliced gain (for UK bonds and offshore bonds), and multiply the result by N. This gives the policyholder’s relieved liability.

Step 5: Deduct the policyholder’s relieved liability at step four from the individual’s higher/additional rate liability at step two to give the amount of top-slicing relief due.

Step 6: Deduct top-slicing relief and the basic rate tax credit on a UK policy, from the total tax on all income in step one.

This six-step process is modified for gains from offshore bonds – see (c) later. In particular, two calculations are needed at step one. For offshore bonds, it is the second figure calculated at step one that is used at step two to assist in determining top-slicing relief.

Multiple CEGs

Where there are multiple CEGs in one tax year, a slightly different approach is used to determine top-slicing relief, as follows:

a) The gain for each policy is divided by its own top-slicing factor. All of those top-sliced gains are then 
added together.

b) The total tax liability is determined on the total top-sliced gain with an appropriate reduction for basic rate tax treated as paid on the whole gain.

c) The total tax in b) is multiplied by the total chargeable gains and divided by the total annual equivalent in a).

d) The total relieved liability in c) is deducted from the tax on the gain calculated as part of the individual’s full tax calculation in that year.

Traps

(a) The personal allowance

Subsections 37(3) and 37(4) of Finance Act 2020 amend Sections 536 and 537 ITTOIA 2005, and means that, in calculating top-slicing relief, a policyholder need only take account of the top-sliced gain in determining ANI for the purposes of the entitlement to a personal allowance. By concession, HMRC will apply this treatment for tax years 2018/2019 onwards. What this change does not mean is that the top-sliced gain is used for all income tax purposes. So, if the policyholder realises a CEG that causes their ANI to exceed £100,000, they will lose some or all of their personal allowance in the calculation of income tax on all income in that year.  This needs to be carefully considered in determining the full tax cost of a bond encashment.
 
Example – Henrietta
Henrietta has a salary of £45,000 in tax year 2020/2021. She encashes a UK bond, which she has held for eight complete years, with a CEG of £80,000. Using our six-step approach, her tax liability is determined as follows:
 
Step 1: Because of the inclusion of the full bond gain, Henrietta will lose all of her personal allowance in 2020/2021. She will be a higher rate taxpayer and so be entitled to a PSA of £500. Her tax liability will be:

 
Step 2: Now we need to calculate higher rate income tax on the CEG.
 

Income tax on CEG =             £31,800
Deduct the basic rate tax credit 
(£80,000 @ 20%) =             £16,000
Total higher rate tax on whole CEG        £15,800
 
Step 3: Calculate the top-sliced gain
£80,000 ÷ 8 =                 £10,000
 
Step 4: Calculate income tax on the top-sliced gain and so the policyholder’s relieved liability.

In this part of the calculation, we need to calculate tax on the top-sliced gain and her other income. To do so, we need to check to see whether she loses any personal allowance using the top-sliced gain.

Following the amendment in Finance Act 2020, Henrietta’s ANI for these purposes is deemed to be £55,000, so she retains her full personal allowance.

She is still deemed to be a higher rate taxpayer and so qualifies for a PSA of £500. 
 
Tax on top-sliced gain

Income tax on top-sliced CEG                          £2,900
Less basic rate tax credit (£10,000 x 20%) =    £2,000
Higher rate tax on top-sliced gain                      £900
 
Higher rate tax on whole gain using
top-slicing (£900 x 8)                                        £7,200
 
Step 5: Top-slicing relief
 
£15,800 (Step 2) less £7,200 (Step 4) =              £8,600
 
Step 6: Total income tax due for the year
 
Tax on earnings                                                     £10,500
Tax on bond encashment:                                      £31,800
Less top-slicing relief                                              £8,600
Less notional basic rate tax credit on bond gain    £16,000
Tax on bond gain                                                    £7,200
 
It should be noted that the personal allowance is still lost for offset against other income (earnings) and this results in additional income tax payable of £4,000 (£10,500 – £6,500), so that the total additional tax because of the encashment is £11,200. So, the total effective rate of tax on the bond gain could be regarded as being £11,200/£80,000 = 14% (due to loss of personal allowance).
 
(b) Personal savings allowance
The level of PSA that a person is entitled to depends on their ANI. For a basic rate taxpayer, it is £1,000; £500 for a higher rate taxpayer; and no PSA for an additional rate taxpayer. 

To determine a person’s PSA in both the calculation of tax on income, including the whole gain, and on the top-sliced gain, the full CEG is used. 
 
Example – Marcia
Marcia has earnings of £40,000 in 2020/2021. She realises a CEG of £30,000 on a policy she has held for six complete years. Even though she remains a basic rate taxpayer if one includes just the top-sliced gain, the full gain is included for the purposes of determining her ANI for PSA purposes. As a higher rate taxpayer, she is therefore entitled to a £500 PSA in the calculation of tax on the full gain and the top-sliced gain.
 
Section 37(2) of the Finance Act 2020 now provides that when offsetting allowances and reliefs against income, those allowances (which include the PSA) and reliefs must be offset against other income in preference to any CEGs.
 
Example – Ralph 
Earnings     = £45,000
Interest    = £200 a year
Ralph encashes a policy he has held for four complete years, which has a CEG of £50,000.
He is higher rate taxpayer so his PSA is £500.
In calculating income tax on the whole gain and the top-sliced gain, £300 of PSA can be deducted against CEGs. The fact that the PSA can be offset against the top-sliced CEG when it is not offset against other savings income, means that top-slicing relief tax savings can frequently be ‘ramped up’. For example, the total tax saving available to Ralph would be £240 (£300 at 20% x 4). If he had been able to offset the whole £500 PSA against the top-sliced gain, the tax saving would have been £400. And, of course, this saving increases with the number of years the policy has been held (N).
 
The point here is that being able to relieve the PSA against the top-sliced gain produces a lesser tax liability for the policyholder on the top-sliced gain and so, because of the multiple, increases the impact of top-slicing relief on the whole gain.
  
(c) Gains on offshore bonds
The calculation of income tax on offshore bond gains poses particular problems.

The issue here is that, technically, CEGs on offshore bonds count as savings income, so when calculating tax on all income at step one, they are taxed before dividends. The CEGs under UK bonds are also technically savings income but a legislative provision in Section 465A ITTOIA 2005 states they must always be taxed as the highest level of income, so always come into the tax calculation after dividends.

It will therefore be appreciated that the inclusion of CEGs on an offshore bond can push up the level of tax on dividend income – from possibly 7.5% to 38.1% in extreme cases.

As far as the calculation of top-slicing relief for higher/additional rate purposes on offshore bond gains is concerned, this applies in much the same way as with UK bonds. This means that when calculating tax on the encashment of an offshore bond, two calculations need to be made at step one:

(i) One to calculate tax on the whole gain before the dividend.

(ii) Another to calculate tax on the whole gain after the dividend - this figure is used in the top-slicing relief calculation at step two to determine the higher rate tax liability. 

At step four, higher rate tax on the gain using top-slicing is calculated. At step five, this is deducted from the higher rate tax calculated at step two to give top-slicing relief. This relief will then be deducted from the tax calculated in calculation (i) at step one to give the individual’s tax liability on all income for the year.
 
Example – Simon
In 2020/2021, Simon has:

• Earnings of £24,000
• Bank interest of £1,000 (gross)
• Dividend income of £10,000.

Simon fully encashes his offshore bond, realising a chargeable event gain of £100,000. He has held the bond for four complete years.

Because this involves a CEG from an offshore bond and Simon has dividend income, to calculate Simon’s increased tax bill in 2020/2021, we need to modify the six-step approach at step one.
 
Step 1 – Simon’s total adjusted net income in 2020/2021, inclusive of the full CEG, is £135,000. He therefore loses all of his personal allowance and, as a higher rate taxpayer, is entitled to a PSA of £500.

Then we apply the two-stage process:

(i) First, we need to calculate the tax on all of his income, including the full CEG. At this stage, the offshore bond CEG is taxed before dividend income and results in a total tax charge on the gain of £37,500.

The total tax on gains is £37,500 (£2,500 basic rate tax and £35,000 higher rate tax).
 
(ii) Then, for top-slicing relief purposes, we must calculate the tax on the full gain on the basis that it is the highest part of income (i.e. taxed after dividends).

 
Step 2 – The total tax on gains (as top part of income) is £500 basic rate tax and £39,000 higher rate tax =  £39,500
Less basic rate tax credit (£100,000 @ 20%) =  £20,000
Higher rate tax =  £19,500
 
Step 3 – Determine the top-sliced gain, which is £25,000 (£100,000 divided by 4).
 
Step 4 – Calculate tax on the top slice.
 
As a result of the change in the Budget 2020, we use the top-sliced gain in determining Simon’s ANI for personal allowance purposes. So, in calculating tax on the top-sliced gain, Simon is entitled to a full personal allowance of £12,500.

Tax on top slice £3,000 + £4,000 =         £7,000
Tax credit = £25,000 @ 20% =         £5,000
Total relieved liability on top slice =         £2,000
Tax on whole gain £2,000 x 4 =         £8,000

Step 5 – Top-slicing relief
£19,500 (Step 2) less £8,000 (Step 4) = £11,500
 
Therefore, the tax on the whole gain is £26,000, being the tax on the full gain at Step 1 (i) (£37,500) less the top-slicing relief of £11,500.

But that unfortunately is not the end of the story. 
 
Step 6 will show that the encashment of the offshore bond will not only cause a liability of £26,000 on the gain, but:

• Cause a loss of Simon’s personal allowance in 2020/2021, meaning an increased tax bill of £2,500.
• Cause Simon to lose £500 of his PSA in 2020/2021, which means he suffers an additional £100 tax on his bank interest.
• Increase the tax on the dividends by £2,000.

Shortcut approach 

In the past, it has been common to calculate tax on a CEG using the ‘quick approach’. Quite simply, where a CEG on a UK bond took a client from one tax band (say basic rate) to another (higher rate), one could simply:

• Calculate the top-sliced gain (total gain divided by number of complete policy years).
• Work out how much of it fell within higher rate tax.
• Calculate the tax on it at 20% (having taken account of the basic rate tax credit).
• Multiply the answer by the top-slicing factor.

Unfortunately, due to the recent complex tax changes (for example the introduction of the PSA), this approach is no longer accurate. It also does not take account of the extra tax that can be paid on other income as a result of the encashment of the bond. In some unusual cases, top-slicing relief may not reduce tax, even though the top-sliced gain just tips the taxpayer into higher rate tax.
 
Example 1 – John
John has non-savings income (earnings) of £48,000 and encashes a UK bond with a £50,000 CEG that has arisen over five complete years.
 
Top-sliced gain = £10,000
 
(a)     Under the six-step process, the income tax liability on     the bond is £7,500.
(b)     Under the shortcut basis:

• £10,000 top-sliced gain over five years
• £8,000 in higher rate tax
• Higher rate tax on slice = £8,000 x 20% = £1,600

 
Total higher rate tax on whole gain = £1,600 x 5 = £8,000
 
Under the new six-step process, there is £500 less tax to pay (because of inclusion of the £500 PSA in the calculation).
 
Example 2 – Paul
Paul has non-savings income (earnings) of £60,000 and encashes a UK bond with an £80,000 CEG that has arisen over four complete years. In this case, the shortcut basis would not work because it ignores the impact of the PSA on the top-sliced gain and the increase in tax on earnings because of the loss of the personal allowance.
 
Example 3 – Ringo
Ringo has non-savings income (earnings) of £20,000, dividends of £25,000 and encashes an offshore bond with a £50,000 CEG that has arisen over five complete years. In this case, the shortcut basis would not work because the bond gain is taxed before dividends in the main tax calculation on income, meaning that tax on dividends is increased (see example – Simon, previous page).

Planning 

Because of the complex tax rules, care needs to be taken 
in determining all of the tax effects of the encashment of 
a life policy. 

The tax liabilities arising on life policy proceeds can be reduced in a number of ways:

• Encashment of the policy in two or more tax years to maximise use of the personal allowances. Simon (previous page) could have solved the problem of loss of personal allowance by encashing the policy over two tax years.
• Paying a pension contribution. Where people have top-sliced CEGs that just tip them into higher rate tax and they have available pension allowance, a pension contribution can solve the problem. For example, if a person has a top-sliced gain that falls £2,000 over the higher rate threshold, a new payment of £1,600 to a pension plan can eliminate the tax on the CEG because of the extension of the basic rate tax band. Unfortunately, this planning is not possible with Gift Aid donations.

John Woolley of Technical Connection/St. James’s Place

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