.png)
.png)
IF YOU ARE hoping that an endowment policy will repay your mortgage, you may well have received a 'red' or 'amber' letter from your insurance company in recent years. When the salesperson sold you the policy, it would have come with a schedule predicting that in twenty-five years time not only would your mortgage be paid off, but you would also receive a cheque that would finance a round-the-world cruise or a new car. Unfortunately this was based on an assumption that past performance was a guide to the future, even though every advertisement for financial products warns that it isn't. For many people promises of a surplus are a distant memory: the present prospect is of either a 'high' or 'significant' risk of a shortfall, (the red and amber letters, respectively) so that the mortgage will not be paid off in full by the policy.
That does not, of itself, justify the payment of compensation for mis-selling. Failure of an investment to live up to expectations is not sufficient to trigger a claim. However, many people were not aware that by choosing an endowment rather than a repayment mortgage they were exchanging the certainty of repayment for the uncertainty of a stockmarket investment. In such cases it may be possible to claim that the endowment was mis-sold and that the taxpayer should be compensated.
Compensation calculation
What should the compensation be? The normal approach which the Financial Services Authority requires insurance companies to use is to compare the position the policyholder finds himself in now with the position he would be in if a repayment mortgage had been taken out. The difference between the two (assuming the policyholder is worse off) is the compensation which is due.
However, in some cases it is considered more appropriate to refund premiums and add interest, even though this is not the Financial Services Authority's preferred approach. This, too, would put the policyholder back in more or less the same position as if he had not taken the policy out and had therefore been able to save the premiums. The question is whether this makes a difference to the tax liability.
Tax Bulletin
The Inland Revenue's Tax Bulletin 72 (see Taxation, 2 September at page 573) says that if interest is included in a compensation settlement, tax should be paid on that interest. It quotes the House of Lords decision in the case of Westminster Bank Ltd v Riches (1947) 28 TC 159 as authority for this. Answering other common objections, it says that interest does not lose its character by being included in a global settlement, that the payments are not ex gratia and that the reason why pension mis-selling compensation is exempt from tax is because there is a specific exemption for it (section 148 Finance Act 1996).
The flak that the Inland Revenue took for this in the newspapers, and even in the trade press, over the next few days was both significant and unfair. The implication of the headlines, and sometimes the stories too, was that the whole of the compensation payment might be taxable, not just the interest payment. The fact that this problem will only affect a small proportion of those who receive compensation (because normally the calculation does not involve the addition of interest) was rarely explained, although to be fair the Inland Revenue might have made this clearer in the Bulletin.
Above all, the argument that such payments 'shouldn't' be taxed, which most of the reports either said or implied, asks the Inland Revenue to usurp the functions of government. Such a decision could only be based on wider grounds of public policy which are not within the remit of the Inland Revenue. If it is thought appropriate to exempt interest payments in this situation from tax, then the Government has to do so.
The Gourley principle
However, it is arguable that the only people who would benefit from giving a tax exemption to these payments would be the insurance companies. At present they have to allow for any tax liability the policyholder may suffer, which effectively means a gross interest rate. If the interest was exempted from tax, then the rate would have to be reduced to reflect the net interest that the taxpayer would actually have received if the premiums had been invested.
This follows from the case of British Transport Commission v Gourley [1955] 3 All ER 796. In this case, a civil engineer was granted damages for loss of earnings following injuries in a railway accident. The appellant successfully claimed that the damages, which were not themselves liable to tax, should be reduced by the hypothetical income tax and surtax which would have been payable on the lost earnings. The point about a claim for damages is to compensate the claimant for the actual loss. Since Mr Gourley would only have taken home his net pay, and since the damages were not taxable, they only needed to compensate him for his net pay.
The policyholder who was the victim of mis-selling needs to have his or her position compared with someone who had not taken out the policy but had saved the premiums instead. Provided the interest is taxable, the interest rate used therefore needs to be gross under the Gourley principle — the policyholder will have to pay tax on the interest paid as compensation just as he would if the premiums had been invested in a bank or building society account. As soon as the interest included in the compensation payment is not taxable, it follows that the interest should be adjusted to reflect the net interest that a taxpaying policyholder would receive, and the only beneficiaries of the exemption would be the insurance companies.
What is interest?
My only difficulty with the Bulletin article is whether it accurately distinguishes between cases that do give rise to a tax liability and those that do not. It is important to be clear what the case that the Inland Revenue relies on, National Westminster Bank v Riches, does and does not cover. Mr Riches had an agreement with a Mr Ridsdel that if Riches would arrange for him to buy a block of shares, Ridsdel would give Riches half the profit he made on their subsequent resale. Ridsdel actually paid him less than half the profit. When Riches found out, following Ridsdel's death, he sued the judicial trustees of Ridsdel's estate for the balance. The judge found in his favour, and also added interest at 4 per cent, which the statutory provisions governing judgments in such cases allowed him to do. The question was whether the interest was taxable.
The House of Lords said that it was. It was interest added to the payment, albeit interest provided for by statute, and therefore taxable. It did not lose its status as taxable interest by virtue of being paid as damages — damages could still be interest.
However, the judgment went on to distinguish, rather than overrule, several other previous decisions. Amongst them was the case of Glenboig Union Fireclay v Commissioners of Inland Revenue 12 TC 427. Here, certain payments within a compensation agreement were referred to as interest, but were really simply a method of calculating the correct capital amount that was due to the plaintiff. That was not taxable, it was only where there was a right to a lump sum and then a subsequent addition of interest that the latter was taxable.
The Inland Revenue rightly says that each case must be decided on its facts, but that in cases where the premiums are repaid with interest, the interest is clearly taxable. However, the Financial Services Agency makes it quite clear that the overriding principle is to put taxpayers back into the position that they would have been in if no policy had been taken out.
It is at least arguable that the 'premiums plus interest' calculation is a method of estimating the loss, as in Glenboig Union Fireclay, and not a payment of interest as in National Westminster Bank v Riches.
