L.A. Shakedown

RICHARD CURTIS wonders why life assurance gains can leave pensioners feeling at a loss.

HANDS UP PLEASE all those who have experienced the following scenario. Mr Mann is coming in to see you, perhaps to sign his personal tax return or just to review his overall income tax liability for the last year and check that his pay-as-you-earn code number for this year is correct. He is 70 years old and you have known him since you acted for the little security business that he sold on retirement. He was a good client for many years, so now you keep an eye on his tax for a modest fee and everyone is happy. He potters about, funded by his state pension and a modest private pension, plus the income from the aforementioned capital, which was invested on his behalf by a local financial adviser. You usually you look forward to your annual chat; he will tell you all about his grandchildren and you will run through his liability. While you have a cup of tea and a biscuit, you will explain that it all stacks up and there is nothing outstanding as tax is paid via pay-as-you-earn or deduction at source.

But this year you are a little apprehensive, as you have to explain that he has a £300 liability, which has arisen due to a 'chargeable event'. First, you have to explain that, although the certificate he received mentions the term 'gain', it will not benefit from his unused capital gains tax annual exemption. Unfortunately, it is treated as taxed income which, when added to his other income, has led to the loss of his age allowance. That is when you hear those words that you have heard several times in the past; 'But my financial adviser told me that I would only have a liability if I had to pay tax at the higher rate'.

In the great scheme of things that pass across your desk every day, it is not a huge amount of money, but to Mr Mann and other pensioners on a limited (and perhaps declining) income, it is.

This has always struck me as unfair, but then I have looked at the top-slicing provision in section 550, Taxes Act 1988, seen the heading - 'Relief where gain charged at a higher rate' - and reminded myself that there is nothing necessarily fair about tax, before moving on to the next client. However, this subject has recently kept cropping up in my mind more and more often (perhaps I am thinking of my own retirement) and I have been re-reading section 550.

The Committee connection

Interestingly, for those of you who are still with me (presumably the high street 'general practitioners' whose clientele does not exist solely of millionaires, offshore trusts and public limited companies), this unfairness recently made an appearance in Standing Committee F's review of the Finance Bill 2002. In brief, clause 86 corrects a couple of anomalies relating to the taxation of gains on life assurance policies.

• First, if all the rights under a life assurance policy, a contract for a life annuity or a capital redemption policy are assigned for consideration, the calculation of that gain will in future exclude the value of any previous assignment by way of gift of a share of the rights under the policy or contract which was not itself taxable.
• Secondly, it retrospectively corrects a defect in Schedule 28 to the Finance Act 2001, whereby some of the conditions limiting when a gain was treated as arising in connection with a qualifying life insurance policy were accidentally disapplied.

In themselves, these provisions are well and good; so good, in fact, that the Committee spent no time discussing them. Instead, the discussion on clause 86 started with Mr Flight (the Opposition Treasury Spokesman) proposing an amendment that would insert a new sentence into section 539, Taxes Act 1988. This was that 'any gain falling to be treated as taxable income by virtue of this Chapter (life policies, life annuities and capital redemption policies) shall be disregarded from total income in applying section 257(5), Taxes Act 1988 (reduction in personal allowances for elderly taxpayers by reference to total income)'.

Mr Flight, with the support of Liberal Democrat Mr Davey, explained that his amendment would keep the higher-rate tax charge on life assurance gains, but these would be ignored in calculating the age-related personal allowances. Mr Davey confirmed that he had written to the Paymaster General on two occasions urging this approach and both Members of Parliament agreed that pensioners who have fairly modest incomes are penalised when a gain results in a loss of allowances. 'The amendment would tackle a genuine unfairness so that pensioner savers would not suffer the tax hit'.

Needless to say, the amendment was defeated, although the feeling was sufficiently strong for it to be taken to a vote.

Section 550, Taxes Act 1988

I will return to the Committee debate, but the proposal did spur me to pluck up the courage and risk ridicule by asking: do the 'top-slicing' provisions of section 550 only apply to higher rate liabilities? Although the title mentions it, I can find no mention of higher rate tax in the section itself. If section 550 were to apply, it would give a measure of relief similar to Mr Davey's proposal, but via a different route. Humour me for the moment, but can we work through the section - the legislation itself is in italics.

Section 550(1). The following provisions of this section shall have effect for the purposes of giving relief, on a claim in that behalf being made by him to the Board, in respect of any increase in an individual's liability to tax which is attributable to one or more amounts being included in his total income for a year of assessment by virtue of section 547(1)(a).

Section 547(1)(a) basically states that if, immediately before the chargeable event, the rights were vested in an individual, the amount of the gain forms part of the total income for the year. This seems straightforward: Mr Mann had a chargeable event, it was included in his total income and that resulted in an increase in his liability.

Section 550(2). Where one amount only is so included (which is the case here), there shall be computed:

(a) the tax which would be chargeable in respect of the amount if relief under this section were not available and it constituted the highest part of the claimant's total income for the year; and

Pausing here, we can have a closer look at Mr Mann (his tax affairs that is). The first two columns of Example 1 show the tax that would be chargeable with and without the chargeable event, i.e. treating the gain as the highest part of his total income. On my suggested calculation, the tax that is chargeable 'in respect of the amount' is £320.10.

Example 1. Mr Mann tax liability calculations 2001-02

(b) the tax (if any) which would be chargeable in respect of the amount if calculated, in accordance with subsection (3) below, by reference to its appropriate fraction;

Pausing again, the gain has accrued over five years. Mr Mann told his adviser that he was 'a simple man with simple tastes' and the income from his pensions paid for his ongoing expenses, food, heat, light, council tax, etc. and the interest paid for the occasional holiday break, etc. His adviser pointed out that, over time, his pension income would devalue (people are living longer) and it would be a good idea if he could invest some of his savings for capital growth, hence the capital investment bond which fortunately matured just before the stock market slump and produced the gain of £5,000. The 'appropriate fraction' is £1,000 (£5,000/5 years) and I calculate that the tax chargeable is nil.

and the relief shall consist of a reduction or repayment of tax equal to the difference between the two amounts of tax so computed, or, if tax would not be chargeable on a calculation by reference to the appropriate fraction, of a reduction or repayment of the tax equal to the tax computed under paragraph (a) above.

The two amounts are £320.10 and nil. In my way of looking at this, 'tax would not be chargeable on a calculation by reference to the appropriate fraction' as above, so the relief consists of £320.10.

Is there anything else in this section that prevents a claim being made?

Section 550(3). In subsection (2) above 'appropriate fraction' means, in relation to any amount, such a sum as bears thereto the same proportion as that borne by one to the number of complete years for which the policy or contract has run before the happening of the chargeable event; and the computation required by paragraph (b) of that subsection shall be made by applying to the amount in question such rate or rates of income tax, other than the basic rate or the starting rate, as would apply if it were reduced to that fraction and, as so reduced, still constituted the highest part of the claimant's total income for the year.

The first phrase does not appear to cause any problems; we calculate the appropriate fraction as above. The second phrase looks a little more worrying, especially 'by applying to the amount in question such rate or rates of income tax, other than the basic rate or the starting rate'. It has been suggested that my calculation is not correct because 'the tax chargeable' is not the net amount of £320.10 arrived at by a 'before and after' calculation, but is £1,100 (i.e. £5,000 at 22 per cent) and this will be the same as for the 'appropriate fraction' (i.e. £1,000 x 22 per cent x 5). However, the Revenue's Assessment Procedures Manual, at paragraph 3185, appears to calculate top slicing relief along the lines of my approach (as do other publications). But a careful reading of section 550(3) shows that calculating the tax on the appropriate fraction and multiplying this by the number of years, is not exactly what the section provides for. In defence of my position, I can only refer back to the (paraphrased) purpose of section 550 as set out in its very first sentence, 'the giving of relief in respect of any increase in liability attributable to one or more amounts being included by virtue of section 547(1)(a)'.

I think that we can safely leave a detailed examination of section 550 at this point. On my reading, none of the other subsections affect the basic principle under discussion.

The fundamental question seems to be whether the only tax that is 'in respect of the amount' in section 550(2)(a) is the basic rate tax charge, which would equate to the tax credit so there is no extra liability on the chargeable event and the loss of age allowance is an unfortunate side effect. I think this then comes down to what does 'in respect of the amount' actually mean? The Concise Oxford Dictionary defines the phrase as 'as concerns' or 'with reference to'. It seems to me that it is the addition of the gain that results in the additional liability, so I think that the effect of the loss of allowances should be brought into account. Again, I believe that this is supported by section 550(1) itself, which states that the provisions apply 'in respect of any increase in an individual's liability to tax which is attributable to one or more amounts being included in his total income'.

Back to the debate

The Opposition's proposed amendment would often have given more relief than my interpretation of section 550, but the underlying aim is the same, so what were the reasons for the defeat of the amendment?

A tax advantage

Ruth Kelly said that the amendment would give a unique tax privilege. Perhaps, but if we were to assume that my interpretation of section 550 was correct and equate this with the proposed amendment, would this be any more of a tax advantage than 'top-slicing' gives to higher-rate taxpayers, many of whom, I would suggest, might need the relief even less. She said that the amendment would privilege one section of the elderly; again, presumably in the same way that top-slicing privileges one section of higher-rate taxpayers.

Take regular income

Ms Kelly pointed out that with most of these products there is the option to take regular income and thus avoid a 'peak' leading to a loss of allowances. True, but is this not also true for some higher rate taxpayers, who could take regular amounts to avoid crossing the higher rate threshold?

Life assurance tax relief

Mr Rob Marris (Labour) made the observation that life assurance policies that were over 18 years old would have 'benefited' from tax relief on the premiums. He was roundly congratulated by Ruth Kelly, although I fail to quite see the point of this.

It's complicated!

Ruth Kelly asserts that applying top-slicing relief to age-related allowances 'would be incredibly complicated … one would have to average the gain over the period of the policy and work out the impact of any age-related allowances in previous years'. Again, top-slicing for higher-rate purposes does not require calculations for previous years and I see no reason why the same principle should not apply here.

The final cut

This approach of having one rule for higher-rate, presumably mainly employed, taxpayers (although no doubt those living on investment income will also benefit) and another for the (mainly) retired, reminds me of the Government's apparent view regarding taper relief for shares in businesses owned by retired employees. Basically, these people are no longer productive, so there is no need for them to have a tax advantage.

Mr Flight remained unconvinced (as do I) by these arguments. Noting that the loss of age allowances came as a surprise to most, he observed that such taxpayers 'believe they are being unfairly screwed and, from their perspective, I can understand that'. Ruth Kelly mentioned that Mr Davey's proposal would cost £5 million, although coming two days after the Government had announced that it was to spend £4.8 million on helping employees 'to reach a better work-life balance', perhaps the money had already been spent. Alternatively, this would only seem to underline the contention that the cost was 'not considerable'.

Mr Marris attempted a final 'coup de grace' with the suggestion that in such cases 'those people who took financial advice appear to have been mis-advised, and they should seek redress elsewhere'. The bitter irony here is that the Inland Revenue also appears to be doing some of the mis-advising. For anyone who is examining the Finance Bill, I can generally recommend the accompanying Explanatory Notes, which provide summary, details and background to each clause and Schedule. Unfortunately, the background notes in respect of clause 86 contain the phrase (and let us hope that this does not comprise 'financial advice', otherwise taxpayers may start taking Mr Marris's suggestion to heart) that, 'There is no further tax charge when a policyholder is not liable to tax at the higher rate'.

If the Revenue can get it wrong, what hope is there for Mr Mann?

Issue: 3868 / Categories: