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I have recently acquired a client who was widowed a few years ago. She has inherited some good pensions from her late husband so she appears likely to be a higher-rate income taxpayer for the rest of her life.
She also owns some single premium life policies from which it appears she has been withdrawing 5% each year. She is now considering cashing them in, and I would like to confirm the tax treatment when she does.
I believe that the 5% withdrawals to date must be included in calculating the amount chargeable to higher rate tax on surrender, but I cannot find that stated explicitly anywhere.
It’s one of those things that has always seemed correct, but now her son has questioned it I can’t point to the rule. I haven’t dreamed it, have I?
And how do I find out what the cumulative withdrawals are – will the insurance company routinely provide details of ‘what’s happened with the policy so far’? Also, if she decides not to cash them in for the moment, what happens to these policies when she dies?
Is there an income tax charge in the year of death based on the normal calculation for a surrender, or do the proceeds on death count as a purely capital matter which would be subject to inheritance tax?
Any advice would be very welcome.
Query 17,587 – Cakeman
Reply from Cello Boy
The gain is treated as being the ‘top slice’ of any income, after dividends, with notional (i.e. non-repayable) basic rate tax deducted. We may then need to prepare a top-slicing relief calculation if the gain puts the client into the higher-rate tax bracket for the year.
Because the gain has accrued over a number of years it is inequitable for higher rate tax to be applied by reference to dumping all of the gain into one year’s assessment, and top-slicing relief can reduce or negate that charge.
I am assuming that it is a ‘non-qualifying policy’ and does give rise to a gain, but a read through of HMRC’s Help Sheet IR320 may assist in confirming the type of policy Cakeman may be looking at.
The chargeable event regime is under ITTOIA 2005, Ch 9 (s 461 to s 546), and HMRC’s Insurance Policyholder Taxation Manual deals with it from IPTM3000.
Each year, 5% or less of the initial value can be taken out without incurring a gain (see ITTOIA 2005, s 507(5)), with unused amounts carried forward.
But eventually either policy maturity or death for Cakeman’s client would potentially give rise to a chargeable event (ITTOIA 2005, s 484) and the gain will be charged to income tax on the beneficial owner (and I assume that the policy is not written in trust).
Cakeman has not been dreaming. Help Sheet IR320 explains that the final gain on the policy is calculated as being the final value of the plan, plus ‘all benefits (money or anything of value) received at any time previously’, less premiums paid and any amounts previously assessed as gains.
See also ITTOIA 2005, s 491 to s 492, where s 491(2) explains that a gain arises where the total benefit value of the policy exceeds the sum of allowable deductions (i.e. the premiums) and total gains on previous events.
Section 492(1)(a) and s 492(1)(b) explains that the meaning of the ‘total benefit value’ of the policy is its current value (per ITTOIA 2005, s 493) and previous capital sums received. IPTM3500 is also a useful reference. Note that policyholders may refer to their ‘five per cents’ as income, but it is strictly capital.
In the current investment environment, be prepared that there could actually be an overall loss. No relief is given for such a deficiency unless there has been a previous chargeable gain on that policy (see RI 277 for a clear explanation). Note that on death there is still a capital sum in the estate subject to inheritance tax.
I am not aware of whether our clients always receive some form of statement when they receive a payment – I only see the chargeable event ‘please show this to your adviser’ certificate – but a policyholder should be able to obtain a history and current value for their policy from any provider worth their salt.
Reply from Hodgy
The calculation is set out in ITTOIA 2005, s 491(2), where there is a chargeable event gain if the total benefit value of the policy is more than the total allowable deductions for the policy as increased by any amounts calculated as event gains on previous events in relation to the same policy. The total benefit value is defined in ITTOIA 2005, s 493.
Six elements can make up the total benefit value of a policy and ITTOIA 2005, s 492(b) reads ‘any capital sum paid under the policy or contract before the event’. This is the legislation under which the past withdrawals from the policy are taken into account in calculating the chargeable event gain.
In terms of finding out about past withdrawals, insurance companies do supply this information. If Cakeman does not have a signed authority from the client, the life insurance company will probably want to send the information direct to the client.
If the client does hold the policies until she dies, then assuming they are not qualifying policies, the position is that there is deemed to be an event giving rise to a chargeable event gain on her death. This can give rise to an income tax charge, which arises in the final period from 6 April to the date of death.
If the death occurs late in the tax year, the pension already received could be more than the client’s basic rate band for that year and so higher rate tax will be payable on the chargeable event gain.
However, if the client dies earlier in the tax year, her pension income to that date plus the chargeable event gains, especially after top-slicing relief, may be fully covered by the basic rate band and so there would be no income tax to pay on the life policies.
The value of the life policies will be included in the client’s estate if she still holds them on death. Any income tax payable on the life policy on the occasion of the client’s death will be a liability to be deducted in calculating the amount of the estate for inheritance tax.
Reply from Magnus
Current legislation in connection with life assurance products, surrenders and top-slicing is found in ITTOIA, 2005, s 491 to 494 and s 535 to 537.
It appears that, from the information given by Cakeman, that the lady client will receive the benefit of ‘top slicing relief’ if she surrenders some or all of her single premium life policies.
The 5% withdrawals already made will have attracted no tax at the time, being ‘allowable aggregate amounts’, but must be taken into account in the surrender calculation.
The amount chargeable to tax will be the proceeds of surrender, plus previous withdrawals, less the original premiums paid. It should be recognised that top slicing relief is given in terms of tax.
The amount chargeable to tax is added to the other income for the year (less allowances). The rate of higher rate tax applicable to this amount can then be established, after the deduction of basic rate tax.
The ‘annual equivalent’ of the gain is the chargeable amount divided by the number of years the product was held.
The amount of this figure that falls within the higher rate band is then calculated in terms of tax at 20% and then multiplied again by the number of years that the product was held.
The amount of top slicing relief then becomes the higher-rate tax for the year inclusive of the chargeable amount less the tax on the ‘annual equivalent’ calculated according to the previous paragraph. This figure is deducted from the total tax for the year inclusive of the full chargeable amount.
The insurance companies involved will provide details of the withdrawals made up to the date of surrender. Death counts as a ‘chargeable event’ and the top-slicing calculation may be relevant in the tax year of death.
Reply from Goldstone
When single premium life policies are encashed in full the chargeable event gain (CEG) is calculated thus: cash value paid from the surrender, plus previous withdrawals, less total contributions, less previous excesses or gains.
Please note that the legislation dealing with ‘calculating gains: general’ may be found under ITTOIA 2005 s 491 to s 526.
The ‘calculation of gain’ is illustrated at s 491 as TB – (TD + PG), where TB is the total benefit value of the policy or contract (see s 492), TD is the total allowable deductions for the policy or contract (see s 494), and PG is the total amount of gains treated as arising on calculation events occurring in relation to the policy or contract before the chargeable event in question. The gain is equal to the excess.
I would add here that the terminology of the above policy may vary from person to person; it also is known as personal portfolio bond, the meaning of which is defined under ITTOIA 2005, s 516.
The basis for the 5% withdrawals figure can be found under ITTOIA 2005, s 507, and although that section deals with part surrenders, reference to this section is mentioned elsewhere in connection with final surrender calculations. (See ITTOIA 2005, s 524 –The total amount of part surrender gains.)
On death, the chargeable event gain is similarly calculated with the amount payable being taken as the encashment value of the policy immediately before death, and the income tax liability being calculated accordingly.
With the client already being a higher-rate taxpayer the benefits of any top slicing relief will not be relevant in connection with any encashments.
Insurance companies will all provide details of previous withdrawals on the chargeable event gain certificate (see TA 1988, s 552(1) – ‘Information: duty of insurers’, and also its supplement under TA 1988, s 552ZA), although obviously a letter of authority will be required for direct communication purposes.
