Insurance bonds produce no income to tax and, accordingly, are subject to special tax rules called the chargeable event regime. Otherwise no tax would be due on gains. Under this regime, tax is only payable when a gain is calculated on a chargeable event. In view of the fact investors could be disadvantaged by being taxed in a single year on gains that have accrued over a period of time, top-slicing relief delivers a spreading mechanism to reduce the effective rate of tax charged on the gain. A full surrender of a bond is one such chargeable event.
Mrs Silver fully surrendered a bond in May 2015, which she had owned for approximately 21-and-a-half years. During that time she took regular withdrawals, and the insurance company correctly added these onto the surrender value when calculating a gain of £110,721.93 for the chargeable gain certificate. This gave rise to a ‘slice’ of £5,272.43 (i.e. £110,721 ÷ 21).
In 2015, Mrs Silver’s other income amounted to £31,101 and Mr Silver, acting on behalf of his wife, did not include the bond gain in her tax return as they believed she had no tax liability on the gain. In due course, HM Revenue & Customs (HMRC) picked up on this and opened an enquiry on the basis they believed she owed tax on the gain. When HMRC subsequently closed the enquiry and amended her tax return, they calculated the tax due on the gain of £22,759.13.
In due course, Mrs Silver appealed to the First-tier Tax Tribunal. The grounds were:
- The annual withdrawals should not be added back when calculating the gain on surrender.
- She was entitled to a personal allowance in 2015.
- She was entitled to top-slicing relief.
The Tribunal sided with HMRC and found the annual withdrawals should indeed be added back in accordance with tax law, as they were capital sums paid under the contract before the surrender event. This reaffirms the concept known by many financial advisers that part-surrenders of up to 5% of accumulated premium are tax deferred, and not tax-free.
Again, the Tribunal agreed with HMRC that Mrs Silver was not entitled to a personal allowance in 2015.
The reason was that for those with adjusted net income (ANI) above £100,000, the personal allowance is reduced by half: £1 for every £2 over the £100,000 limit. If ANI is large enough, the personal allowance will be reduced to nil. In 2015, when the standard personal allowance was £11,000, an ANI of £122,000 and above wiped out the personal allowance.
In Mrs Silver’s case, her total was £141,822, as it comprised her bond gain plus her other income. This highlights the fact the full bond gain and not just the top-sliced gain is included.
As an aside, bond withdrawals within 5% limits are ignored. Incidentally, although not pertinent to this case, it should be noted that pension contributions are deductible in calculating ANI.
The key to this issue lies firstly in following the seven steps set out in tax law to calculate an individual’s income tax liability. HMRC considered steps four and five and calculated tax due on the bond gain of £22,759.13. Moving onto step six, any top-slicing relief can then be deducted.
The Silvers claimed top-slicing relief was due, but HMRC asserted Mrs Silver was not entitled to any top-slicing relief, as HMRC’s manual was quite clear it could not be used where the taxpayer was not entitled to a personal allowance.
With that in mind, what are the basic steps in a top-slicing relief calculation for Mrs Silver? In broad terms, three steps are required:
1. Calculate Mrs Silver’s individual liability: tax on the bond gain, which is treated as the highest part of income, then deduct basic-rate credit.
2. Calculate Mrs Silver’s relieved liability: tax on the slice (again treated as the highest part of income), then deduct basic-rate credit on the slice. Multiply the result by 21, which is the number of years.
3. Top-slicing relief is then the individual liability less the relieved liability.
The parties agreed the individual’s liability was £22,007.
The relieved liability was, however, disputed. The Silvers argued taking this calculation in isolation, it comprised other income of £31,101 and a bond slice of £5,272 = £36,373. This fell well below the personal allowance threshold of £100,000, meaning in this particular calculation, Mrs Silver was entitled to a personal allowance.
As a consequence, Mrs Silver’s liability on the slice (i.e. her relieved liability) was £0, giving a rise to top-slicing relief of £22,007. The figure of £0 derived from the fact total income of £36,373 less personal allowance of £11,000 fell below the basic-rate limit. This means the slice was only taxable at 20%, and, as she is given a basic-rate credit, the hypothetical liability is £0.
In contrast, HMRC computed the relieved liability assuming a personal allowance of £0.
The tribunal decision
Broadly, the top slice was a hypothetical calculation of what the liability would have been had the gain been added each year. As such, the hypothesis should follow that a personal allowance would have been available each year. HMRC was not allowed to use the actual situation of not having a personal allowance available in the hypothetical calculation.
The Tribunal stated: ‘We prefer Mr Silver’s interpretation of the legislation. Consistently applying the assumption that Mrs Silver’s income was only £36,373.43 meant she was (in this hypothetical scenario) entitled to a personal allowance in this calculation.’
This is an important decision concerning top-slicing and the taxation of insurance bonds. On two counts, the tribunal confirmed matters well known by many financial advisers:
- Part-surrender withdrawals need to be added back when calculating a gain on a full surrender.
- Full amount of bond gains are included within ANI with regard to the £100,000 personal allowance threshold.
With regard to the third count, the decision that the top-slicing relieved liability calculation should include a full personal allowance if the hypothetical income does not exceed £100,000 will be welcome to many clients. The tribunal decision is logically explained in this extract, which refers to top-slicing relief:
‘The relief was intended to make the tax liability approximate to what it would have been had the income been taxed in the year it was actually received. So when carrying out the hypothetical tax calculation, it made every kind of sense the taxpayer should be treated as entitled to the reliefs the hypothetical income would have entitled her to.’
Although not covered in the decision, this ruling presumably points to the fact that in the ‘relieved liability’ calculation, the starting rate for savings and the personal savings allowance should also be set by virtue of the slice, rather than the full bond gain. HMRC has the right to apply for permission to appeal.
In the meantime, calculators to the ready for future (and previous) calculations where bond gains cause the £100,000 threshold to be breached. For some, might refunds of tax be due?
Graeme Robb is technical manager at Prudential.