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Personal portfolio bonds

Reviewing the property categories

At the 2016 Budget it was announced that the government would review the categories of permitted investments which could be held in a policy of life insurance, life annuity or capital redemption policy without it becoming taxable as a personal portfolio bond (PPB).

HMRC has now launched a consultation which invites views on the current property categories and further property types which may be held within a PPB.  The title of the consultation document, published on 9 August, is the same as the title of this article.

Broadly, there are three types of investment vehicle which are being considered to be included within the permitted category list. These are:

  • real estate investment trusts (both UK and foreign equivalents);
  • overseas equivalents of UK approved investment trusts; and
  • UK authorised contractual schemes.

The government is keen to hear from interested parties, especially policyholders and their representatives, members and representatives of the life assurance and funds industries and life policy administrators for whom these changes may have a material impact.

The consultation closes on 3 October 2016 and draft legislation is expected in advance of Finance Bill 2017.

The aim of this article is to examine the nature of PPBs to serve as a refresher for some readers and provide a source of new information for other readers.

BACKGROUND

By way of background, Finance Act 1998 introduced a penal annual tax charge on PPBs issued by either a UK or non-UK resident life company.  Broadly, the tax charge is levied on a deemed chargeable event gain.  This is based on 15% of premiums paid plus all previous amounts brought into charge to tax under the PPB provisions - see example in section 4.

The PPB rules were introduced because taxable gains can only arise under non-qualifying policies, the majority of which take the form of single premium investment bonds, when cash is taken from the policy.

The ability to defer any tax charge until encashment encouraged exploitation of the legislation - for example, individuals would introduce shares in their own company into the life policy to defer personal tax on income and/or capital gains derived from those shares.

The definition of a PPB includes a life policy whose terms allow the policyholder (or, essentially, those acting for the policyholder) to select the property in which their premiums will be invested.  However, to narrow the scope of the rules, regardless of who has the power to select the property underlying the policy, investment is permitted into what are called "pooled investments" - see section 3 below.  A feature of these pooled investments is that the funds are managed by professional managers who make the decisions as to where the funds are ultimately invested.  In other words the investor has no control over the underlying investments.

THE DEFINITION OF A PPB

Section 516 ITTOIA defines a personal portfolio bond as a policy of life insurance, contract for a life annuity or capital redemption policy (in practice most PPBs will be single premium investment bonds) that meets two conditions, AandB.  These conditions are examined below.

Condition A

Condition A will apply when the investments, by reference to which the benefits under the policy are calculated, are outside the following types of investment:

  • property in an internal linked fund of the insurer.  It is important to note that, depending on circumstances, an EEA insurer may be subject to the Interim Prudential Sourcebook for Insurers made by the Financial Services Authority which prescribes what type of assets may be used to determine the value of benefits payable under a unit-linked life assurance policy.  This would therefore have the effect of restricting the investment links of the fund.
  • units in an authorised unit trust or shares in an approved investment trust or shares in an open-ended investment company as defined in section 236 Financial Services and Markets Act 2000.
  • certain general published indices of prices or of shares quoted on a recognised stock exchange.  These consist of the following:

    the retail prices index

    any similar general index of prices

    any published index of prices of shares quoted in the official list of a recognised stock exchange

  • units or shares in overseas collective investment funds. The precise wording of this section is:

    "an interest in a collective investment scheme constituted by:-

    (i) a company which is resident outside theUnited Kingdom(other than an open-ended investment company);

    (ii) a unit trust scheme the trustees of which are non-UK resident; or

    (iii) any other arrangement which takes effect by virtue of the law of a territory outside the United Kingdom, and which under that law creates rights in the nature of co-ownership (without restricting that term to its legal meaning in any part of the United Kingdom)".

  • cash, including cash in a bank or building society account (except cash held for speculation)
  • insurance policies that are not themselves personal portfolio bonds.

All of these investments (which are generally referred to as "pooled assets" or "pooled investments") are also subject to the conditions in sections 519 (for indexed funds) and 521 (for other funds) of the Income Tax (Trading and Other Income) Act 2005 or ITTOIA 2005 that the insurer makes the investments generally available to all other, or to all of a class of, policyholders.  Subject to these conditions, of which there are three and which are described below, a class of policyholders means a number of policyholders to whom the opportunity is given to select the property.  One person cannot constitute a "class". 

Section 519(4) or section 521(4), as appropriate, provide that the insurance company can satisfy the "available to a class" rules by, in effect, satisfying the three conditions in section 519(4). 

The three conditions to be satisfied for a number of policyholders to represent a "class" are as follows:-

  1. The opportunity to select the property or index is clearly identified in marketing or other promotional literature that the insurer has published.  The marketing material must have made the opportunity available to potential policyholders at large.
  2. The insurer does not limit the opportunity solely to persons who are connected with each other.  The meaning of "connected" is defined in sections 827 and 993-995 Income Tax Act 2007.  It is not necessary for two or more unconnected policyholders to select a particular property so long as the class of policyholder to whom the insurer makes available the opportunity does not consist solely of a group of connected policyholders.
  3. The insurer alone determines the composition of the class.

As far as sections 519(4) and 521(4) are concerned, the wide menu of investments that insurers can and do offer could mean that there could be one policyholder of a policy issued by a particular insurer who selects a particular property to determine the benefits under that policy.  The test laid down is the extent to which the ability to select particular property is available to potential policyholders of that insurer not the number of policyholders who make the selection.  In theory, therefore, there might only be one policyholder investing in one fund and this may be permissible provided the investment fund is generally and genuinely available to all policyholders.

Condition B

In addition to satisfying condition A then, under Condition B, for the PPB tax charge to apply the policyholder, or a person acting on behalf of the policyholder, must,under the terms of the policy, be able to select the property.  This aspect concerns the policyholder's control over the investment fund - section 516 (4) of ITTOIA 2005.

For these purposes, a policyholder will be treated as having the "ability to select" if, under the terms of the policy, the property which determines the policy benefits may be selected by any of the following:

  • the policyholder;
  • a person acting on behalf of the policyholder;
  • a person connected with the policyholder;
  • a person acting on behalf of a person connected with the policyholder;
  • the policyholder and a person connected with the policyholder;
  • a person acting on behalf of both the policyholder and a person connected with the policyholder. 

Where a policyholder is unable to select, within the extended meaning set out above, property that determines the policy benefits, the policy is not a PPB. This is the case even if the property that determines the policy benefits does not comprise of the "permitted investments" allowed in sections 518 (the index categories) and 520 (the property categories) of ITTOIA 2005.

Basically, what matters is whether, under the terms of the policy, the policyholder has or does not have the ability to select the property held in the policy.  For this purpose the ability to select is interpreted widely.  Therefore if a person other than the policyholder (or somebody within the meaning of policyholder above) had the ability to select the property - even if that property was not a permitted investment - the policy will not be a PPB.  However, HMRC has stated that this interpretation may be tested if personal assets are held within the PPB and by this it is thought it means highly personalised assets e.g. shares in a family company, fine wines, vintage cars, paintings and racehorses.

THE CALCULATION OF THE TAX CHARGE

The tax charge did not apply until the first policy year endingafter5 April 2000 and taxable amounts are treated as arising at the end of the policy year (before other charges arising at the end of the policy year).

Where the tax charge does apply it takes effect under the chargeable event legislation.  The following points are relevant in this connection:

  • The taxable amount is 15% of an aggregate amount equal to the premium(s) paid to the policy plus the aggregate of all the previous taxable amounts arising under the PPB provisions.
  • This annual charge only arises during the currency of a policy and not when it comes to an end.
  • A deduction is allowed for taxable amounts withdrawn from a policy, i.e. withdrawals in excess of the 5% allowances, from inception to the end of the policy year immediately preceding the current policy year.
  • The deemed gain is treated as arising before any other gain.  This means that the deemed gain for a policy year will be calculated before the gain on a part surrender chargeable event occurring in the same policy year.
  • Taxable amounts are assessed to tax in the same way as other chargeable event gains butno top-slicing reliefis available in respect of the charge.
  • The total amount treated as a notional gain under the provisions is allowed as a deduction from any other chargeable event gain arising on death, maturity, surrender or assignment of the policy for consideration in money or money's worth.  If a deficiency (i.e. a final loss) arises relief can be given against the individual's other total income on the usual basis.

Example of tax calculation

The following is an illustration of how the tax charge could work.

Assume that an investment of £50,000 is made in a non-UK bond the underlying terms and investments of which have made it subject to the PPB annual charge.

The legislation provides that amounts are treated as gains for each policy year ending after 5 April 2000. Such deemed gains are treated as arising at the end of each policy year before any other tax charges arising at the end of the policy year in question e.g. gains arising in respect of an actual part surrender.

The first charge arises on the final day of the first policy year.  For a policy which commenced on 1 July 2015, for example, the first gain, assuming that the policy is a PPB, would have arisen on 30 June 2016, in the year of assessment 2016/2017.  

Under section 522 of ITTOIA 2005 a deemed gain arises when the sum of PP and TPE exceeds TSG where:  

PP = the amount of the premium paid in respect of the PPB

TPE = the cumulative total of past deemed gains under these provisions

TSG = any excess over the cumulative total of 5% allowances in respect of any withdrawal taken during the immediately preceding policy year and treated as arising at the end of that policy year and any such excesses that had occurred in policy years prior to that.

The deemed gain is 15% of the excess.

On the assumption that no withdrawals had been taken under the bond the following would be the position in years one to four for a UK resident higher rate taxpayer where the higher rate of tax remains at 40%. 

Year 1:

15 x (£50,000)[PP]/100 therefore gain = £7,500

Tax = £3,000

Note: As this is year 1 there has been no previous past "deemed gains" so there is no "TPE" and there have been no withdrawals and so there is no "TSG".

Year 2:

15 x (£50,000 [PP] + £7,500 [TPE]) / 100 therefore gain = £8,625 

Tax = £3,450

Note: TPE is the year 1 deemed gain.  There have been no withdrawals so there is no "TSG"

Year 3:

15 x (£50,000 [PP] + £16,125[TPE]) / 100 therefore gain = £9,919 

Tax = £3,968

Note: TPE is the cumulative total of deemed gains for years 1 & 2. There have been no withdrawals so there is no "TSG".

Year 4:

15 x (£50,000 [PP] + £26,044 [TPE]) /100 therefore gain = £11,407 

Tax = £4,562

Note: TPE is the cumulative total of deemed gains for years 1, 2 & 3. There have been no withdrawals so there is no "TSG".

As can be seen, regardless of actual growth in the bond, there is an increasing gain and tax liability.

If the bond is encashed at the end of year 4 and, based on growth of 7% per annum (on the original £50,000) after all charges it is worth £65,540, the final gain calculation would take account of past annual amounts brought into charge to tax and would be as follows:-

Value of bond on encashment

£ 65,540

Less original single premium

(£50,000)

Less total annual gains under section 523

(£37,451)

 

______

Deficiency/loss

(£21,911)

Such a deficiency/loss can provide relief for higher rate tax purposes.  However, in this example, though, deficiency/loss relief would not be available as there have been no previous chargeable event gains on part surrenders or part assignments by way of sale under the same policy.

In conclusion, the investor has made a gain of £15,540 but paid tax of £14,980 (40% on deemed gains of £37,451).  Also, this takes no account of the adverse cash flow involved in making regular annual tax payments.

CONCLUSION

The possibility of increasing the scope of the investments available to a life fund underlying a single premium investment is to be welcomed.  In stating this care will still need to be exercised to ensure that a policy is not classified as PPB to prevent an annual tax charge applying.