Some less frequent aspects of the taxation of chargeable event gains

As will be widely known chargeable event gains arising on life assurance policies, capital redemption policies and purchased life annuities are subject to income tax under the chargeable events regime.

In this article we consider certain less common aspects of the chargeable event rules as they apply to life assurance policies. For this purpose life assurance policies can be split into three categories - exempt policies, qualifying policies and non-qualifying policies.

Any gain arising on anexemptpolicy is exempt from income tax. Exempt policies include certain policies taken to cover a repayment mortgage, excepted group life policies and life policies issued in connection with a registered pension scheme.

In most cases, any gain arising under aqualifyingpolicy will normally arise free of income tax in the hands of the policyholder.  A policy is a qualifying policy if it satisfies the qualifying rules set down in the Income and Corporation Taxes Act 1988. 

A policy which is neither an exempt policy nor qualifying policy is anon-qualifyingpolicy.  The main disadvantage of such a policy is that on the happening of a chargeable event any gain that arises may be liable to an income tax charge on the policyholder.

The prime examples of non-qualifying policies are those issued from outside the UK (non-UK policies) and single premium policies - the prime example of these being investment bonds - which we call "Bonds" in this article - which are issued by UK or non-UK companies.

For the sake of convenience we use the expressions "UK Bond" and "non-UK Bond" in this article because these are the types of policy under which gains most often arise, but what follows applies equally to non-qualifying polices which are not Bonds.

Multiple chargeable event gains

In this section we consider the top-slicing relief situation when chargeable event gains arise on more than one Bond in the same tax year.

A client has two Bonds which he has fully encashed in tax year 2015/16.  Both are UK Bonds although the principles explained in this section apply equally to non-UK bonds.  Bond A had been in force for 10 complete years and produced a chargeable event gain of £24,000.  Bond B, which had been in force for 4 complete years, gave rise to a gain of £3,600.  The client's estimated taxable income (after deductions and allowances) for 2015/16 is £30,285 and he wishes to know what his prospective liability to income tax would be on the chargeable event gains.  This means that after addition of the unreduced chargeable event gains totalling £27,600 the client would be a higher rate taxpayer (with £57,885 taxable income) so will benefit from top-slicing relief.

When a chargeable event gain arises under one non-qualifying policy, such as a Bond, the fractional gain, calculated by dividing the chargeable event gain by the number of complete years the Bond has been in force, is treated as the most highly taxed part of income for that tax year. This gives effect to top-slicing relief.  Higher rate tax, less an amount equal to the basic rate of tax (i.e. 40%-20% in tax year 2015/16), on the fractional chargeable event gain is then calculated and multiplied by the number of complete years the policy has been in force to determine the amount of tax due on the whole chargeable event gain.

Where chargeable event gains arise in the same tax year on two or more Bonds, the fractional gain for each Bond is calculated.  The total amount of the fractional gains is then added to taxable income and tax at 20% (ie. 40% higher rate less 20% basic rate) is calculated on the excess of the total fractional gains over the basic rate limit. 

In the example above, the fractional gain under Bond A is £2,400 (£24,000 ÷ 10) and under Bond B £900 (£3,600 ÷ 4).  Total fractional gains are therefore £3,300.

Adding £3,300 to taxable income of £30,285 gives an amount of £33,585 on which tax is £360 [that is £33,585 less the basic rate limit of £31,785 x 20%].  The average rate of tax on the fractional gains is therefore 10.91% (360 ÷ 3,300).    
The average rate of tax (i.e. 10.91%) is then applied to the fractional gain under each Bond and each answer is multiplied by the number of complete years for which that Bond has been in force to give the amount of tax due on the whole gain for that Bond.

Thus for Bond A, tax payable on the chargeable event gain would be £2,400 x 10.91% x 10 = £2,618.40. For Bond B, tax would be £900 x 10.91% x 4 = £392.76. Therefore, total tax payable would be £3,011.16.

The same calculation is undertaken for non-UK Bonds but the figure for the number of complete years in the calculation is reduced, broadly, by the number of complete years, if any, during which the policyholder was not resident in the UK during the currency of the Bond.  In addition, of course, 20% basic rate tax would also be due on the whole chargeable event gain.

Non-uk bonds denominated in a foreign currency

When a UK resident investor takes out a non-UK Bond it may be denominated in sterling or in a foreign currency. For the purposes of calculating a chargeable event gain where the non-UK Bond is denominated in sterling throughout, the position is straightforward, ie. the chargeable event gain calculation is carried out in the usual way and the investor will be subject toUKincome tax in accordance with their own tax position.

Where the non-UK Bond is denominated in another currency, HMRC gives guidance in its Insurance Policyholder Taxation Manual (IPTM3700). In these circumstances, for the purposes of the chargeable event gain calculation, the gain should be computed in the foreign currency and then converted to sterling at the exchange rate applicable at the date of the chargeable event.  But what happens if a non-UK Bond is taken out in, say, sterling but changes to a foreign denominated currency before encashment?

In this case, the position is less straightforward as there appears to be no set practice in terms of how the currency conversion should be applied when calculating a chargeable event gain.  However, we understand that HMRC takes the view that each element should be converted to sterling using the exchange rate at the time of the chargeable event and the gain calculated accordingly. This means that if at the time the non-UK Bond is encashed it is denominated in a foreign currency, the investor must convert the surrender value into sterling prior to calculating the chargeable event gain. By adopting this approach, a sterling acquisition cost is compared with sterling disposal proceeds to produce a sterling gain (or loss).

Presumably, if a non-UK Bond is taken in a foreign currency and subsequently denominated in sterling, the acquisition cost would be converted to sterling using the exchange rate at the time of the chargeable event.

If a UK Bond is denominated in a foreign currency then the above rules would equally apply.

Trusts with more than one creator

In this section we look at the assessment to tax on a chargeable event gain in the situation where a trust has more than one creator. For these purposes, anybody who contributes property to a trust is a trust creator.

Say individual X establishes a trust. Then individual Y effects a Bond and assigns it to the trust established by individual X. Sometime later a part surrender is taken from the Bond which gives rise to a chargeable event gain. Both X and Y are alive and UK resident at the time the chargeable event gain arises so any chargeable event gains would be taxed on the trust creators. In this situation, how is the chargeable event gain assessed to tax?

In the case under consideration, there is a trust with multiple creators - X and Y.  Any chargeable event gains will be split between them in the proportions in which the trust property derived from X's contribution and Y's contribution.  If, for example, X set the trust up with £10,000 and the same day Y assigns a Bond worth £40,000 to the trust, subsequent chargeable event gains will be apportioned 20% to X and 80% to Y.  If X dies and a couple of years later a chargeable event occurs then 20% of the gain will be assessed on the trustees in respect of X's contribution and 80% on Y.  In other words, the trust has to be treated in effect as two trusts with two different creators but with any chargeable event gains apportioned between both trusts.

Where the additional payment (£40,000 in the above example) is made after the trust is created, the basis of apportionment will be established at the time the additional payment is made.  In the above example, say the £40,000 Bond is assigned into the trust 5 years later, when the trust had grown to £20,000 in value, the apportionment would be ⅓: ⅔ (ie. £40,000: £20,000).

Bond encashment on the death of a sole owner

We recently had a query which involved a sole owner (policyholder) under a last survivor non-UK Bond who died testate in December 2015 leaving two surviving lives assured.  Her husband is an executor of her estate.  We were asked to outline the income tax implications where:-

(i)         The executors encash the Bond. 

(ii)        The executors assign the Bond to the deceased's husband. 

(iii)       The executors assign the Bond equally to three adult children. 

Before considering (i) to (iii) the general point has to be made that the executors have a duty to administer the Bond for the beneficiary(ies) entitled under the terms of the Will.  Therefore, it will only be possible to take the action under (ii) or (iii) if the husband or three adult children, as the case may be, are entitled under the Will. 

If they are not so entitled then they could become entitled

• under a deed of variation; or 
• if the estate has been left subject to a Discretionary Will Trust they are named amongst the beneficiaries and the trustees (ie usually the executors) make an absolute appointment of benefits to them and assign the Bond to them as appropriate.  

We now consider the proposed actions (i) to (iii) in turn. 

(i)      Encashment by the executors. 

The position envisaged here is that the executors encash the Bond with a view to paying the surrender proceeds to the beneficiary(ies) entitled to the Bond (or the proceeds of the Bond) under the deceased policyholder's Will rather than simply encashing the Bond to satisfy certain cash legacies. 

If at the time of surrender of the Bond the administration of the estate has not yet been completed (which was the position in the case in question as confirmed to us by the solicitors dealing with the estate), the executors hold the rights in the Bond.

On encashment of a non-UK Bond by the personal representatives the chargeable event gain would be subject to a 20% income tax charge on the personal representatives. This is because under section 466(2) ITTOIA 2005, in cases where section 531(3)(b) ITTOIA 2005 applies (ie. the Bond is a non-UK Bond), the gain is treated as income of the personal representatives and is therefore taxed at the basic rate only.  

On distribution of the proceeds to the beneficiary, the chargeable event gain would be treated as estate income in the hands of the beneficiary.  The trustees must therefore provide the beneficiary with form R185 (Estate Income) which identifies the source of the income received.  The gain is treated as estate income of the beneficiary even though proceeds from the Bond are capital. This is because the income of personal representatives forms part of the aggregate income of the estate - section 664(2)(e) ITTOIA 2005.

This means the chargeable event gain will be taxed at 40% if the beneficiary is a higher rate taxpayer or 45% if the beneficiary is an additional rate taxpayer. HMRC will allow the beneficiary a 20% tax credit for the tax suffered by the personal representatives.  As the gain is treated as estate income, top-slicing relief would not be available - compare this with the position in (ii) and (iii) below. 

The tax position for a UK Bond would be the same as above except that the personal representatives would have no basic rate income tax liability and the beneficiaries would therefore have no 20% tax credit.

(ii) and (iii) Assignment by the executors

As an alternative, under (ii) the executors could vest legal title in the husband.  This would not give rise to a chargeable event as no consideration is involved.  The husband could then encash his Bond in his personal capacity with the benefit of top-slicing relief if appropriate. However, if the husband were a higher rate/additional rate taxpayer on vesting then he could instead consider deferring encashment if his tax rate is likely to reduce in the future ie he becomes a basic rate or non-taxpayer.

In connection with the position in (iii), it might be difficult to assign a Bond equally between beneficiaries unless it is segmented.  The problem of the Bond not being segmented (ie. it is not issued as a number of identical smaller policies) could possibly be overcome by assigning the Bond into a bare trust for the equal benefit of those beneficiaries although this slightly complicates matters.