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Arnold Aaron provides an introduction to the taxation of a popular form of investment known as the Investment Bond. 

Background

Chargeable event certificates, partial surrenders, top slicing relief, 5% allowances… the list goes on. The Investment Bond available through Life Companies has existed since the early 1970s if not earlier.  Because they have their own unique tax rules, policyholders and on occasion tax practitioners are sometimes in a muddle over the tax treatment. This article is intended to shed some light on how it all works.

The Investment Bond is basically an investment vehicle offered by life assurance companies, and although an investment, it does not fall under the Capital Gains Tax (CGT) regime because technically it is classed as a life policy. Firstly we’ll look briefly at the conditions which trigger a chargeable event which could result in a gain and therefore a potential tax liability.

A Chargeable Event is triggered on:

• Death of the owner of the investment bond
• Assignment of the bond for money or money's worth
• Maturity or full surrender of the investment bond
• Partial Surrender in excess of the 5% allowances (see below)

5% withdrawals rules

One is permitted to withdraw 5% of what was invested, each year the policy is in force without any immediate liability to tax, or having to declare anything on one's tax return. If withdrawals are not taken each year, the allowance is carried forward. Here’s an example.

An investment of £100,000 is made in Jan 2004. £5,000 can be withdrawn during each policy year with no tax to pay at the time.  If no withdrawals are made, then for example in Feb 2008 which is actually 5 policy years (when lookin to see if there's an excess, part-years count as a whole year), 25% or £25,000 in this case can be withdrawn (5% x 5years), again with no immediate liability to tax.  Let’s call this example 1.

Calculating the gain on an excess over the 5% allowances

At the end of each policy year, a comparison is made over the available 5% allowances against the amount actually withdrawn from the policy. If during the policy year one has withdrawn more than the 5% allowances then a Chargeable Event certificate for the ‘excess' is issued on the policy anniversary with the ‘Gain' being for the excess i.e., the amount withdrawn over the allowance.  Taking the example above, if in Feb 2008 £35,000 was withdrawn, a Chargeable Event Certificate would be issued in Jan 2009 (on the policy anniversary) showing a ‘gain' of £10,000 .  This gain will be classed as having occurred during the tax year 2008/09, and is taxed as described later on.  Let’s call this example 2.

Calculating the Gain on Full surrender

Now we understand what the tax treatment is on a withdrawal from an investment bond let’s have a look at the tax treatment of a full surrender.

Calculating the ‘Gain' on the policy for a full surrender is a simple formula:

GAIN = Current value + previous withdrawals - initial investment - previous excesses

Taking example 2 above, suppose the Investment Bond was worth £150,000 in March 2010 (after having made a withdrawal of £35,000 in Feb 2008 - yes, what spectacular investment growth!) the GAIN on full surrender of the £150,000 would be:

GAIN = £150,000 (current value) +  £35,000 (previous withdrawals) - £100,000k (initial investment) - £10,000 (previous excess) = £75,000.

For a full surrender, the Chargeable Event Certificate is issued as at the date of the full surrender, in this case March 2010 for a Gain of £75,000. This is then taken into account in the tax return for the tax year 2009/2010.

Now that we’ve seen how the Gains are calculated, the good news is that no tax advisor or policyholder should ever need to do these calculations themselves as these figures are given on the Chargeable Event certificate. In addition, before making the surrender, a simple telephone call to the Life Company with which the policy is held is all it takes and they should be able to tell you straight away what the Gain will be on making either a full or partial surrender.  After all, it is they who will be producing the chargeable event certificate.

Let’s now look at how the Gain is treated for tax purposes.

How Gains are taxed

For an onshore UK Investment Bond, if the policyholder is already a higher-rate taxpayer in the tax year the Gain occurs, he simply pays tax of 20% of the ‘Gain' with no further liability, the reason being that an investment bond is deemed to have paid basic rate tax at source.

For basic-rate and non-taxpayers, they can benefit from what is known as ‘top-slicing relief', which works as follows.

One simply takes the gain, and divides it by the number of full policy years the investment has been in force to give what’s known as the average gain.

e.g. In our example above where a full surrender of a policy worth £150,000 resulted in a gain of £75,000, we divide £75,000 by 6 complete policy years (2004-2010) to give £12,500.

We then add £12,500 to the policy holder’s other total taxable income for the tax year in question and if the result is less than the higher-rate tax threshold there is no tax to pay. If the result exceeds the higher-rate tax band, then we calculate by how much and multiply it back by 6 policy years.  Take this example;

e.g. Say a policy holder has other taxable income of £30,000 in tax year 2009/10, we add £12,500 which gives a total of £42,500.

For tax year 2009/2010 higher rate income tax applies above £37,400 of taxable income so; 

£42,500 - £37,400 = £5,100. (This is known as the top slice).

We then multiply by the number of whole policy years, thus

£5,100 x 6 = £30,600. This is the taxable Gain and is taxed at 20% with no further liability, hence 20% of £30,600 = £6,120 tax liability.

When one puts this in perspective, in this case the investor made a total profit of £85,000 including the withdrawal of £35,000, over a 6-year period and the investor himself only paid £6,120 in tax on the profit - an effective tax rate of 7.2% - much less than CGT at 18%!

Policyholder and tax advisor beware costly partial surrender?

Consider the following case:

£150,000 was invested in an Investment Bond in July 2007.  Due to the adverse investment conditions, the bond fell in value, and was valued at £135,000 in January 2009. The policyholder wanted to make a partial withdrawal and, thinking the policy was in loss meant there would be no tax to pay, went ahead and withdrew £50,000, after all you don’t pay tax on a loss, do you..?

Following through our calculations for a partial withdrawal using the 5% rule as in examples 1 and 2, the 5% allowance accumulated on this policy is 5% of £150,000 x 2 policy years = $15,000.

In this case withdrawing £50,000 results in an excess and consequently a Gain of £35,000 in July 2009, to go on the 2009/2010 tax return. So we can clearly see here that making a partial surrender can trigger a tax liability even though there is no profit, because excess calculations do not take into account whether there is actual profit or loss on the policy. Only in the tax calculation on final surrender do we take account of the profit or loss where there can only be a gain when there is profit.  However, in our case having to fully surrender a £150,000 policy, when all that is needed is £50,000 is a rather inefficient way of doing things.

To avoid such an undesirable scenario many providers now issue their Investment Bonds as segmented mini-policies, perhaps made up of 1,000 identical mini-policies or more. One therefore makes a full surrender of individual mini-policies to raise the amount needed and avoid a Gain, particularly when there is a loss on the investment. The calculation is just as we saw earlier in calculating the Gain on a full surrender, which in this case is as follows:

GAIN = Current value + previous withdrawals - initial investment - previous excesses

GAIN = £135,000 + 0 - £150,000    = MINUS £15,000 or Zero Gain.

We can clearly see then that as there is no profit, there is no gain, and one can confidently fully surrender individual policies and not trigger a tax liability. In this case the policy is made up of 1,000 mini-policies (each now valued at £135), and as we want to withdraw £50,000, we simply fully surrender (£50,000/£135  = 371) 371 mini-policies, or policies 1 through 371 inclusive.

As has been illustrated, policyholder and tax advisor alike must tread carefully when wanting to make a partial surrender.  All too often policyholders simply send in an instruction to the life office requesting a partial withdrawal without consideration of the tax position or seeking advice, resulting in a totally unnecessary tax bill. Again, rather than ploughing through these calculations, all it takes is a telephone call to the Life Office beforehand asking what the gain would be if withdrawing the required amount on doing a partial surrender across all mini-policies (as in examples 1 and 2) and on a full surrender of a number of mini-policies (as in the last example) to raise the required amount. They will even give you the number of years to use for top-slicing relief. The point here is that this should be done before making the withdrawal.

The only time Accountants need get involved in calculations is for top slicing relief, and Solicitors are only ever likely to meet these rules when doing probate work.

Additional points:

• Additional investments or top-ups to a policy will produce their own 5% allowances.
• 5% allowances build up over a maximum of 20 years and once 100% (5% x 20 yrs) has been withdrawn any further partial withdrawal results in an excess
• For the top-slicing relief calculation, in the case of an excess on a partial surrender, the gain is divided by the number of years since the last excess, not the number of complete policy years as in the case of a full surrender. If there has been no excess previously, then one can use the number of years including part-years since inception.
• For top-slicing relief, remember the average gain is added to taxable income, so although the higher-rate tax threshold is £37,400 (tax year 2009/10), one generally benefits from the personal allowance (£6,475 tax year 2009/10) and so one can earn up to £43,875 (including the average gain added to other income) before a gain becomes taxable. 
• Certain allowances, such as Age Allowance for those over 65 or Children’s Tax Credit depend on overall income. As the total gain (without averaging) is treated as part of your income for that year, these allowances may be reduced or eliminated by the gain.
• If an excess and a full surrender occur in the same tax year, the excess is ignored. The calculation of the gain on cashing-in takes the withdrawals into account.
• When the policyholder dies, it is treated as if they fully surrendered their bond one day before death, and any gains are included in their final income tax calculation in the year of death - this is where probate lawyers are likely to encounter these policies.
• For an Investment Bond in Trust the gain is generally taxed against the settlor if alive and if not alive, then the Trustees, except in the case of a Bare Trust where gains are always assessed against the beneficiaries.
• If the bond is owned jointly, the gain is split according to their respective share.
• Full information can be found in HMRC help sheet HS320: HMRC Help Sheet HS320

Tax planning opportunities

One will notice that, unlike in the case of a Unit Trust investment, switching funds does not result in a Chargeable Event and therefore no tax liability. Nowadays on modern policies, with the a plethora of investment funds to choose from, everything from low risk and cash funds to speculative commodity investments is available and this versatility allows an investor to time his investment decisions without being bound by tax considerations, which is often the case with other investment structures.

In addition the gains are assessed against the policyholder’s income in the tax year when the gain arises.  With some clever planning, one could be a higher-rate tax payer throughout one's working life, make 5% withdrawals to raise extra income and then on retirement when income drops into the basic rate band, one could benefit from top-slicing relief having had the policy over many years, and withdraw potentially substantial sums without incurring any tax. 

Another valuable opportunity, sadly little advertised, is where the policyholder remains a higher-rate taxpayer, he can exploit his spouse’s basic-rate or non-tax status by transferring ownership of the bond to the spouse at the time they want to make the surrender. They may then immediately go ahead and make the surrender and the gain is assessed on the income of the spouse.  As the transfer of ownership is a deed of assignment by way of gift and not for money or money's worth, it is not a chargeable event.   

Similarly, in the case of surrendering a trustee investment one could avoid trustee tax by assigning the investment bond to the beneficiaries first and then making the surrender.

As investment bonds are classed as non-income-producing (any income derived accumulates as capital growth) they are particularly appropriate for Trustee investments, which also means they are ideal vehicles for Inheritance Tax planning, one example being the Discounted Gift Trust; The Discounted Gift Trust

Conclusion

Investment Bonds enjoy their own tax rules and with the right guidance open up many tax planning and investment opportunities. As has been illustrated, seeking advice is paramount at every step of the process, and it is indeed a shame that lack of understanding of a system which is not particularly complicated has meant these investments often don’t get the publicity that they deserve.