INTRODUCTION TO CHARGEABLE EVENT TAXATION.

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1 TAX & ESTATE PLANNING PROFILE INTRODUCTION TO CHARGEABLE EVENT TAXATION. Gains arising on a non-qualifying single premium whole of life assurance policy such as an Investment Bond issued by either a UK or offshore life office - will be taxed in accordance with legislation contained within Chapter 9 of Part 4 of Income Tax (Trading and Other Income) Act Whilst the provisions of the Act can be complex this Guide aims to provide a clear and concise synopsis of the fundamental principles that will help advisers to understand when a tax liability could arise and the basis on which it will be calculated. Under the relevant provisions of the above Act an Investment Bond that produces a gain will be subject to income tax rather than capital gains tax. Terminology such as gains chargeable to income tax can appear both contradictory and confusing! When considering the potential income tax liability that could arise in relation to an Investment Bond, a good place to start is to always remember that: Income tax is only payable if: A chargeable event occurs and A chargeable gain arises as a result and The gain is attributed to a chargeable person. A chargeable event can arise on: Death of the last life assured under the policy Full surrender of the policy Certain part surrenders of the policy Assignment or part assignment of the policy for money or moneys worth Maturity of the policy The switching of an underlying investment fund is not a chargeable event. When a chargeable event occurs a calculation must be made to see if a chargeable gain has arisen. There is a gain on a chargeable event where the whole of the rights under the policy (or one or more individual segments) are given up, for example, in the case of a full surrender. The chargeable gain arises if the amount paid from the policy whilst it has been in force exceeds the premiums paid plus the total gains on previous chargeable (excess) gains. Where there has been a part surrender, or part assignment for money or money s worth under a policy, a periodic calculation must be made at the end of the policy year in which that event occurred to see whether a chargeable gain has arisen. A policy year begins on the date the policy is issued and future policy years on each subsequent anniversary of that date. A part surrender results in a chargeable (excess) gain where the 5% allowance is exceeded. The 5% allowance allows withdrawals of up to 5% of the premium paid under a policy in the policy year in which the premium is paid and in the following 19 years without an immediate income tax liability. This means that 100% of the premium paid can be withdrawn over 20 years at a rate of 5% a year.. ANY QUESTIONS? If you have any questions or comments in relation to this article, please INSURANCE. SAVINGS. INVESTMENT MANAGEMENT.

2 TAX & ESTATE PLANNING PROFILE 2 The 5% allowance is cumulative; if it is not fully used in one policy year the unused balance can be carried forward and is available to be used in the next or subsequent policy years until such time as 100% of the premium paid has been withdrawn. For example, 4% per policy year can be taken each policy year for 25 years or, alternatively, no withdrawals are taken at all for 19 policy years and then a withdrawal of 100% of the premium paid is taken in year 20. A chargeable (excess) gain arises if the withdrawal exceeds the cumulative 5% allowance. The amount of the gain is the amount of the excess. For example, if 12% of the premium paid is withdrawn in policy year 2, the cumulative 5% allowance in year 2 is 10% and the chargeable gain is 2% of the premium paid irrespective of the actual investment return under the policy. If a chargeable event has occurred and a chargeable gain arises, then the income tax charge can be calculated. The income tax charge is subject top slicing relief, which is available only to individuals. Chargeable event gains are charged to income tax in the tax year that the event occurs, even though the gain may have accrued over many years. Top slicing relief can help reduce the impact of a chargeable event gain for tax purposes by reducing the amount of the gain that is subject to tax at the higher and/or additional rates of tax (see below). If the policyholder s other taxable income for the tax year in which the gain arises is less than the higher rate income tax threshold, but the total of this other taxable income and the chargeable event gain takes the policyholder into the higher rate income tax band, then top-slicing relief will apply. If none of the gain falls in the higher rate income tax band, then no top slicing relief is due. If the whole of the gain falls in the higher rate income tax band, then the amount of top slicing relief will be nil (unless part of the gain falls in the additional rate tax band see below). WORKED EXAMPLES Amanda (55) and Derrick (57) took out an onshore bond in their joint names on 17 August 2003 with a single premium of 50,000. Their 18 year-old daughter Emma is due to start at university shortly and, after passing her driving test during the summer, they decided to surrender the bond as they wish to use some of the proceeds to buy Emma her first car. The bond was surrendered on 1 September 2011 realising proceeds of 62,000 - no previous withdrawals had been taken whilst the bond was in force. The chargeable gain that arose on encashment of the bond is calculated as follows: Encashment proceeds 62,000 Less: Single Premium 50,000 Gain 12,000 Since the bond had been held for eight complete policy years prior to its surrender (17/08/ /09/2011) the top-sliced gain is: 12,000/8 years 1,500 Let s now consider the potential income tax liability on the 12,000 chargeable gain in each of the three following scenarios. SCENARIO 1 Prior to the surrender, Amanda and Derrick assigned the ownership of the bond to Emma. Whilst studying for her A-levels Emma had held a Saturday job working at a local bakers and, once her exams had finished, she had gone full-time on a temporary basis during the summer before stopping completely just before starting at university. As a consequence, her total taxable income for 2011/12 is anticipated to be no more than 5,400: Other taxable income 5,400 Chargeable gain 12,000 Total taxable income 17,400 Since Emma s total taxable income, after the addition of the chargeable gain, falls entirely within the basic rate income tax band, she has no personal tax liability to pay in respect of the gain realised on the bond. In assigning the ownership of the bond to Emma her parents will be making a transfer of value for IHT purposes which, initially, will be treated as a potentially exempt transfer (PET). In so doing they will have to accept that Emma is then free to deal with the policies assigned to her however she chooses. In reality, it is more likely that Amanda and Derrick would only assign the actual number of policies required to produce the cash amount needed for Emma to make the purchase of the car.

3 TAX & ESTATE PLANNING PROFILE 3 SCENARIO 2 Prior to the surrender Derrick makes an outright and unconditional gift of his interest in the policy to Amanda. This is achieved by effecting a two to one assignment so that the legal title to the bond is subsequently held in Amanda s sole name. Amanda s other taxable income for 2011/12 is anticipated to be 32,500: Other taxable income 32,500 Chargeable gain 12,000 Total taxable income 44,500 Because Amanda s total taxable income exceeds the higher rate tax threshold of 42,475 (7,475 personal allowance + 35,000 basic rate band), top-slicing relief will apply. If, after the addition of the top-sliced gain to Amanda s other taxable income, the resulting figure does not exceed the higher rate tax threshold she will face no personal income tax liability on the chargeable gain realised: Other taxable income 32,500 Chargeable gain 1,500 Total taxable income 34,000 Since this amount falls completely within the basic rate income tax band, Amanda has no personal tax liability to pay on the gain realised. SCENARIO 3 At the date the bond is surrendered, it is still held in the joint names of Amanda and Derrick. Since they were joint owners at the date the chargeable event arose, the resulting chargeable gain will be assessed to income tax on a 50:50 basis, split equally between them both. This means that the chargeable gain attributable to each of them is 6,000 with a corresponding top-sliced gain of 750 apiece. Since Amanda s circumstances are as described in 2 above, she faces no personal income tax liability on her share of the chargeable gain. In contrast, Derrick has other taxable income of 42,400. Consequently: Chargeable gain 6,000 Total taxable income 48,400 Since Derrick s total taxable income exceeds the higher rate tax threshold (42,475), top-slicing relief will be available: Top sliced gain 750 Total taxable income 43,150 Less: personal allowance & basic rate band (7, ,000) 42,475 Amount sitting in higher rate tax band 675 Higher rate tax 40% 270 Less: notional 20% tax credit (135) Derrick s personal tax liability per slice 135 Total tax liability on 8 slices 1,080 If Derrick were to make an additional net pension contribution of just 540 before the end of the 2011/12 tax-year, this would have the effect of increasing his basic rate tax band by 540/80% = 675. The outcome of this is that all of the top-sliced gain would then sit within the basic rate tax band - meaning that Derrick would then have no personal income tax liability on his share of the chargeable gain. Prior to tax year 2010/11, if the chargeable gain was assessed on an individual who was already a higher rate taxpayer before the addition of the gain, top-slicing relief did not apply. This meant that the whole of the chargeable gain would be liable to tax at the difference between the basic and higher rates of tax (40% - 20% = 20%). However, for chargeable gains

4 TAX & ESTATE PLANNING PROFILE 4 assessable in tax year 2010/11 and later, where some of the gain lies in the additional rate (50%) tax band (taxable income over 150,000), top slicing can still provide a measure of relief potentially saving the taxpayer 10% tax on at least some of the gain. (For more on this please see Bond Essentials: Top Slicing, Adjusted Net Income & the Additional Rate of Tax) However if the assessable person has scope to make additional pension contributions (possibly out of the proceeds of the encashment) then it may be possible to reduce or mitigate completely any personal tax liability relating to the chargeable gain. GAINS ON OFFSHORE BONDS Gains arising from chargeable events relating to offshore policies are calculated in the same way as for onshore bonds however the potential tax liability of the assessable person(s) will differ to reflect the different internal tax treatment of the two types of policy. Because the underlying funds of an offshore bond are not generally subject to UK tax, the policyholder will not benefit from the notional 20% tax credit associated with onshore bonds. As a result, any chargeable gain is thus taxable in full. This means that: 1. The assessable individual(s) pays tax at their top rate of tax on the gain. This will be 20%/40%/50% as appropriate, unless they are non-taxpayers with unused personal allowance, or some of the 10% starting rate of savings income tax band, available to offset against some or all of the gain. 2. Gains assessed on UK resident trustees (other than those of Bare trusts) will be taxed at the rate applicable to trust (50%) after the application of any standard rate tax band available to the trustees. 3. Top-slicing relief is available to individuals to determine how much, if any, of the chargeable gain will be taxed at the higher and/or additional rates. It should be noted that top-slicing relief only helps to avoid assessment at the higher/additional rates of tax it does not apply with regards to assessment at 0%, 10% or 20%. (N.B. In relation to offshore bonds, the number of years available for top-slicing relief is always calculated with reference to when the policy commenced this is so even if there has been a previous chargeable event). 4. Where the policyholder has been UK resident for only part of the time the bond has been in force, the assessable gain can be reduced to reflect this period of non-uk resident ownership. This is known as time apportionment relief. The relief is given by reducing the gain by a fraction equal to A/B, where: A = the number of days on which the policyholder was not UK resident in the policy period, and B = the total number of days in the policy period. (The policy period means the number of days the policy has run before the chargeable event occurs.) For the purposes of top-slicing relief, it should be noted that the number of eligible years that can be claimed will be reduced by the number of complete years for which the policyholder was not resident in the UK. Furthermore, this relief is not available in respect of polices issued after 19 March 1985 that, at any time during the period in force, have been held by non-uk resident trustees. (This also applies to pre 20 March 1985 polices where the trustees subsequently become non-uk resident. 5. Gains on offshore investment bonds are reported as Foreign income for self-assessment purposes meaning that a supplementary form will have to be completed to report this income. Let s now return to Emma, Amanda and Derrick and look at their respective income tax liabilities if we assume that the 12,000 chargeable gain that arose in the previous example related to an offshore bond. OFFSHORE BOND WORKED EXAMPLES EMMA We already know that, after the addition of the chargeable gain, Emma s total taxable income is unlikely to exceed the higher rate tax threshold and if this should be the case, the chargeable gain would be taxed as follows: Unused personal allowance (7,475-5,400) 0% Starting rate (savings income) 10% Basic rate (12,000 [2, ,560]) 20% Tax due on chargeable gain Representing an effective rate of tax: ,473 1, %

5 TAX & ESTATE PLANNING PROFILE 5 AMANDA Since Amanda s other taxable income is less than the level at which higher rate tax becomes payable but the total of this income and the chargeable gain exceeds the higher rate tax threshold, top-slicing relief will apply. As has already been demonstrated, when the top-sliced gain (1,500) is added to Amanda s other taxable income, the resulting total (34,000) falls entirely within the basic rate tax band. The outcome of this is that the whole chargeable gain will be taxed at the basic rate, giving rise to personal tax liability of: 20% 2,400 Representing an effective rate of tax: 20% DERRICK As was the case with Amanda, because the addition of the chargeable gain to Derrick s other taxable income results in his total taxable income exceeding the higher rate tax threshold, top-slicing relief becomes relevant. However, in Derrick s case, since the combination of top-sliced gain and other taxable incomes is greater than the level at which higher rate tax becomes payable, the chargeable gain will be taxed as follows: Top sliced gain 750 Total taxable income 43,150 Less: personal allowance & basic rate band (7, ,000) 42,475 Amount sitting in higher rate tax band % x 8 slices 2,160 Add: 20% tax due on remaining portion of sliced gain: 20% x 8 slices 120 Total tax due if chargeable gain assessed on Derrick 2,280 Representing an effective rate of tax on his share of the gain: 38% This is not a consumer advertisement. It is intended for professional financial advisers and should not be relied upon by private customers or any other persons. This document is based on Legal & General s current understanding of tax law, HMRC practice and legislation, which may change. It should not be considered a definitive statement in law. While we believe this interpretation to be correct we cannot guarantee it. Legal & General cannot accept any responsibility for any loss or liabilities arising from any action(s) taken as a result of the information contained in this communication. Legal & General Assurance Society Limited Registered in England No Registered office: One Coleman Street, London EC2R 5AA We are authorised and regulated by the Financial Services Authority. TT09/11 Non GASD

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