Partial surrender of life insurance policies informal consultation on options for reform Comments from the Chartered Institute of Taxation

Transcription

1 options for reform Comments from the Chartered Institute of Taxation 1 Introduction 1.1 The CIOT applied for, and was granted permission, to make written and oral submissions in the appeal to the Upper Tribunal in the case of Lobler v HMRC [2015] UKUT 152 (TCC). The CIOT s application was made against a background of a number of First-tier Tribunal decisions where the tax regime governing the partial surrender of life insurance policies in Chapter 9 of Part 4 of ITTOIA 2005 was subject to severe judicial criticism. In the Lobler case, the Upper Tribunal in effect allowed rectification of the taxpayer s partial surrender (such that the taxpayer was treated as though he opted instead for full surrenders) in order to remedy the substantial unfair 1 tax charge incurred by the taxpayer. Whilst the Upper Tribunal stopped short of also finding that the tax charge was disproportionate such that it constituted a breach of human rights, it held that this was only just 2 the case. 1.2 Following the decision, the CIOT has engaged informally with professional bodies 3 representing the life insurance industry, other representative tax bodies 4 and with HMRC to discuss possible options for legislative reform. In order to promote debate and thought, the CIOT produced a preliminary discussion paper outlining some options for legislative reform. The options paper circulated is attached at Appendix 1. The options identified were not intended to offer a definitive solution. Indeed, each has its drawbacks. The purpose of the paper was to initiate discussion and invite alternative solutions. 1.3 We understand that informal discussions on options for reform have also subsequently taken place both within professional bodies representing the insurance 1 Paragraph 102 of the Upper Tribunal s decision in Lobler. 2 Paragraph 90 of the Upper Tribunal s decision in Lobler. 3 Informal exploratory discussions have taken place with the ABI, ILAG, 4 Informal exploratory discussions have taken place with the Low Income Tax Reform Group (LITRG), Tax Help for Older People and the Tax Faculty of Institute of Chartered Accountants of England & Wales

2 industry and between those bodies and HMRC. 1.4 The CIOT has received a number of comments. The informal comments received, including those from members of the CIOT s technical sub- committees, are summarised at paragraph 2 below. In addition we have received two standalone responses that we attach at appendix 2 (from Deloitte) and appendix 3 (from ILAG). The Deloitte response includes an alternative option in addition to those outlined in the CIOT options paper. In addition the Deloitte paper comments on an alternative put forward by HMRC in their discussions with them. (The comments from both ILAG and Deloitte on the CIOT options are also reproduced below in respect of each option.). 1.5 Four general comments which have been made by a number of those responding are: - First, that any new rules must keep the existing 5% cumulative allowance; - Second, insurers must continue to be permitted to segment policies; and - Third, the insurance industry would not be in favour of an option that required a significant and expensive change to the insurers systems and/or reporting requirements. - Fourth, whatever solution / solution is proposed, it will need to be sufficiently flexible to prevent a Lobler-type charge from ever arising in the future. For example, the possibility of relief must not be lost if the policyholder (say) has assigned his policies to another person by the time he realises that he is facing substantial tax charges of which he was previously unaware. 1.6 The CIOT is also concerned that any amendment to the legislation has transitional provisions capable of providing a solution to those currently facing substantial tax charges on chargeable event gains (if any remain after Lobler). 1.7 The CIOT is also conscious that any legislative change is not inadvertently susceptible to abuse. The CIOT notes that it would be difficult to frame a targeted anti-avoidance rule which included a motive test because policyholders needing to use whatever remedy is created by the change in law will be doing so precisely to reduce a charge/charges to tax. However, the CIOT considers that the General Anti- Avoidance Rule ( GAAR ) in Part 5 of Finance Act 2013 should provide sufficient protection against any abuse. Indeed, the CIOT notes that the GAAR was created/drafted with, amongst other things, the avoidance scheme in HMRC v Mayes 5 in mind which created tax losses through the generation of deficiency relief under the provisions as they stood at the time. 2 Summary of informal comments received on the CIOT options paper Option 1 Removing the restrictions on deficiency relief (including the higher rate restriction) and allowing a taxpayer to carry back deficiencies (currently only relieved in the year of final surrender) to use them against an earlier gain on partial surrender. 5 HMRC v Mayes [2010] EWCA Civ 407 P/tech/subsfinal/CGT/2015 2

3 2.1 We understand that following a recent meeting, the ABI have indicated an initial preference for option 1 outlined in the CIOT paper and has made this preference known to HMRC. Along similar lines, the ICAEW s TAXREP 31/15 Budget representations 6 said in relation to the Lobler case Where a profit is taxed in one tax year it is frequently the case that a deficit on exactly the same source cannot receive tax relief in a later year. It would be more equitable if the deficit in the later year could be set off against the profit in the earlier year resulting in a tax repayment. 2.2 As can be seen from Appendix 3, ILAG have indicated that Option 1 is the preferred option for many members, and the second best option for all others, observing that: - It might be a workable add-on to any wider solution. - The carryback period would need to be sufficient to avoid a Lobler situation. - The carryback must be effective immediately the policy is terminated. - The policyholder is forced to make a full surrender to trigger a deficiency in a short timeframe. - The policyholder could still have an accelerated a tax charge compared with his economic profit. - Some policyholders might still be in a Lobler situation if they do not terminate the policy or fail to make a claim (for whatever reason). 2.3 The ICAEW agree that a change in the legislation is required to allow the true economic reality to be reflected in the tax treatment. They considered that one solution might be to change the law in a similar way to that relating to earnouts. This would enable excess relief to be offset against income arising on an encashment of a policy in an earlier year of assessment. This solution is equivalent to the CIOT s proposed option As set out at Appendix 2, Deloitte agrees that deficiency relief, as it currently operates, does not provide adequate relief for the reasons they set out as reproduced below: - It only provides relief based on the difference between the basic and higher rates of tax, meaning that additional rate taxpayers are unable to claim full relief where gains on partial encashment exceed economic gains made. Depending on the size of the part-withdrawal, individuals who would normally pay tax at the basic or higher rates can become additional rate taxpayers due to a part-withdrawal being made. - While chargeable event gains realised on UK policies benefit from a notional 20% tax credit, most gains realised on offshore policies are not eligible for a tax credit, meaning that a real tax cost arises on the basic rate tax liabilities. - Under the proposals for the Personal Savings Allowance, Deloitte notes that chargeable event gains will be eligible for the Allowance. However the Consultation Document does not appear to propose any changes to the rules 6 P/tech/subsfinal/CGT/2015 3

4 relating to the basic rate tax credit. - As deficiency relief cannot be carried forward or back, it is only useful where the policyholder has sufficient income in the year of encashment for relief to be used in full. Individuals do not always have sufficient income to use deficiency relief in full, and in some cases may ordinarily be basic rate taxpayers, meaning that relief cannot be used at all. In order for deficiency relief to resolve the issue of tax being paid based on the year of the part encashment, it would ideally be possible for deficiency relief to be carried back to the year of the part withdrawal. Deloitte agrees with the CIOT proposals for changes to the relief by removing the higher rate restriction and providing a more flexible carry back position. However in their view this is not a solution in itself, but could be added on to another solution. Deloitte notes that it should be borne in mind that deficiency relief is only available where all of the rights under a policy or contract are surrendered, or another event which occurs on termination of a policy occurs, as specified by ITTOIA 2005 section 540. Some policies may contain terms that restrict surrender or various other events occurring, which may mean that it will be impossible for policyholders to claim deficiency relief. It therefore seems that deficiency relief cannot provide a complete solution to Lobler situations. In terms of reporting, insurers are not currently required to calculate the deficiency realised on full surrender (or other termination event) of the policy. If this option were to be implemented, it may be necessary for insurers to calculate the amount of the deficiency in order to enable policyholders to calculate the amount of deficiency relief available to them, though Deloitte expects that insurers would already have the information they would need in order to do so. 2.5 Option 1 is also the preferred option of a member of the CIOT technical subcommittee as representing the most practical option because it causes the least disruption to insurance providers systems. An important point is that if a deficiency is offset it must have the effect of preventing interest running on the original assessment ab initio and of preventing penalties being chargeable in respect of that original assessment. 2.6 One member felt that option 1 is flawed in that the interval between the initial part surrender and the final surrender/maturity could be many years. The ultimate tax position for the year of the part-surrender would be vulnerable to change as long as maturity is deferred. 2.7 In order for option 1 to be viable, in particular: - It must not be possible for policyholders to fall foul of time limits for making a carryback claim. - Policyholders must be permitted to carryback relief to all years in respect of which chargeable event gains arise. - There needs to be some alternative option available to those who are for some reason prevented from using option One possible amendment to option 1 which might address the issue of policyholders being forced to terminate their policies under the option as currently framed might be P/tech/subsfinal/CGT/2015 4

5 to introduce the concept of a notional deficiency relief ie the deficiency relief that would be available to be carried back under the current option 1 if the policies were surrendered in full but are not so surrendered. Policyholders would be allowed to carryback this notional relief and offset it against chargeable event gains whilst at the same time reducing the deficiency relief available to him on the eventual final surrender. It is appreciated that this adds complexity to the rules but would address the main problem with option 1 as it currently stands. 2.9 In summary, it was considered that option 1 would be a good solution in combination with another option which would reduce unfair charges of those for whom option 1 was not available (some offshore policies have restrictions on full surrender, for example). For policyholders to whom option 1 is potentially available, it presents them with a commercial choice between paying the tax or fully surrendering their policies. 3 Summary of informal comments received on the CIOT options paper Option 2 Charging only the economic gain using the familiar CGT part disposal rule (A/A+B) to apportion the premiums paid to be set against the amount payable 3.1 Option 2 found little favour amongst those responding. 3.2 ILAG considered that: This option found no favour with any members. The reasons were: - Complicated for people to understand - Difficulty with top slicing relief - Would require expensive system changes 3.3 Deloitte notes, for example, that this option appeared to them to remove the benefit of 5% allowances and would also be administratively difficult and expensive for insurers, as it would require policy valuations to be made at any withdrawal date. In addition, it would be necessary for insurers to change the information included on chargeable event certificates, which would likely require significant systems changes. Accordingly Deloitte do not think this option is workable. 3.4 One member commented that option 2 removes the simplicity that is a fundamental feature of the present system (apart from the part-surrender trap); but if the industry is prepared to provide post-withdrawal values ('B' in the formula) as a matter of routine it does give the fairest answer. However, it would add an unwonted burden on insurance companies and it is unlikely that offshore providers would see any need to give a statement of residual value. 4 Summary of informal comments received on the CIOT options paper Option 3 Treating a partial surrender across a number of segments / policies as if a full surrender of individual segments / policies had been made instead, so far as possible 4.1 ILAG considered this the preferred option for some members and the second best for others. Comments were: P/tech/subsfinal/CGT/2015 5

6 - Some proposed a threshold for such claims, ie only gains above a certain amount are able to be elected for. - It could be problematic if further chargeable events arise following the original part surrenders. - There could be a significant compliance burden for some insurers. 4.2 Deloitte feels that it may be a viable option from a policyholder perspective. Whilst it is simple and easy to understand on the first occasion an election is made, it is not clear how this approach would work on subsequent chargeable or potentially chargeable events. In addition, whilst most insurers with a significant number of UK resident clients, or funds invested by UK resident clients, establish a number of segments when premiums are paid by investors, it is possible that some jurisdictions may not do this, and so could instead establish a single policy, which would mean this option is not a viable solution in all circumstances. Furthermore, it may be administratively difficult for the insurers themselves and significant (and so expensive) changes may be required to IT systems to make this work. 4.3 It is acknowledged that not all policies are sold in segments or the size of the segments might be such that a policyholder is still left with significant (albeit reduced) gains so this may not provide a solution for some policyholders. 4.4 One member commented that option 3 is much the best. Indeed it could be expressed even more simply as deeming a multi-segment 'policy' to be a single policy - unless perhaps the policyholder makes a perhaps irrevocable election not to do so. A possible development of this idea put forward by a respondee is to arrive at a mandatory method for determining the chargeable event gain based on the optimal surrender of a combination of surrendered and part-surrendered segments. 4.5 From the responses received, it appears that option 3 might be a good additional option to have as part of a wider solution but might not be suitable as a standalone solution. 5 Summary of informal comments received on the CIOT options paper Option 4 Taxing the chargeable event gain on a just and reasonable basis 5.1 Commenting on a possible variant of option 4 (the just and reasonable option), one member pointed to a Statutory Roxburghe principle akin to the Roxburghe case where a non-dom makes a mistaken remittance to the UK. This would simply say that where a policy-holder and the life company agree, within a period of [say 6 years or perhaps to the extent that tax years are open], that a particular partial surrender amounted to a fundamental mistake on the part of the taxpayer, and the policy-holder and the life company agreed to take such steps as to put the taxpayer back in the position he or she would have been in had the mistake not been made, then that outcome should be read back for tax purposes (as is the case for deeds of variation and IHT, for instance). The member notes that, in effect, this approach is how the Upper Tribunal reached its decision in Lobler. Therefore the concept of mistake in this context could be put onto a statutory footing. P/tech/subsfinal/CGT/2015 6

7 5.2 In debating the variant at 5.1, the counter argument was put forward that the application of this rectification principle would almost certainly lead to a taxable amount that is different to the amount actually paid with the consequential need for complex (manual) adjustments and a potential economic result that would favour either the policy-holder or the provider to the detriment of the other. 5.3 Deloitte notes that it is not clear how this option is intended to work. Deloitte assumed that the intention was to provide HMRC discretion to apply a just and reasonable approach in cases where the strict legislative rules lead to an unreasonable result (the intention was in fact for the test to be an objective one see the further clarification below). In Deloitte s view this would provide a sensible fall back, but would be less appealing than a legislative solution, in view of the uncertainty that it would give taxpayers. The interaction with self-assessment would also need to be considered further, as would the information which insurers will be required to produce. 5.4 Others were concerned that this option is simply too vague and at worst offered HMRC a de facto discretionary power to tax. 5.5 The CIOT considers that something akin to option 4 might be an appropriate add-on to a wider solution. If one of the more prescriptive options outlined above (or an alternative option generated by these responses or otherwise) was enacted in due course, it may still be possible for unforeseen circumstances to arise such that a particular policyholder with a particular set of facts, unanticipated during the course of this consultation, is still left with an unfairly high tax charge. If that is the case, then it seems sensible that the legislation provides a fail safe. Such a provision might be drafted so as only to come into effect in circumstances where the policyholder is left with (say) chargeable event gains over a certain limit after applying the solution(s) provided in the legislation. Similar types of provisions can be found in, for example: - 41G(9) ITEPA 2003 (rules relating to the taxation of internationally mobile employees) If the relevant period determined in accordance with subsections (2) to (8) would not, in all the circumstances, be just and reasonable, the relevant period is to be such period as is just and reasonable ; or - Para.3A(4) TMA 1970 (special relief) in the opinion of the Commissioners it would be unconscionable for the Commissioners to seek to recover the amount (or to withhold payment of it, if it has already been paid). Special relief is referred to by way of illustration only. The CIOT considers that the subjective test in the special relief provisions would not be suitable here. Rather, an objective just and reasonable test is to be preferred. 6 Other comments and/or further options 6.1 One theme of the informal comments is the aspiration for a simple system that taxes real gains only and that is easily understood by less sophisticated investors, while fully recognising the need to guard against the avoidance risk. One member commented: Pursuing that line to a small degree I do wonder if a simple override would do the job: that there was a rule that the taxable gain could never be more than the real gain that has been established. Using the example in the CIOT letter, investing 1000 in a policy that gets to 1100 and the investor withdraws 1000, the taxable CEG remains P/tech/subsfinal/CGT/2015 7

8 950 but the maximum that could actually be taxed would be = 100. It would no doubt require some record keeping/tracking but if the value of the remainder rose to 200 and the investor withdrew 50, another CEG calculation would be needed with a maximum gain at that point being 100 and so on. 7 Concluding remarks 7.1 The CIOT continues to be willing to work alongside HMRC and the other professional bodies to provide assistance as required in order to find a legislative solution to the issues raised by the partial surrender regime as it currently stands We understand that HMRC intends to produce a paper for consultation during a brief period, with a view to introducing draft amendments in the Finance Bill During the course of gathering responses, the ABI amongst others suggested that a round table discussion during the consultation window and involving all interested parties might be beneficial. The CIOT agrees and would welcome the opportunity to participate in that discussion. 8 The Chartered Institute of Taxation 8.1 The Chartered Institute of Taxation (CIOT) is the leading professional body in the United Kingdom concerned solely with taxation. The CIOT is an educational charity, promoting education and study of the administration and practice of taxation. One of our key aims is to work for a better, more efficient, tax system for all affected by it taxpayers, their advisers and the authorities. The CIOT s work covers all aspects of taxation, including direct and indirect taxes and duties. Through our Low Incomes Tax Reform Group (LITRG), the CIOT has a particular focus on improving the tax system, including tax credits and benefits, for the unrepresented taxpayer. The CIOT draws on our members experience in private practice, commerce and industry, government and academia to improve tax administration and propose and explain how tax policy objectives can most effectively be achieved. We also link to, and draw on, similar leading professional tax bodies in other countries. The CIOT s comments and recommendations on tax issues are made in line with our charitable objectives: we are politically neutral in our work. The CIOT s 17,000 members have the practising title of Chartered Tax Adviser and the designatory letters CTA, to represent the leading tax qualification. The Chartered Institute of Taxation 6 October 2015 P/tech/subsfinal/CGT/2015 8

9 APPENDIX 1 CIOT DISCUSSION PAPER OPTIONS FOR REFORM Taxation of part surrenders of life insurance investment products a frankly ludicrous result 7 The product Life insurance investment products provide a policyholder with the ability to surrender all or part of the policy. A UK resident taxpayer is charged to income tax on any gain as defined by the legislation arising on a chargeable event. This term includes both a full and a partial surrender. The tax regime 8 works effectively on a full surrender, broadly taxing the economic gain. The problem is the tax treatment on a partial surrender. The issue On a partial surrender, the legislation requires a calculation to be made to determine whether a gain has arisen. There is a gain if the value received from the insurer exceeds 5% of the total premium invested for each policy year. Any excess is subject to income tax and is treated as arising at the end of the insurance year. As a result, income tax can become payable in the year of partial surrender on an amount that far exceeds the growth of the value of the assets underlying the policy. A basic example (used in the recent case of Anderson v HMRC 9 ) illustrates the point starkly: A taxpayer invests 1000 in a single premium life policy. At the end of year 1 the policy value is 1100 (i.e. 10% return has been earned by the insurer) and the policyholder withdraws The return included in that withdrawal cannot exceed 100. However, the taxable chargeable event gain will be (5% of premium) which is 950. If the policy had been surrendered in full by the end of the insurance year, the gain would have been only i.e. the return on investment. If, in contrast, the policy is surrendered in full in a subsequent insurance year, there is no reduction or repayment of the previous tax charge. Rather, the regime provides for deficiency relief that can reduce the amount of tax due on income chargeable at higher or dividend upper rate (subject to restrictions). But in many cases, taxpayers will not have other income approaching that figure, so the relief may well be of very little use. Who is affected? The tax regime governing the taxation of partial surrenders has drawn severe criticism from the First-tier Tribunal in several recent tax cases. The regime affects elderly or retired taxpayers particularly harshly. These individuals may have invested life savings or proceeds on downsizing their house under the impression that these products are suitable for low-risk, short-term investment. If substantial partial surrenders are made without a proper 7 Judge Nowlan Shanthiratnam v Revenue & Customs [2011] UKFTT 360 (TC) 8 Chapter 9 of Part 4 of ITTOIA [2013] UKFTT 126 (TC) P/tech/subsfinal/CGT/2015 9

10 understanding of the tax regime, the consequence may be a devastating loss of life savings and even bankruptcy. In the recent Upper Tribunal case of Lobler v HMRC, 10 a tax charge of around 350,000 arose, yet the taxpayer only made a comparatively small economic gain on the policies. The Upper Tribunal s decision in Lobler Prior to the Upper Tribunal s decision in Lobler, the FtT had considered that it was prevented by the clear terms of the legislation from finding for taxpayers in a similar position, despite each Tribunal s obvious sympathy for them. In contrast, the Upper Tribunal decided that Mr Lobler had made a sufficiently serious mistake in completing the withdrawal form and erroneously selecting a partial surrender across all policies. Accordingly, the Upper Tribunal allowed his appeal and held that his tax position should be determined as if he had instead made full surrenders of policies to the extent possible. HMRC have not appealed. An amendment to the legislation In the light of the Upper Tribunal s decision in Lobler, the CIOT has been working with HMRC to find a suitable amendment to the legislation to provide a statutory remedy for policyholders who would otherwise find themselves in Mr Lobler s position. Four options have been considered so far: Option 1: Removing the restrictions on deficiency relief (including the higher rate restriction) and allowing a taxpayer to carry back deficiencies (currently only relieved in the year of final surrender) to use them against an earlier gain on partial surrender. Option 2: Charging only the economic gain using the familiar CGT part disposal rule (A/A+B) to apportion the premiums paid to be set against the amount payable. Option 3: Treating a partial surrender across a number of segments / policies as if a full surrender of individual segments / policies had been made instead, so far as possible. Option 4: Taxing the chargeable event gain on a just and reasonable basis. Some policyholders may wish to make partial surrenders and be taxed under the rules as they currently stand. Accordingly, it is anticipated that the option(s) would be available on the making of a claim/election. HMRC would be provided with a general discretion to extend any time limit for the making of such claims/elections. Example Developing the example above further to illustrate the options, the current regime operates as follows: 10 Lobler v HMRC [2015] UKUT 152 (TCC). The CIOT was granted permission to make submissions in the taxpayer s appeal to the Upper Tribunal in the wider public interest of finding a solution for taxpayers across the board in equivalent positions to the taxpayer in the appeal P/tech/subsfinal/CGT/

11 A taxpayer invests 1,000 in a single premium life policy. At the end of year 1 the policy value is 1,100 (i.e. 10% return has been earned by the insurer) and the policyholder withdraws 1,000, leaving 100 as the value of the policy. The return included in that withdrawal cannot exceed 100. However, the taxable chargeable event gain will be 1, (5% of premium) which is 950. At the end of year 2, the remaining policy value is now 110 (i.e. a further 10% return has been earned by the insurer). The policyholder makes a full surrender of the remaining 110. The legislation provides for a deficiency of 840 (i.e. previous gain of 950 less economic gain of 110). Under the current rules, the deficiency can only be used against amounts subject to higher rate tax (including the dividend upper rate) in year 2. Option 1 Deficiency relief Under this option, the policyholder could make a claim to carry back the deficiency arising in year 2 and use against the chargeable event gain of 950 such that, in effect, only 110 would end up being subject to tax in year 1. Option 2 Taxing the economic gain Under this option, in year 1, the allowable cost to be deducted from the disposal proceeds would be 1,000 x ( 1,000/( 1, )) = so the chargeable event gain would be 1, = When the remaining 110 is surrendered in year 2, a further gain of = would be brought into charge. Aggregate gains of 110 will be charged to tax over the two years. Option 3 Deemed full surrender of some segments Assume that the policy in this example is made up of 100 segments of 10 each. In year 1, the policyholder erroneously makes a partial surrender of 10 of all segments at a time when the value of each segment had increased to 11. Under this option, the policyholder could make a claim in year 1 to be charged to tax as if he had made a full surrender of segments so far as possible. In other words, the policyholder would be taxed as if he had made a full surrender of 90 segments of 11 each and made a partial surrender of 10 from a further segment of 11. Gains of 90 would arise on the full surrender of 90 segments (being ). Gains of would arise on the partial surrender of the remaining segment (i.e (being 5% of the premium of 10)). So the gain in the first year would be When the remaining 110 is surrendered in year 2, a further gain of 2.10 (value of policy less premium of 10) would arise from each of the 9 policies unaffected by an earlier part surrender ( in total). The single policy that had been part surrendered would give rise to deficiency relief of 9.40 (previous gain of less economic gain of 1.10) P/tech/subsfinal/CGT/

12 Total gains of would be charged to tax over the two years and the policyholder would be able to claim deficiency relief of 9.40 in the second year. Option 4 just and reasonable Feedback Under this option, there would be no prescribed mechanism for calculating the year 1 chargeable event gain arising. However, the overall tax charge would be one that reflected the economic gain made by the taxpayer. Any adjustment made to the year 1 chargeable event gain would automatically carry through to the year 2 computation on final surrender under the current computational rules. In the alternative option 4 might offer a statutory back up to any of the above options in the event that a claim is missed or to rectify an inequity. The CIOT invites feedback on these options and/or on suitable alternatives not identified above which will be shared with HMRC. Please send responses to Kate Willis at kwillis@ciot.org.uk by Friday 11 th September P/tech/subsfinal/CGT/