for financial advisers only

UK Bonds

Printer friendly version
24/09/2013

Chargeable Gains on Onshore Bonds and Taxation

This article is designed to discuss the detail of chargeable gains and show what it is, when it applies and who it applies to. This will be laid out with a general overview and then subsections dealing with each scenario. This article deals with individuals and trusts and does not include corporate gains.

For corporate information please look at ‘Taxation of Company Owned Life Assurance Policies’.

What is a chargeable gain?

A chargeable gain is a tax charge that arises on the ‘disposal’ of a life assurance contract under certain circumstances which is chargeable to income tax rather than capital gains tax. ‘Disposals’ can include a full or partial surrender or an assignment of a policy.

What events create a chargeable gain?

Events that will cause a chargeable gain calculation are generally where there is a disposal of the bond which is going to involve the client (or their estate) receiving a cash value in return. Examples of this would be:

  • death of the life assured that results in a claim
  • full surrender of the whole bond
  • part surrender across all policies within a bond which are more then the 5% cumulative annual allowance (see later heading)
  • full surrender of some policies within the bond
  • maturity of the bond (if appropriate)
  • assignment of the bond for monies worth (ie receiving a payment for transferring the bond) or for consideration (ie in anticipation of a connected transaction)
  • substitution eg addition or removal of a life assured.

What events do not create a chargeable gain?

Some events mean that it is possible to take some benefits of the bond or give the bond away where there is no chargeable event. These latter events are normally where there is no exchange of a monetary value. Examples of this would be:

  • part surrender across all policies within a bond up to the cumulative 5% annual allowance
  • assignment of all or part of the bond as a gift to an individual or a trust (although not a chargeable event it will create either a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfer (CLT) for inheritance tax purposes
  • assignment as security for a mortgage loan.

When is the gain taxed?

Any chargeable gain is taxed within the same tax year the gain arises.

Regular withdrawals and/or ad hoc partial surrenders taken across all policies within a bond in any policy year are aggregated and treated as having been taken together on the last day of that policy year. The aggregated payments will be treated as occurring in the tax year in which the last day of the policy year falls.

The chargeable event certificate will be issued within three months of the end of the policy year for any partial surrender across all policies and within three months of any final surrender of the full bond or surrender of full policies within a bond.

Who pays the Tax?

Gains on chargeable events for individuals will follow a logical route of the gain being levied on the owner of the bond at the time of the chargeable event. If the bond is jointly owned by more than one person any gain will be apportioned between them. If the bond has policiess that have been assigned to another person as a gift those policies will be chargeable on their respective owner(s) and separate certificates will be required.

If the bond has been assigned into a discretionary type trust, although it has been assigned into the ownership of the trustees, any chargeable gain will still fall on the settlor during their lifetime and in the tax year of their death. If the bond is encashed or creates a gain at any time after the tax year of the member’s death but before assignment out of the trust into the ownership of a beneficiary, the trustees will be liable for any chargeable gain created.

If the bond has been assigned into a Bare/Absolute Trust, this gives the absolute entitlement to the bond to the beneficiary and cannot be varied. As this is the case any chargeable gain will not fall on the trustees or the settlor but will be levied on the beneficiary irrespective of their age and based on their own personal allowances.

Where a bond is owned by Trustees any chargeable event certificate will be issued to the Trustees as the legal owners but they do not need to declare the gain on their tax return unless they are liable. They can forward the certificate to the person liable for them to declare on their own tax return.

There are some exceptions to these rules, which can get quite complex and therefore specialist advice should be sought. Examples of this are:

Where the settlor is non UK resident at the point the gain arises. If this is the case the gain will fall to be paid by the trustees. If there is no trustee who is UK resident at the point of the gain then the liability will fall upon the beneficiaries. It should also be noted that if this is the case the beneficiaries cannot utilise top slicing relief, as described later in this document.

Another scenario to watch out for is where the bond was created and put under trust prior to
17 March 1998. Where the settlor has also died before that date then there is no entity to levy the chargeable gain on and so there is nothing to pay. This will only apply where the bond has not been varied in any way or the term of a life assurance policy extended. This is known as the dead settlor rule.

These last two areas can be very complex and advice should be sought before proceeding in these circumstances.

Taxation of the gain

Any chargeable gain is subject to income tax and is added on to the income the client or trustees already have so will always attract tax at the highest marginal rate.

For individuals and bare trust beneficiaries the income tax rates are 20%, 40% and 45%. Under a bond the underlying fund is taxed as insurance company taxation (broadly equivalent to corporation tax) and this covers any individuals liability for personal basic rate tax. So if any gain falls entirely into the nil or basic rate tax band there is no further liability to tax for the individual, however, they will not be able to claim any tax back if they are a nil rate tax payer. If the tax falls into the higher or additional rate tax band, the client can reduce the tax rate by 20% as this tax has already deemed to have been paid.

Example:

A client is a higher rate taxpayer and has a gain of £5,000. The tax due is 40% but 20% is deemed to have already been paid via the underlying bond taxation and therefore they only have to pay an additional 20%.

For income tax purposes Trusts have a standard rate band (SRB) of £1000 where they pay tax at 20%. Any income not covered by the SRB is liable for tax at 45%. Like an individual, the trustees can reduce their tax rate by the 20% tax that has already deemed to have been paid.

Example:

The trustees have a gain of £10,000. The first £1,000 falls within the trustees' 20% band and the tax is deemed to have been paid due to the bond underlying taxation. The remaining £9,000 is liable to tax at 45%. As 20% is deemed to have already been paid, the trustees only have to pay an additional 25%.

Where a gain falls over two tax bands, each part of the gain will be taxed at the appropriate level. This is especially significant where a client utilises top slicing relief as described in the following section.

Top slicing (personal, trusts and age allowance)

Now the taxation of the gain has been described, it will need to be determined how the tax is applied to any gain.

HMRC have a system called top slicing where they allow the overall gain to be spread over the number of full policy years the bond has been held if you are a basic rate tax payer and the total gain moves you into the higher rate tax bracket or a higher rate tax payer and the total gain moves you into the additional rate tax bracket.

To determine the gain you will take the overall gain and divide this figure by the number of complete policy years the bond has been running for. This will give you the ‘annualised’ amount. This amount is then added to the individual’s income to determine if this sliced gain will push their income into a higher tax bracket.

If the income stays within the nil or basic rate tax bracket after the sliced gain is added there is no further tax to pay on the whole gain (as the underlying bond taxation accounts for basic rate tax). If however, after adding the sliced gain this pushes the client into a higher rate tax band there will be a further calculation to carry out to determine the taxable gain. The amount of the gain that falls into the higher rate band will be multiplied back up by the number of full policy years the bond has been running for and this amount will be the amount that is taxable as the gain.

Example:

A bond has been running for 10 full policy years and has created an overall gain of £60,000.
The client has total income for the year in which the chargeable event falls (2013/14) of £38,975. Higher rate tax starts at £41,451 (assuming the policyholder has the standard personal allowance).

The gain is top sliced by the full number of policy years, so £60,000/10 = £6,000.

This sliced gain is now added to the client’s income to produce a total of £35,535.

£2,475 of this gain falls into the basic rate tax band and the client is liable to tax on this amount. However, as the bond suffers corporation tax on the underlying funds which is equivalent to 20% the client has no further tax to pay.

However, £3,525 of the gain falls into the higher rate tax band and so is subject to tax.

To determine the taxable income that will be charged you multiply £3,525 back up by the number of full policy years completed (10) to get a figure of £35,520.

This figure is then taxed accordingly by the difference between the 20% tax deemed to have been paid and the 40% appropriate tax rate.

The same principle will operate where the client is already a higher rate taxpayer and, when top sliced, the gain takes the client into the additional rate tax band. Remember that as the client is already a higher rate taxpayer they will be liable for 40% tax on the whole of the gain (20% deemed to be paid due to underlying corporation tax) and the top-slicing is merely to see what portion of the gain falls into additional rate tax.

Top slicing can be applied to both full surrenders and partial surrenders however, there are exceptions where it cannot be used or it is restricted as follows:

  • For partial surrenders across all policies within a bond if there has been a previous chargeable gain on those policies you can only go back as far as the last gain when calculating years used for the top slice calculation on a UK bond. However, if the bond is offshore and there has been a previous chargeable gain you are not restricted in the same way you are for an onshore bonds and top slicing can be used back to the start date of the bond.
  • Trustees are not allowed to use top slicing when calculating their gains.
  • If the client is old enough to benefit from age allowance they are not allowed to use top slicing to determine if their overall income is great enough to reduce or lose the age allowance (although it will still be used for the calculation of the actual tax to pay).

That where the whole of the gain takes the client's total income above £100,000, this will affect their personal allowance.

5% rule

You are allowed to withdraw 5% of your initial investment each year (this is cumulative) without any immediate liability to tax, or having to declare anything on your tax return up to a maximum amount of 100% of the initial investment. If you have made an additional investment at any time, the 5% allowable will then also apply to that investment on the same basis and for 100% return of that sum.

Example:

Client invests £100,000 in 2003 and takes £5,000 per year. However, in 2013 they top up this policy by an additional £100,000. They then take a total of £10,000 per year from this bond until 2023. In 2023 the initial investment of £100,000 will have been exhausted by the withdrawals and so the 5% amounts relating to this will have to stop or be subject to a chargeable gain. So from 2023 the 5% limit drops from the £10,000 back down to £5,000.

If this withdrawal amount is not used fully or at all each year, the unused allowance is carried forward. There is no timescale as to how far this can be carried forward but it will always be restricted to a total of 100% of the investments made.

Here’s an example:

An investment of £100,000 is made in January 2009. £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 June 2013 which is actually in the fifth policy year, 25% or £25,000 in this case can be withdrawn (5% x five years), again with no immediate liability to tax.

How is the amount of the gain calculated?

Chargeable gains are based on the amount of the investment and full bond surrender (including previous withdrawals) or amounts in excess of the tax deferred amount (5% withdrawals). The actual calculation to determine the gain can be relatively simple as long as you have all of the information needed to hand. However, in certain circumstances it can also be more complex. Under the sub-headings below we give a brief description of different gain scenarios and the calculation to work out the gain.

Full bond encashment

In the simplest form where no previous withdrawals or chargeable events have happened the calculation can be as simple as:

Surrender value of the bond – total initial investment = chargeable gain

However, in many circumstances people will have taken money out of the bond over the term and may have even created a previous gain or possibly topped up the bond with another investment.

In these circumstances each element will need to be considered and put into the calculation as a point to either be added or subtracted from the simple calculation mentioned above. This will change the calculation above to:

(the total amount of payments taken from the bond plus the surrender value of the bond)
Minus
(the total of all investments made plus the amount of any previous chargeable gains)

Example:

A client invests £100,000 into a bond. The client takes regular withdrawals of £4,000 in each of the first three years and a one-off withdrawal of £12,000 in year three. The client adds an additional £50,000 to the investment in year 7.

In year 12, the client fully surrenders the bond for £173,000.

The regular withdrawals were within the 5% tax-deferred allowance, but the one off withdrawal in year three, when added to the regular withdrawals, exceeded the cumulative allowance and gave rise to a chargeable gain. The calculation will be as follows:

(The total amount of payments taken from the bond plus the surrender value of the bond)
((£12,000 + £4,000 + £4,000 + £4,000) + £173,000) = £197,000
Minus
(the total of all investments made plus the amount of any previous chargeable gain)
((£100,000 + £50,000) + £9,000) = £159,000

So total gain is £38,000 (£197,000 - £159,000)

This example shows how to work out a simple gain. In addition to this, top slicing could be used for individuals to potentially reduce the gain by the number of complete policy years the bond has been running as described in the appropriate section. Remember that top slicing cannot be used for age allowance purposes when considering the £100,000 income limit or for trustees.

Partial encashment

In addition to the full encashment scenarios mentioned above, there will also be occasions where partial encashments are required. These can be done in two different ways and both options will have advantages and disadvantages.

Across all policies

Most bonds will be split into a number of identical policies, each of which will operate within the same rules as the bond and each have the allowable 5% withdrawal limits. When looking to take a withdrawal from the bond this can be done by utilising the available 5% withdrawal limits. For example, if there is a bond that has run for three years with an initial investment of £10,000 and no withdrawals have been taken so far the bond holder will be able to take £1,500 (£500.00 x 3yrs) with tax deferred under the 5% rules. However, if more than then 5% sums available are taken then any excess will be treated as a chargeable gain.

The allowance is per policy year; where a part surrender is taken during a policy year that year's allowance can be utilised.

Example:

£100,000 was invested in 2010 into 100 identical policies.
Two years and 11 months later this bond is now worth £120,000.
No withdrawals have been made and now the client wishes to take £36,000.
Answer
The client has the 5% withdrawal with deferred tax for three policy years (the two full years already passed and the current policy year) = £15,000.
Any excess taken over this amount is subject to chargeable gains, so
£36,000 - £15,000 = £21,000. This is the amount of the chargeable gain.
Top slicing may be used for three policy years. This is because the gain arises at the end of the policy year in which the partial encashment was made.

Full surrender of individual policies

As mentioned above, most bonds will be split into individual policies. An alternative way to surrender some money from a bond without full encashment and ignoring the 5% withdrawals would be to encash separate policies to the approximate value of the withdrawal needed. So full encashment rules on an individual policy basis would apply.

Example.:

£100,000 was invested in 2010 into 100 identical policies.
Two years and 11 months later this bond is now worth £120,000.
No withdrawals have been made and now the client wishes to take £36,000.
Answer
Each policy was originally valued at £1,000 and is now valued at £1,200. This means that each policy has a gain of £200, so
The number of policies the client will need to encash to get the sum required is £36,000 divided by £1,200 = 30.
As each policy has made a gain of £200 you multiply this figure by the number of policies being encashed
30 x £200 = £6,000. This is the amount of the chargeable gain
Top slicing may be used for the two full policy years the bond has been running.

As you can see from the above examples, there can be a wide difference in the amount of the gain the client is subject to depending on the circumstances. Although this example works in favour of full policy encashment for a lower gain this may change significantly if for example, the bond had been running for a longer period of time and no 5% withdrawals had ever been made. Alternatively the client may be paying a lower rate of tax at the point of encashment so the full gain will remain in the basic rate tax band. For these reasons, amongst others, it is always advisable to do both of these calculations to find the best option available for the client and their circumstances at the time.

This article has been designed to explain many of the points commonly confused and misunderstood about bonds and transactions surrounding them but is in no way comprehensive and it is still strongly recommended that you get expert advice in more complex cases.

The information in this article is based on Skandia’s interpretation of legislation as at September 2013. While we believe the interpretation to be correct, we cannot guarantee it.

Extended policy year and final encashment

Where a previous partial encashment has been made from a bond which creates a chargeable gain and then subsequently the full bond is encashed soon after, it may be possible to incorporate the gain created by the partial encashment into the final bond disposal chargeable gain calculation.

Only one policy year may end in any one tax year. This means that if there is a full encashment of a bond half way through a policy year, this may mean the shortened final policy year will end in the same tax year as the previous policy year anniversary. Under these circumstances to stay within the policy year rules you will extend the full previous policy year to incorporate the shortened policy year.

Example:

A bond was taken out on 1 May 2010 and so the end of the policy year is 30 April each year.

If the bond was fully encashed on 1 December 2013 this would create a shortened policy year and fall into the tax year 2013/14. However as the previous full policy year has an end date of
30 April 2013 this would mean there were 2 policy years ending in the same tax year.

To avoid this happening the earlier policy year will be extended to incorporate the later shortened policy year and will now run from 1 May 2012 to 1 December 2013.

This can be advantageous where the client has made a partial encashment within a policy year and created a large chargeable gain and then fully cashes in the bond shortly afterwards. In these circumstances the gain in the last full policy year will be ignored and incorporated within the final encashment of the bond. This can produce significant savings in chargeable gain taxation due.

Example:

A client has a bond taken out on 1 May 2009 for £100,000 and takes no withdrawals. Policy year runs from 1 May to 30 April.

On 1 June 2012 they take a partial withdrawal across all policies of £85,000. Based on the 5% withdrawals they can take £20,000 with tax deferred leaving a gain of £65,000 to pay.
A chargeable events certificate will be issued within three months of the end of the policy year.

However, on 1 November 2013 the client fully cashes in the rest of the bond. At this time the bond value is £40,000.

As the last full policy year ends on 30 April 2013 and the shortened final policy year ends on the date of full encashment on 1 November 2013, this will create two policy year end dates in the same tax year (2013/14). As this cannot happen the final policy year is extended to run from
1 May 2012 to 1 November 2013 (18 months).

This means that the previous partial encashment is incorporated within the final encashment chargeable gain calculation as follows:

Surrender value of the bond (£40,000) plus previous encashments (£85,000).
Minus
Initial investment (£100,000) plus any previous chargeable gain (none as in this example the only excess occurred at the point of the earlier part surrender in the same policy year and is therefore disregarded).

So the total gain is £25,000.

This example demonstrates how this calculation works. However, it should be noted that with bonds which have run for longer periods of time and therefore have more 5% allowances, this will not always produce such favourable chargeable gain calculations.

Upon this calculation a new chargeable event certificate will be issued to reflect the new chargeable gain (assuming a gain has been made). The previous chargeable gain certificate from the partial encashment can be disregarded.

Is this information helpful

More UK Bonds articles