Unfortunately, where clients withdraw funds from their bond without seeking advice, a tax bill can arise which the client doesn’t anticipate. This is because a liability to tax can arise even where overall the investment in the bond has not made a gain. To understand why this may happen we need to consider how and when a tax liability actually falls due.

Withdrawals taken by partial surrender are liable to UK income tax under the Chargeable Events regime on the amount of the withdrawals which exceed the cumulative 5% tax-deferred allowance. We will refer to these as excess withdrawals.

The ‘insurance year’, better known as policy year, begins on the day a bond is taken out and on the same day in subsequent years. It ends on the day before the anniversary of the bond, and on the same day each subsequent year (except for the final policy year, which we will consider later). An excess withdrawal is treated, for tax purposes, as having occurred at the end of the ‘insurance year’ and is calculated on all withdrawals taken in that ‘insurance year’.

The implications of this are best demonstrated by the following example:

A bond taken out on 1 July 2006 has a policy year end of 30 June 2007.

Although an excess withdrawal on 1 April 2008 would happen in the 2007/08 tax year, the excess event would not be treated as arising until the final day of the policy year, ie 30 June 2008, which means it is assessable for tax within the 2008/09 tax year, not the 2007/08 tax year. A chargeable event certificate must be issued to the bond owner by the life company within three months of the end of the policy year (ie 30 September 2008).

The calculation and timing of chargeable events for a full surrender of rights is different, however.

In this instance, the policy year is treated as coming to an end on the date of the surrender. This is then known as the final policy year. Where the previous year finished in the same tax year, the final policy year is extended to include that previous policy year and so may be lengthened by up to a whole year depending on when the bond commenced and when the full surrender was triggered.

For example: a bond taken out on 1 July 2006 has a policy year end of 30 June 2007. If the bond is encashed on 1 December 2008 it will mean that the policy year runs from 1 July 2007 to 1 December 2008 (in this case an 18-month policy year).

Example

£100,000 invested on 1 July 2006 into a UK bond, issued as 100 identical policies of equal value.

An £80,000 withdrawal is made across all policies on 1 April 2007 (bond surrender value £100,000, so no gain in any of the policies).

This would result in an excess of £75,000 (£80,000 - £5,000 (5% allowance)).

This would be liable in the 2007/08 tax year – with an income tax liability of up to £75,000 x 20%* = £15,000 despite there being no investment gain. If the bond in question was an offshore bond, a liability up to 40%** could be due, ie £30,000.

The life company would send out a chargeable event certificate within three months of the policy year end (30 June 2007), but nearly six months would have elapsed since the withdrawal.

Where a bond owner has created excess withdrawals there may be a planning opportunity to reduce or negate any tax liability created. However, a clear understanding of how the policy year and the start of the next tax year interact is essential when trying to ‘reverse’ out of these excess withdrawals. It is important to realise that in certain instances this approach may still not achieve the desired result, or could even result in a higher tax liability.

There may be other factors that you and your clients may need to consider before fully surrendering a bond. Early surrender charges may apply as well as the loss of life cover. Where the bond is held in trust, full surrender may affect future rights under the trust, for example.

* 30% for a gain assessable in tax year 2010/11 where an individual’s income exceeds £150,000 in 2010/11.
** 50% for a gain assessable in 2010/11 where an individual’s income exceeds £150,000 in 2010/11.