Individuals holding investment based insurance policies will be familiar with the withdrawal allowance under which they can take up to five percent of the initial premiums each policy year without triggering any immediate tax charge, deferring the taxation of any gain until the full surrender of the policy. However if the partial withdrawal exceeds the cumulative annual allowances, the tax rules apply a rigid formula which can result in a gain becoming taxable which bears no resemblance to the underlying position of the policy. For example, a partial surrender of £75,000 in the first year of the policy where the premium was £100,000 would result in a gain, taxable as income, of £70,000 regardless of the underlying performance of the policy. The First-tier Tribunal (FTT) in Joost Lobler v HMRC (2013) commented that these rules produced “an outrageously unfair result”. HMRC’s consultation suggests three options to correct this legislative shortcoming.
HMRC have published ideas for resolving the legislative problem that gives rise to disproportionate gains becoming taxable on individual taxpayers on a partial surrender, or partial assignment, of life insurance policies.
One option aims to tax the economic gain on withdrawals in excess of the five percent annual allowance. The gain on a partial surrender would be the value of the surrender less a proportion of the available premium. If the policy was standing at a loss at the time of the event, then no gain would be chargeable. The gain on final surrender would be calculated in the usual way with the gains already taxed on partial surrenders being deducted from the overall gain.
The second option defers gains arising until the full amount of the initial premiums have been withdrawn. Subsequent withdrawals would then be taxed in full. This method provides additional deferral compared to the option above as it would not attribute any inherent gain in the policy to partial withdrawals in excess of the five percent allowance if the cumulative withdrawals did not exceed the full amount of the initial premium.
The third option would retain the existing rules but overlay them with a restriction on the amount of any partial surrender gain that could be immediately taxable so that excessive and disproportionate gains are deferred. The gain immediately chargeable would be limited to a pre-determined cumulative amount (the consultation document uses three percent of the premium per annum) and on a subsequent full surrender the taxable gain would be the overall economic gain less the restricted gains already taxed on partial surrenders.
HMRC’s willingness to adapt the rules which apply to partial surrenders and partial assignments is welcome. Insurance policies are a popular means of investment for many taxpayers and the ability to make annual withdrawals within the annual allowance without giving rise to an immediate tax charge has been a popular feature of these policies. It is good to see that HMRC are keen to retain this feature and some of the simplicity of the current regime while aiming to tax the gains on partial surrenders based more on economic reality. The outcome of the consultation will be of interest to policyholders of UK and non-UK policies.
The closing date for comments on the consultation document is 13 July.
Please speak to your usual contact if you have any questions on this consultation.