Life Assurance Bonds – Taxation on Encashment

 In Finance & Investments

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TAXATION ON ENCASHMENT

Information in this article should not be taken or relied upon as personal financial advice. Any individual requiring information or advice on their own specific circumstances or on their own account should contact a suitably qualified professional.

 

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This article looks at the broad tax situation when a life assurance bond is encashed, either as a claim because the sole or last surviving life assured has died, or because the executors require the liquid funds that would be released by a policy surrender.

Note that an assignment “for monies worth” will also give rise to a tax charge, although in most scenarios assignments of bonds or bond segments are arranged to pass on an entitlement, so that would be a rare occurrence.

Chargeable Event gains

The encashment of the bond will result in what is called a Chargeable Event gain (assuming there is a profit). The rules for Chargeable Events are part of the Income Tax regime, something that comes as a surprise to many people, as the phrase implies a liability to some sort of capital tax. The tax liability that arises will depend on whether the bond was issued onshore or offshore and the tax status, after allowing for the Chargeable Event gain, of the bond owner. So if trustees of a discretionary trust were the owners at the point of encashment, the applicable tax rate would be 50% less any basic rate credit due, but if the owner (probably after an assignment) was a 19 year old student, the tax rate might be nil. Note that in the later case tax paid already within an onshore bond by a life assurance company is not reclaimable.

Offshore on onshore?

In simple terms the difference between an onshore and an offshore bond is that the Chargeable Event gain from an onshore bond is treated as having been taxed at the basic rate of income tax already (to credit the tax paid by the UK life assurer while the bond’s investments were owned). So if the proceeds fell to be taxed at 40% in the hands of a high earning owner, for example, extra tax would currently be calculated at an extra 20% of the already “net” profit. If the bond is held offshore, there is no tax offset, as virtually no tax will have been paid during the investment period and the gross gain is tax at the applicable rate in full.

How much?

The amount of the Chargeable Event gain is generally the proceeds received less the amount originally invested. If withdrawals have been made at 5% per annum or less (commonly the case), they will have been treated as withdrawals of capital and tax on these sums will have been deferred, so they will need to be added back at the point of encashment.

For example, a bond is purchased for £100,000 and the owner takes an “income” of 3% for 10 years before the policy is surrendered. The surrender value is £122,000. The Chargeable Event gain is: £122,0000 + (10 x £3,000) – £100,000 = £52,000.

The amount of the gain is then “top sliced”, that is divided by the number of years of investment (not the number of years the current owner has held the bond, say after an assignment). In the above example the top sliced gain would be £5,200. That amount is added to the other taxable income of the owner to establish the rate tax payable. The whole gain is then taxed at that rate, less a credit for basic rate tax if the bond was issued onshore.

Segmentation

Note that if a bond is partially surrendered, the whole amount released is treated as a gain for the immediate tax calculation. That is one reason why bonds are issued in multiple segments, as total encashment of a number of segments will allow realisation of part of the investment and full operation of the top slicing rules, whereas partial encashment can have very adverse short term tax consequences!

Conclusion

This article has explained in general terms how the proceeds of a life assurance bond will be taxed on encashment, but there are variations that need accounting for, especially when the bond was issued with a specific tax planning motive and practitioners are strongly advised to take specialist advice before dealing in bonds if they do not have the necessary tax expertise.

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