Premium limitation on qualifying life policies and restricted relief qualifying policies - part 1

This series of articles has been prompted by an increase in the number of questions we have recently received relating to the £3,600 annual premium limit imposed on certain qualifying life assurance policies from 6 April 2013.  

The questions relate primarily to the implications for qualifying policy status following a premium increase which may cause the £3,600 premium limit to be breached. Such a breach could result in the policy becoming a restricted relief qualifying policy (RRQP). This means that the benefits under the policy will not be fully relieved from income tax when a deemed chargeable event occurs.  In some circumstances a qualifying policy could also become a non-qualifying policy in which case the policy benefits would not benefit from tax freedom.

In this first article we briefly examine the qualifying policy rules and the benefits of qualification. We then go on to look at the basic rules as regards the application of the £3,600 annual premium limit.

1. The qualifying policy rules

In broad terms, under the UK income tax legislation, known as the ‘chargeable events regime’, when a life policy is issued it will be one of three types of policy as follows:

• An excluded policy. These polices are excluded from the chargeable events regime and include policies issued before 19 March 1968, mortgage repayment protection policies, policies issued in connection with a registered pension scheme and excepted group life policies. Exclusion means there is no income tax payable on policy benefits.

• A qualifying policy, the benefits under which are not subject to income tax, provided a number of conditions are satisfied. For example, for a savings plan the main conditions are:

• the policy must be effected with a UK life insurance company and therefore any investment growth accrues in a taxed UK life fund which would suffer corporation tax at 20% on income and capital gains (after indexation allowance for capital gains arising before 1 January 2018);

• the policy must be capable of running for at least 10 years;

• at a minimum, any death benefit paid under the policy must generally be 75% of the premiums payable; and

• the amount of premiums paid in any one year cannot exceed twice the amount of premiums payable in any other year.

• A non-qualifying policy. Non-qualifying policies are all policies that are not qualifying or excluded policies. The prime example of a non-qualifying policy is a single premium investment bond, although additional premiums may be allowed.  Some regular premium whole of life policies are also non-qualifying because they are so flexible that they cannot satisfy the qualifying policy conditions.

A non-qualifying policy can never become a qualifying policy, but a qualifying policy can become non-qualifying once issued by infringing the qualifying policy conditions eg. the premium is quadrupled.  Once a qualifying policy becomes non-qualifying it cannot later regain its qualifying status.

As mentioned above, the investment growth under a UK life policy accrues in a taxed UK life fund which suffers corporation tax on income and capital gains at 20%.  Any gain arising on the payment of benefits under a qualifying policy suffers no personal tax in the hands of the policyholder but the tax charged in the life fund cannot be reclaimed.

When benefits are paid under a non-qualifying policy any gain, called a chargeable event gain, is subject to income tax as savings income but with a credit for basic rate tax (20% currently) treated as deducted in the life fund.  Therefore, from a tax perspective a higher/additional rate taxpayer generally pays no tax on a gain arising on the payment of benefits under a qualifying policy whereas a higher rate/additional rate taxpayer would pay 20% and/or 25% tax on such a gain, after allowance for the 20% tax credit, that arises under a non-qualifying policy.

2. The background to the introduction of the £3,600 premium limit

In his 2012 Budget the Chancellor announced surprise changes to the rules that apply to qualifying policies. In effect, these changes meant that, in future, on “new policies” (or policies that are amended and brought into charge) full tax freedom would only apply to benefits secured on policies with premiums which, in total, do not exceed £3,600 in a 12-month period.

The background to this change was that the benefits of qualifying policies had suddenly come into the spotlight as a result of the increase in the top rate of income tax to 50% (at that time). Also, at that time, restrictions were imposed on other tax-efficient investments, such as registered pension schemes. As a result of these changes higher and additional rate taxpayers were looking for other areas in which to invest and, because of the personal tax freedom on the payment of benefits, short-term savings plans that were qualifying policies naturally appealed.

The type of policy that such investors would be considering would usually be the Maximum Investment Plan. The MIP, as it was known, was attractive for the higher additional rate taxpaying investor who wished to pay considerable regular premiums because it not only gave tax free savings over 10 years but also included other options that gave flexibility for the policyholder to vary premiums and increase the savings term, within limits, without damaging the tax freedom of the benefits. 

In particular, the qualifying policy legislation imposed no limit on the amount of premiums that could be paid into the policy and also there was no limit on the amount of tax free benefits that could be taken from the policy on maturity, surrender or death. 

3. A summary of the changes in the 2012 Budget

The main changes to the extent to which a person could benefit from tax freedom under the qualifying policy rules were as follows:

• The total premiums payable by one individual on all “new” qualifying policies must not, from 6 April 2013, exceed £3,600 in a 12-month period;

• For these purposes a “new” qualifying policy is one taken out:

• after 5 April 2013 (unless it is an excluded policy – see 5 below); or

• between 21 March 2012 and 5 April 2013 (the transitional period) – but the new rules only apply to premiums paid after 5 April 2013; or

• before 21 March 2012 (known as protected policies) but only if those policies are varied after 20 March 2012 and become restricted relief qualifying policies because they cause the £3,600 annual limit to be exceeded.

Tax exempt savings plans issued by Friendly Societies are included within the annual premium limits.

If a policy is issued on or after 6 April 2013 and the total premiums payable exceed £3,600 in a 12-month period, or could exceed £3,600 as a result of options or terms within the policy, then the whole policy will be non-qualifying.

The annual premium limit applies to premiums payable throughout the life of the policy. Variable premium policies will be non-qualifying from the outset if premiums payable will exceed £3,600 in any 12-month period.

5. Excluded policies

The following policies are excluded from the annual premium limit:

• Policies taken out before 6 April 2013 (called “existing protected policies”), which secure a capital sum payable either:

• on survival for a specified term or on earlier death or disability; and

• which had been issued and are maintained for the sole purpose of ensuring that the borrower under an interest-only mortgage will have sufficient funds to repay the capital lent under the mortgage. This will include part repayment and part interest only mortgages and mortgages where other investments are being used to make up any shortfall.

• “Pure protection” policies. These are policies taken out at any time which:

• have no surrender value or are not capable of acquiring a surrender value; or

• under which the benefits payable cannot exceed the amount of premiums paid except on death or disability.

Certain premiums are excluded from the premium limit.  These are:

• premiums payable on the grounds of exceptional risk of death

• the first premium payable out of sums retained by the insurer following the maturity or surrender of a previous qualifying policy.

However, premiums that are waived do count towards the premium limit.

6. How the system works

The rules work on the basis that you must first  establish all of the policies that a person owns that may be affected by the rules. Having done this it is then necessary to ascertain the premiums paid to all of those policies to determine whether or not the £3,600 limit is exceeded. 

A tax exemption under the qualifying policy rules will then be given to the benefits arising from the first £3,600 of premium payments to the affected policies. This exemption is given to benefit payments under a policy on a chronological basis. 

Any tax charge is based on the deemed chargeable event gain under the policy. This means that a proportion of the deemed chargeable event gain will be tax free (ie. that attributable to the first £3,600 of premiums paid on “new” policies) and the balance will be taxable.

In summary, therefore, it is necessary to deem that a chargeable event gain arises under a qualifying policy and then apportion the gain between the taxable and the tax-free element. The deemed chargeable event gain will be calculated in the normal way, ie. surrender value paid less premiums paid, and then be apportioned between the tax-free and taxable element.

We will look at these calculations in greater detail in a later article.

7. The owner of the policy for the purposes of the £3,600 rule

Clearly, it is important to identify which policies belong to which person in order to determine whether the £3,600 limit has been exceeded by that person. The general rule here is that a policy belongs to a person if they are the “Beneficiary” of a policy. 

In broad terms, the “Beneficiary” would be as follows:

• The beneficial owner of the policy. This is the individual entitled to benefit from the proceeds of the policy. Where there is more than one beneficial owner of a qualifying policy the premiums under the policy will count in full towards each beneficial owner’s premium limit of £3,600.

Example – Sara and Simon

Sara and Simon are the beneficial owners of a policy taken out in May 2018. Annual premiums under this policy are £3,000.

Simon takes out a further policy in September 2018 with annual premiums payable of £300.

Sara takes out a further policy at the same time with annual premiums payable of £700.

Both of Simon’s policies will be qualifying policies because his premiums payable annually (£3,000 + £300) do not exceed his annual premium limit of £3,600.

It will be noted from this example that the £3,000 premium under the jointly owned policy counts against each joint owner’s £3,600 limit.

The policy taken out by Sara in September 2018 will be non-qualifying because her premiums payable annually (£3,000 + £700) exceed her annual premium limit of £3,600.

• In the case of a policy held subject to a bare/absolute trust, the beneficiary under the trust will be the Beneficiary for the purposes of the £3,600 rule.

• Where a policy is held subject to a discretionary trust, the settlor will be the Beneficiary of the policy for the purposes of the £3,600 rule.

In the next article we will look at the application of the rules in more detail.