Losses on single premium investment bonds

 

If no chargeable event gain(s) has arisen under the policy while it was in force, e.g. withdrawals have not exceeded cumulative 5% annual allowances, the negative answer means that an investment loss has been incurred for which there is no relief from tax. Nor can a loss on one policy be set against the gain on another policy.

On the other hand, if the answer is negative but chargeable event gains had arisen under the policy while it was in force, the negative amount is technically known as a deficiency and, depending on the circumstances, that deficiency can be used to reduce income tax arising in the same tax year as the deficiency, where income is taxed at the higher rate and/or dividend upper rate. 

In more detail…

The amount of the deficiency, which can arise under UK and non-UK single premium investment bonds, that can be used to reduce income tax is restricted to the amount of previous chargeable event gains that have arisen under the same policy. It doesn’t matter whether any tax was actually paid on those previous chargeable event gains.

Deficiency relief is only available to individuals and is not available for policies owned by companies, policies held in a trust created by a company or policies held in a trust where, if there were a chargeable event gain on that policy, the tax liability would fall on the trustees.

Where the relief applies the deficiency relief in the tax computation can reduce the level of income subject to higher rate tax. Of course, the rate of higher rate tax that income will suffer depends on the type of income, namely whether it is dividend income or not. Dividend income would be subject to the dividend upper rate and other income to the higher rate.

The rules

The rules are to be found in sections 539-541 Income Tax (Trading and Other Income) Act 2005.

There are three time periods, which we will call A, B and C:

1. Pre-3 March 2004 policies;

1. Post 2 March 2004 policies and pre 3-March 2004 policies treated as being post 2 March 2004 policies;

1. Post 20 March 2012 and pre-21 March 2012 policies treated as being post 20 March 2012 policies.

The rules for each “time period” are now considered in more detail: 

1. Pre-3 March 2004 policies

The basic rules as regards deficiency relief set down below apply to policies effected before 3 March 2004:

• The amount of a deficiency that can be used is restricted to what is termed “the allowable amount”. The allowable amount is previous chargeable event gains, i.e. on part surrenders (withdrawals) or “part assignments” (transfers) but excluding the annual charge on personal portfolio bonds, which have arisen in previous tax years.

(An example of a part assignment is where A and B own a policy and transfer the policy so that after the transfer the policy is owned by A, B and C. A personal portfolio bond is broadly a policy investing outside of pooled insurance company investments that allows the investor control over selecting the investments).

• It doesn’t matter whether any tax was actually paid on the previous chargeable event gains.

• The top-slicing relief calculation is not used in determining the amount of a deficiency which can reduce income tax.

• Deficiency relief is not available for policies owned by companies or for policies held in a trust created by a company. Nor is it available under a trust policy where the liability falls on the trustees. If, on the other hand, the liability under a trust policy falls on the settlor then relief will be available if the settlor is an individual.

A policy effected before 3 March 2004 will be subject to the post 2 March 2004 legislation if, on or after 3 March 2004:

• it is varied so as to increase the benefits payable (which includes being varied by exercise of an option conferred by the policy); or

• there is an assignment (transfer), by way of gift or for consideration, of the whole or part of the rights under the policy; or

• the whole or part of the rights under the policy become held as security for a debt.

1. Post 2 March 2004 policies

The pre-3 March 2004 rules apply apart from rule A(i) which changed from 3 March 2004. The change is highlighted in black in rule B(i) which follows:

• The amount of a deficiency that can be used is restricted to what is termed “the allowable amount”. The allowable amount is previous chargeable event gains, i.e. on part surrenders or part assignments but excluding the annual charge on personal portfolio bonds which have arisen in previous tax years to the individual on whom any chargeable event gain arising on termination, if there were one, would be assessed to tax.

Under the pre-3 March 2004 rule A(i) above, all previous chargeable event gains under the policy were taken into account – irrespective of who owned the policy at that time. This meant that a higher rate taxpayer could encash a policy that had been assigned to them by, say, their spouse and utilise deficiency relief in respect of previous chargeable event gains that arose throughout that spouse’s period of ownership – even though the spouse was a non-taxpayer. 

This loophole was closed by limiting the amount of deficiency relief to previous chargeable event gains that have arisen to the policyholder at the time the termination event occurs. This change was significant because previously all chargeable event gains from inception of the policy, no matter to whom those gains arose, would fix the maximum amount eligible for deficiency relief.

• It doesn’t matter whether any tax was actually paid on the previous chargeable event gains.

• The top-slicing relief calculation is not used in determining the amount of a deficiency which can reduce income tax.

• Deficiency relief is not available for policies owned by companies or for policies held in a trust created by a company. Nor is it available under a trust policy where the liability for tax on any gain would fall on the trustees. If, on the other hand, the liability under a trust policy falls on the settlor then relief will be available if the settlor is an individual.

1. Post 20 March 2012 policies

The basic rules as regards deficiency relief set down below apply to policies effected after 20 March 2012 (and certain policies effected before that date – see below). They repeat the post 2 March 2004 rules in B above with the exception of rule (ii), which is replaced as follows, in bold type:

• The amount of a deficiency that can be used is restricted to what is termed “the allowable amount”. The allowable amount is previous chargeable event gains, i.e. on part surrenders or part assignments but excluding the annual charge on personal portfolio bonds, which have arisen in previous tax years to the individual on whom any chargeable event gain arising on termination, if there were one, would be assessed to tax.  

• The amount of previous chargeable event gains that can be set off against income to reduce tax is restricted to gains that have been taken into account in calculating the total income of the policyholder for tax purposes.

• The top-slicing relief calculation is not used in determining the amount of a deficiency which can be attributed to income.

• Deficiency relief is not available for policies owned by companies or for policies held in a trust created by a company. Nor is it available under a trust policy where the liability falls on the trustees. If on the other hand the liability under a trust policy falls on the settlor then relief will be available if the settlor is an individual.

Under the law as it stood before the new rule (ii) above was introduced, a chargeable event gain arising (e.g. due to a part encashment) was deductible from the final gain regardless of whether any tax was actually due on the earlier gain.

For example, a large policy excess (e.g. an amount taken significantly in excess of the accumulated 5% allowances) taken from an offshore bond when the policyholder was non-UK resident would not have given rise to a UK tax charge – despite an excess arising. 

If the offshore bond was encashed when the policyholder was UK resident then the previous gain under the policy (despite no tax having been paid) could be set against the final gain. In the right circumstances, this could often give rise to a substantial deficiency to set against other taxable income. The new rule (ii) closed this loophole.

A policy effected before 20 March 2012 will be subject to the post 20 March 2012 legislation if, on or after 21 March 2012:

• it is varied so as to increase the benefits payable (which includes being varied by exercise of an option conferred by the policy); or

• there is an assignment, by way of gift or for consideration, of the whole or part of the rights under the policy; or

• the whole or part of the rights under the policy become held as security for a debt.

Calculating the tax reduction

Deficiency relief is given by way of a computational adjustment that reduces the amount of income tax chargeable. The practical effect of the relief is to reduce the level of income charged at the 40% higher rate (or the dividend upper rate of 32½%) with the effect that the same income is charged to tax at the 20% basic rate (giving relief at 20%), or 7½% dividend ordinary rate (giving relief at 25%) as appropriate.

This means that the relief can only benefit an individual who is liable to tax at the 40% higher rate or 32½% dividend upper rate. 

The rules apply in the same way to those who own non-UK bonds, even though they will not have been entitled to the 20% tax credit.

Example – Rick

Rick effected a UK Bond on 26 May 2014 for £300,000. He had been UK tax resident throughout the period the policy had been in force, and he had taken the following withdrawals by way of part surrenders:

Policy year to	Withdrawals £	5% allowances – available limit £	Balance £
25/5/2015	15,000	15,000	-
25/5/2016	22,500	15,000	(7,500)
25/5/2017	13,500	15,000	1,500
25/5/2018	13,500	16,500	3,000
25/5/2019	13,500	18,000	4,500
25/5/2020	13,500	19,500	6,000
Total	91,500

On 15 July 2020 he fully surrendered the bond for £199,400.

The chargeable event gain is calculated as follows: 

(Surrender value + withdrawals) – (Premium + excesses)

= (£199,400 + £91,500) – (£300,000 + £7,500)

= - £16,600 deficiency. A deficiency (loss) has therefore been incurred.

But the deficiency can only be attributed (i.e. offset) against higher rate tax to the extent that previous chargeable event gains have arisen and those previous chargeable event gains have formed part of the policyholder’s total income for UK tax purposes (the policy was taken out after 20 March 2012). This means that only £7,500 can be offset. And, of course, whether that relief is available depends on the amount of Rick’s income that is subject to higher rate tax in tax year 2020/21 when full surrender took place.

For example, if in tax year 2020/21 Rick had taxable earned income of £39,500 (after deducting his £12,500 personal allowance), only £2,000 of his income is taxable at the higher rate and this will restrict his deficiency relief. (The basic rate threshold for 2020/21 is £37,500). In effect, the relief will be calculated as follows:

	£
Taxable income (all earned) for 2020/21	39,500
Less: deficiency relief	(2,000*)
	______

 

Basic rate limit	37,500
Deficiency relief 20% (i.e. 40% - 20% basic rate tax) of £2,000	400

* Relief only available for higher rate tax purposes – therefore restricted to £400.  

It should be noted that relief is only allowed if the excess gave rise to a potential tax charge at the time of the previous chargeable event giving rise to the excess. Also, as stated earlier, it is important to note that the excesses taken into account on the happening of previous chargeable events have been assessed to tax on the same person who would be assessed on any gain on final encashment – this is so in Rick’s case whose previous chargeable event gain would have been included in his total income for UK tax purposes, and who has owned the policy throughout which commenced after 20 March 2012.

The extra tax on income liable at the higher rate or dividend upper rate of tax depends on the nature of the income. It is the difference between the liability on that income under the normal rules before deficiency relief, and the liability on that income assuming that it is wholly liable at:

• the basic rate, for other income (apart from dividend income), such as employment income;

• the dividend ordinary rate, for dividend income.

Example: 

If Rick’s income in tax year 2020/21 had instead been made up of £110,000 salary and £30,000 of dividends (i.e. £140,000 in total) then the tax relief by virtue of the bond deficiency would be calculated as follows:

	£
Taxable income for 2020/21	140,000
Top £28,000 (£30,000 - £2,000 dividend nil rate band) dividend income taxed at 32½%
Deficiency relief 25% (32½% - 7½%) of £7,500                        =	1,875

When the additional rate of tax was introduced, deficiency relief was not extended to income that suffers the additional rate of income tax. Indeed, deficiency relief is not available at all in respect of income that suffers the additional rate of income tax.  

This means that for somebody with earned income of, say, £300,000 in 2020/21, they would be restricted to deficiency relief on £112,500 (i.e. the income in the band £37,500 to £150,000 which suffers income tax at the higher rate and/or dividend upper rate).

Example:

If Rick’s income in 2020/21 had, instead, been made up of £140,000 salary and £30,000 of dividends (i.e. £170,000 in total) then the tax relief by virtue of the bond deficiency would be calculated as follows:                                                                                   

	£
Taxable income for 2020/21	170,000
Top £20,000 (£170,000 - £150,000 higher rate threshold) dividend income taxed at 38.1%
Next £8,000 (£10,000 - £2,000 dividend nil rate band) dividend income taxed at 32½%
Deficiency relief 25% (32½% - 7½%) of £7,500                        =	1,875

Note that the £2,000 dividend nil rate band reduces the available basic and higher rate tax bands to the extent that it is used to relieve dividends received. 

The first £10,000 of the dividend falls within the higher rate threshold of £150,000. So, of this £10,000, £2,000 is taxable 0% and £8,000 is taxable at 32½%. The top £20,000 of dividend income falls above the higher rate threshold (£170,000 - £150,000 higher rate threshold) and is taxed at 38.1%. However, the maximum amount of deficiency relief is 25% (32 ½% - 7½%) against dividend income that is subject to higher rate tax (i.e. not additional rate tax).

A word of warning

For investors who pay income tax at the additional rate and who suffer a deficiency on the encashment of a single premium investment bond, it is important that they are made aware that the tax relief will be at the higher rate and not the additional rate, i.e. relief will be at 25% (divided upper rate) and/or 20% (higher rate) depending on whether it is dividend income or other income that suffers higher rate tax. 

In addition, relief will only be given against income that suffers tax at the higher rate, i.e. falls within the band £37,500 to £150,000 for tax year 2020/21.

Where there is no dividend income, extending the basic rate tax band by the amount of deductible deficiency relief will give the correct tax effect by restricting the benefit of the relief to the extra liability.

Where the deficiency relief is set against dividend income, the calculation is more complex but the relief will be limited to the liability on the dividend income at the difference between the upper and ordinary dividend rates.

In determining eligibility for deficiency relief and the amount of deficiency relief available (if any) it is also imperative to take due account of the commencement date of the policy, as different rules apply for pre-3 March 2004 policies, policies taken out from 3 March 2004 to 20 March 2012, and post 20 March 2012 policies, as set out above.