Technical Note 4 – A consequence of ticking the wrong box

Inadvertently tick the wrong box and pay over 1000% more tax than you need to.

Back in April I posted an article about the condensed Finance Bill, which saw a raft of Budget measures cut because of the early dissolution of Parliament for the June general election. One of the abandoned measures was a proposal to allow for investment bond tax to be recalculated. Today, I am going to explain why this would have been very welcome. I usually try and inject a little humour into these posts, but bond taxation is something of a dry subject and I fear I have failed in that regard. So apologies in advance if you struggle to make it to the bottom of this one. If you do find it too taxing – and please excuse the pun – I can tell you now that the impact of ticking the wrong box in the example described is paying over 1000% more income tax than is necessary!
First of all I need to talk about segmentation. An investment bond, in most cases, is a series of identical mini-policies, usually referred to as segments. There might be anything from 20 to 1000, but for this article I’m using examples based on 100 segments, if only for ease of illustration. An initial investment of £100,000 into a 100 segment bond would have segments of £1,000 each. And when the value has grown to £120,000 each segment would have a value of £1,200.
Investment bonds come with an annual withdrawal facility that allows you to withdraw up to 5% of the original amount each year with no immediate tax to pay. So, in this example of a £100,000 investment, up to £5,000 per year could be withdrawn without paying any tax at the point of withdrawal. This is known as a ‘partial surrender’; from each of the 100 segments £50 is partially surrendered and withdrawn.
This pattern can continue for 20 years, by which time the full value of the initial investment has been withdrawn and you have, in effect, had back your capital investment. If in one year nothing is withdrawn by this method, the allowance is carried over to the next year. So if nothing is withdrawn in year one, 10% could be withdrawn in year two, or if nothing is withdrawn in years one and two, 15% could be withdrawn in year three, and so on. It doesn’t have to be 5%, you could withdraw say 3%, which would last 33 years, or which would carry 2% over to the next year, allowing 7% to be withdrawn in that year. Or you could withdraw 2% every year for 50 years. The basic principle is that, provided the withdrawal does not exceed the accumulating 5% allowances, you can continue until the full 100% has been withdrawn. But remember, that is 100% of the original capital investment, not any growth.
That then is partial surrender. The second method of withdrawal is by full surrender. In a full segment surrender, what you withdraw is the full value of that segment, so it includes the original capital amount plus investment growth. You are in fact closing down that segment. Using the above example, if the bond has grown to say £120,000 and ten segments are surrendered, the proceeds would be ten amounts of £1,200 of which £1,000 is capital and £200 is investment growth, or gain. You would be left with a bond of 90 segments, each still with an initial invested amount of £1,000 and value of £1,200, and a total value therefore of £108,000.
So how are these two different withdrawal methods taxed? I’m going to start with the second, full surrender, scenario. The act of surrendering a segment is a Chargeable Event. When a segment is surrendered a calculation assesses how much of the surrendered value is capital and how much is growth, or gain, and you pay the relevant tax on the gain through your self-assessment or via an adjustment to your tax code. So you are fairly taxed on the profits you have made. Simple in concept but, as is often the case, rather complicated in practice but that’s beyond the scope of this piece. Phew!
A partial surrender is not tested for tax until the end of each policy year. At each anniversary of the launch date the amount of any partial withdrawals taken during that policy year is compared with the accumulated 5% allowances. Provided this is not exceeded, there is no Chargeable Event and therefore no tax to pay. But, if a larger partial withdrawal has been taken it is the difference that is taxed. Another example is needed. Let’s say that a withdrawal is taken in year two, and nothing had previously been withdrawn. The accumulated allowances (10%) mean that up to £10,000 could be withdrawn. Let’s say that £12,000 had been withdrawn during the year. This exceeds the allowances by £2,000 and therefore creates a Chargeable Event and £2,000 is the Chargeable Gain for tax. The amount of the actual growth is irrelevant.
Where problems arise is when large partial withdrawals are taken early on in the life of the bond when modest 5% allowances have accumulated. Another example will illustrate this.
An offshore bond of £100,000 is invested and the 5% allowances are not immediately used. In the second policy year the bond has grown in value to £108,000. The bondholder has an unexpected bill to pay so requests a withdrawal of £60,000; but, not appreciating the consequences, he ticks the box for a partial surrender not the box for full segment surrenders. The total of unused withdrawal allowances, this being the second policy year, is 10%, or £10,000. So the withdrawal of £60,000 exceeds this by £50,000. This is the Chargeable Gain and is the amount that is taxed, and as the bondholder is a higher rate tax payer (and this is an offshore bond) he would need to pay £20,000 in tax, even though the bond as a whole has only £8,000 of gain.
Had he ticked the right box on the withdrawal form, and the £60,000 was taken as full segment surrenders, the tax would have been just shy of £1,800, not £20,000. That hurts! The measure from the March 2017 Budget that was dropped as a result of the early election would have meant that a claim could have been made to HMRC for a ‘just and reasonable’ tax charge to apply – perhaps something of the order of £1,800!
We are led to understand that the dropped measures will be reintroduced in due course and we will keep an eye open for this. But, in the meantime, if you’re thinking of taking a withdrawal from an investment bond, may I urge you to speak to us first?

Philip Chandler APFS, CFPTM, Chartered MCSI

Chair of Aspinalls Technical and Investment Committee