Techzone

For many years advisers have been able to make a quick assessment of the likely tax payable on a bond surrender. The so called 'shorthand' method provided an easy way of estimating the potential tax on a bond after 'top slicing relief'.

However, HMRC guidance on how top slicing relief should be calculated has changed. As a result, the shorthand method may not be as dependable as it has been in the past. So what do these changes mean for advice?

What has changed?

The rules for top slicing relief haven't actually changed. The legislation remains the same with the relief being the difference between the tax payable on the full gain and the tax on the averaged gains.

However, HMRC guidance has been updated to allow for the personal savings allowance (PSA) and the starting rate band for savings (SRB) to be included when determining the amount of relief available. This was welcomed as there had been a certain level of uncertainty in the industry as to the correct way of applying them in the calculation.

What is top slicing relief?

Gains on investment bonds are not charged to tax until there's a chargeable event, such as the surrender of the bond or the death of the last life assured.

The tax deferral feature of bonds can be a huge advantage in financial planning. But taxing the gain in the year money is withdrawn could lead to more of it landing in higher rate tax bands. Had those gains been taxed on an annual basis, the tax liability would have been spread more evenly. And this is exactly what top slicing relief attempts to put right.

Relief is given as an amount to be deducted from the final tax bill and is broadly based on the difference between the full gain and the average gain.

It's important to note that top slicing relief reduces the tax that would otherwise be paid on the full gain. It doesn't reduce the calculation of the gain itself.

Calculating the amount of relief

The HMRC method of calculating the relief is really not as scary as it may at first seem, and is the same for both offshore and onshore bonds. A notional tax calculation is done with both the full gain and the average gain, with the difference being the amount of top slicing relief.

The steps in the calculation are as follows:

• Calculate unused Allowances. Before calculating the relief, you need to work out how much of the personal allowance (PA), starting rate band for savings (SRBS) and the personal savings allowance (PSA) are unused.
• Calculate the total liability on full bond gain. Work out the notional tax on the full bond as if it's the top part of total income, deducting the unused allowances as appropriate. There is also another figure to deduct. This is known as the 'tax treated as paid' (TTAP) figure and will normally be 20% of the gain (but may be reduced if any unused PA is set against the bond gain). This is because the main purpose of top slice relief is to limit the amount of higher rates of tax payable in the year of encashment.
• Calculate the relieved liability on the average gain. Do exactly the same calculation as above but using the average gain. This time the TTAP will normally be 20% of the average gain. This is then multiplied by the number of years over which the gain was averaged. The resulting figure is known as the 'relieved liability'.
• Calculate top slice relief (TSR). Simply deduct the relieved liability from the total liability.

Having calculated TSR, this will reduce the tax due on the main tax computation. Remember, the main tax computation will have all income taxed in the normal order of income, which means that gains on offshore bonds will no longer be the top part of income, but will come before dividends and onshore bond gains.

You can see an example of this calculation in action in our Technical Guide 'Taxation of bonds'.

Should I still be using the shorthand method?

Many advisers will be familiar with the 'shorthand method' for top slicing. This method involved calculating the additional tax payable on the amount of the averaged gain which falls within higher rate and has served advisers well for many years.

However, this method will now not always give a true and accurate picture of the tax payable, largely due to the impact of the unused personal savings allowance.

In fact, it has never provided the true answer where a client's income included offshore bond gains and dividends, or a mix of onshore and offshore bond gains in the same tax year.

Apart from these circumstances, the shorthand method will, however, continue to give the correct result but only if the savings rate band and PSA are not available or have already been used by other income.

When is relief available?

Top slicing relief can only be claimed on bond gains where some of the gain is subject to tax at higher or additional rate.

Previously, it was generally accepted that no relief was available if the bond holder was already a higher rate tax payer and the gain did not push them into the additional rate. In such cases the full gain would have been subject to tax at 40%.

However, some higher rate taxpayers may now receive top slicing relief if they have unused personal savings allowance (PSA) or savings rate band available (SRSB).

Conversely, clients who remain below the higher rate threshold when the sliced gain has been added, and who also have unused allowances (PA, PSA or SRSB), may find that the shorthand method underestimates the amount of tax due.

Could more change be on the way?

A recent First Tier Tax Tribunal Case (Silver v HMRC) has called into question how top slicing relief is calculated for those whose gain when added to income means they lose their personal allowance.

HMRC's current practice is to determine the availability of allowances based on the total income including the full gain (not the 'average gain'). This is for both the tax on the full gain and the averaged gain.

However, the decision in this case was that a full personal allowance was available for calculating the tax on the averaged gain; as the averaged gain when added to income was below £100,000.

HMRC are expected to appeal this decision. So advisers should continue to calculate relief using HMRCs current practice and await the outcome of any appeal.