Techzone

A recent First Tier Tribunal (FTT) tax decision has called into question how tax relief available on bond surrenders is calculated. This decision may mean a smaller tax bill for some clients, particularly those whose total income is normally less than £100,000.

The FTT decision takes a different interpretation of how the legislation is applied when calculating top slicing relief. The FTT agreed with the taxpayer argument that the ‘averaging’ principle that underpins top slicing relief should be applied when determining how much income tax personal allowance (PA) can be used in the calculation.

So instead of the full gain being added to total income to determine any tapering reduction in the amount of PA used in the top slicing part of the calculation, the average gain is added. This may result in more top slicing relief where the full gain plus other income would otherwise mean a loss or reduction in the PA.

In a separate but related issue to this challenge, HMRC recently updated their guidance to clarify how both the personal savings allowance (PSA) and the £5,000 starting rate band for savings (SRB) can be used when calculating top slicing relief.

What is top slicing relief?

The increase in value of an investment bond is not taxed on an annual basis and instead is deferred until there's a taxable event which results in a chargeable gain - for example, on surrender of the bond or on death of the last life assured.

This means investment returns accrued over many years are taxed in a single tax year. To overcome this spike in taxable income, a relief known as ‘top slicing’ aims to put the taxpayer back into the position they would have been in if taxed annually over the investment period. This is achieved by calculating a figure that reduces the total tax bill.

The amount of relief available is broadly the difference between the tax payable on the full gain and the tax that would have been due on the average gain over the investment period.

Many advisers may be familiar with a shorthand method of arriving at the tax payable on a bond gain that doesn’t require the longer method of calculating the amount of ‘top slicing relief’. Instead, they can simply divide the gain by the relevant number of policy years held and add it to all other income to determine how much additional tax (if any) would be payable on the bond gain. This is then multiplied by the number of years held. But this will no longer work in certain circumstances.

When can the short hand method be used?

The FTT ruling and the clarification of how the PSA and SRB is to be applied will mean that there are situations where the short hand method of top slicing does not give an accurate assessment of the tax due.

It can still be used as a rule of thumb to establish if there is any tax to pay at higher or additional rates as a result of surrendering a bond. However, top slicing relief is actually given as a deduction from tax payable rather than reducing the amount of gain subject to tax.

With the availability of the PSA and the SRB, there may be additional relief available which would not be accounted for under the shorthand method. Following the full calculation, as set out in the legislation, will always give the correct tax due. We will be writing a separate article and updating our guides in these areas soon.

The case

The recent case centred around the availability of the personal allowance when calculating the tax on the averaged gain.

In 2015/16, Mrs Silver surrendered an onshore bond that she had held for 21 years and realised a gain of £110,721. When added to her other income of £31,101, it meant her personal allowance had been tapered to zero, as her adjusted net income was significantly in excess of £100,000.

HMRC believe that if there's no personal allowance available in the year of assessment, then there's also no personal allowance to determine the tax on the averaged gain.

With no personal allowance, Mrs Silver’s averaged gain of £5,272 would mostly fall in the higher rate band, with only £684 of the basic rate band (£31,785 2015/16) remaining.

However, the Judge ruled that the notional tax on the averaged gain will benefit from a full personal allowance as the averaged gain, when added to her income, was well below £100,000. With a full personal allowance available, all of the averaged gain would fall within the basic rate band and, therefore, there would be no higher rate tax due. The result in this case meant Mrs Silver saved more than £20,000 in tax.

Summary

It will be interesting to see what happens next. A First Tier Tribunal decision doesn’t set a legal precedent, but it may influence future tax cases.

HMRC may challenge the Judge’s decision. If unsuccessful, HMRC would seemingly have two choices:

1. Accept the decision and update the guidance to reflect the ruling. This would give clarity to those in the process of surrendering their bond, but could open the way for those who may have overpaid in the past to make a reclaim.
2. Change the legislation so that it's explicit that the availability of the personal allowance for top slicing relief is based on the full gain, not the averaged gain in the year of assessment. But this may not be enough to prevent reclaims for those cases wrongly assessed before the legislation is enacted.

In the meantime, you might decide it best for your clients to pay the tax according to the HMRC’s interpretation of the legislation and subsequently make a reclaim when further clarity is received. This would at least avoid unnecessary penalties for underpayment.