One helpful feature of the taxation of investment bonds is the ability for the client to take partial withdrawals each year of up to 5% of the amount invested, for at least 20 years, without triggering an immediate tax liability.
Used properly, this facility can give access to regular or one-off payments with minimum admin, as such payments do not have to be declared on the policyholder’s self-assessment tax return.
Used improperly, however, this simplification measure can create wholly artificial gains that do not exist in the real world. This is illustrated in the following case study.
George took out an international investment bond for £100,000 on 1 July 2014.
On 1 September 2015 the value had increased to £110,000 and George decided he would like to withdraw £90,000, leaving £20,000 invested. The chargeable event triggered by this withdrawal occurred at the end of the policy year, on 30 June 2016, which meant George had a total tax-deferred allowance of 2 x 5% x £100,000 = £10,000.
Since he had withdrawn more than this, the excess – £80,000 – was a chargeable gain assessable to income tax at his marginal rate, even though the value of the investment bond had actually grown by much less than this. Additionally, as the gain plus his other income exceeded £100,000 by more than £22,000, his entitlement to the £11,000 personal allowance was reduced to zero.
Of course, George could have avoided this result by taking full encashments from some of the bond segments. However, he was not aware of this and simply requested a partial withdrawal without the benefit of professional advice.
At Budget 2016, the Government announced its intention to change the tax rules so that disproportionate gains cannot arise in the future and in April 2016 HM Revenue & Customs issued a consultation document inviting views on three options for change. These are briefly described below.
The 5% allowance would be retained but, if a partial withdrawal exceeded the allowance, the economic gain actually realised would be calculated. This would utilise the formula A/(A+B) to calculate how much of the premium should be deducted from the withdrawal, where A is the amount withdrawn and B is the bond value after the withdrawal. This will be a familiar approach to anyone dealing with capital gains calculations for a partial withdrawal from an investment subject to capital gains tax.
Had this option been in force at the time of George’s £90,000 withdrawal the gain would have been:
£90,000 – (£100,000 x £90,000/(£90,000 + £20,000))
= £90,000 – £81,818
This would be assessable at George’s marginal rate of income tax and, if the gain plus his other income did not exceed £100,000, he would retain the full benefit of his £11,000 personal allowance. If George made any future withdrawal that exceeded the 5 per cent allowance, the A/(A+B) formula would again be used but based on a premium of £100,000 – £81,818 = £18,182.
The 5% allowance would be replaced by a 100 per cent allowance, which would be available throughout the lifetime of the investment bond. In other words, policyholders would be able to make partial withdrawals of whatever amounts they wanted, whenever they wanted, and no chargeable gain would arise until the total amount withdrawn from the bond exceeded the total amount paid into the bond.
Had this option been in force at the time of George’s £90,000 withdrawal, there would have been no chargeable gain and no immediate tax liability.
The 5% allowance would be retained and any partial withdrawals that exceeded it would result in a chargeable gain equal to the excess but subject to a pre-determined ceiling. The consultation document suggests this ceiling might be, say, 3 per cent each year, but it could be higher or lower than this if option three is implemented. Any partial withdrawal that exceeded the 5 per cent allowance plus the ceiling would result in a chargeable gain that would be deferred until the next chargeable event.
Had this option been in force at the time of George’s £90,000 withdrawal, there would have been an £80,000 chargeable gain as under the current tax rules. However, since the gain exceeds the 2 x 5 per cent allowance plus the 2 x 3 per cent ceiling, the immediate gain would be limited to 2 x 3 per cent x £100,000 = £6,000.
The remaining £74,000 of gain would then be deferred to be brought into account at the next chargeable event.
Each of the options will indeed achieve the main objective of preventing large artificial chargeable gains, while preserving the benefits of the existing 5% tax-deferred allowance. Some, however, are easier to understand and administer than others. The consultation, which has now closed, made no reference to the application of any of the options to existing investment bonds. How these will be catered for will hopefully be addressed in the Government’s response to representations received.