You may have seen recent articles and statements on slight changes to the way HMRC deal with bond chargeable events. You may, or may not, have also heard about a tribunal ruling in April which HMRC lost (but are appealing) about the way in which an investor’s Personal Allowance is dealt with when surrendering a bond. This article covers how bond gains are assessed for tax and considers the Personal Allowance aspect.
Top slicing and surrenders
The development here is accounting for the Personal Savings Allowance (PSA) when dealing with surrenders of both Onshore and Offshore bonds. A significant number of clients are likely to have some or all of entitlement to a PSA. As a reminder, these rates for 2019/20 are:
- PSA is £1,000 if total income (which includes the gross bond gain) is below the higher rate tax threshold.
- PSA is £500 if total income (again including the gross bond gain) is above the higher rate tax threshold but below the additional rate threshold.
- No PSA if income (including gross bond gain) is above the additional rate threshold.
Scotland; the PSA is set and covers the whole of the UK and so for the purposes of entitlement to PSA, the tax bands used in England, Wales and Northern Ireland should be used (note, this could create a quirk where a Scottish Higher Rate taxpayer is entitled to the Basic Rate PSA).
Calculating the gain and tax payable is governed by a 5-step process. For the purposes of this calculation, we will assume an investor has an offshore bond valued at £80,000 which was bought for £60,000 five years ago. The client’s income (non-Scottish taxpayer) is £43,000.
Step 1: Calculate total income for the client, considering where the gain falls
Client total income: £43,000.
Bond gain: £20,000.
No savings income or dividend income.
PSA entitlement is the full £500 based on the above total income.
Step 2: Calculate the overall tax liability on the bond gain – Deduct a basic rate tax credit from the total gain (even with an offshore bond)
Bond gain: £20,000.
Amount in basic rate threshold: £7,000.
Tax at 20%: £1,400.
Amount in higher rate threshold: £13,000.
Tax at 40%: £5,200.
– Basic rate tax credit on full bond gain: £4,000.
– Tax of £6,600 minus credit of £4,000 = £2,600 liability.
Step 3: Calculate the annual equivalent (top-slice)
Full gain of £20,000.
Divided by 5 years.
Annual equivalent: £4,000.
Step 4: Calculate liability to tax on the annual equivalent. Note: use any PSA available here to reduce the gain. Reduce the tax figure by a basic rate tax credit previously used (even though this is an offshore bond)
Annual equivalent: £4,000.
Minus Higher rate PSA of £500 = £3,500.
Taxed at 20% = £700.
Minus basic rate credit of 20% on the whole slice = £800.
£700 – £800 = nil.
The above figure is the ‘relieved liability’ which will be negative if all of the slice is within the basic rate band (due to the PSA).
Step 5: Deduct the figure in ‘Step 4’ from ‘Step 2’ to find the top-slicing relief provided
£2,600 liability minus £0 = £2,600.
The overall tax charge of £6,600 can be relieved through top-slicing by £2,600. This gives a charge of £4,000.
The charge of £4,000 is also simply the result of applying basic rate tax to the whole gain of £20,000 which reflects the more traditional approach of noting that the top slice will be below the higher rate threshold and applying basic rate tax to the gain as a whole.
Where the ‘annual equivalent’ (the top slice) straddles the basic and higher rate bands, however, the steps here will ensure the correct process is used.
This can be shown by changing the client’s income to £48,000 per annum and running through the steps again:
Step 1: Calculate total income
Total Income (£48,000) plus bond gain (£20,000) = £68,000.
PSA is again, £500.
Step 2: Calculate total tax liability
Bond gain: £20,000
Amount in basic rate threshold: £2,000
Tax at 20%: £400
Amount in higher rate threshold: £18,000
Tax at 40%: £7,200
– Basic rate tax credit on full bond gain: £4,000
– Tax of £7,600 minus credit of £4,000 = £3,600 liability
Step 3: Calculate the annual equivalent – as before £4,000
Step 4: Calculate liability to tax on the annual equivalent
Annual equivalent: £4,000
Minus Higher rate PSA of £500 = £3,500
£2,000 within Basic $ate tax band charged at 20%: £400
£1,500 within Higher Rate tax band charge at 40% = £600
Minus basic rate credit of 20% on whole slice = £800
£1,000 – £800 = £200
Step 5: Deduct the figure in ‘Step 4’ from ‘Step 2’ to find the top slicing relief provided
£3,600 liability minus £200 = £3,200
The overall tax charge of £7,600 can be relieved through top-slicing by £3,200. This gives a charge of £4,400.
The Personal Savings Allowance provided relief against tax and the use of the remaining basic rate tax band provided relief against the whole gain being taxed at 40%.
If the above bond were Onshore, a basic rate tax credit of 20% on the whole gain (again £4,000) would be used at the very end to reduce the tax payable to £400.
The background of this is a bond surrender case in which HMRC lost a claim brought by an individual. The summary can be found here or here.
For years, individuals have been basing entitlement to Personal Allowance on the full gain on the bond (i.e. no accounting for top slicing for this test) and this has had the unwelcome effect of a large bond gain being untaxable in itself (due to top slicing) but causing other earned income to suffer tax.
The main implication of this is that we see income earned elsewhere now subject to Basic Rate tax. This has the effect of incurring an extra £2,500 in income tax in cases (based on 2019/20 Personal Allowance of £12,500).
The more damaging implication for clients will be where the loss of the Personal Allowance results in the top sliced gain crossing the (now reduced) threshold for higher rate tax.
With a full Personal Allowance, an individual can have an income of £50,000 (£12,500 Personal Allowance and £37,500 Basic Rate bracket) before Higher Rate tax is an issue.
If the Personal Allowance is lost through the gross bond gain being of sufficient value, the top sliced bond gain and all other income will need to be below £37,500 to avoid the double whammy of creating tax charges on the bond surrender.
As an example, if a bond that started at £200,000 was invested for 20 years and had a surrender value of £350,000, the gain would be £150,000. Top sliced, this would be £7,500.
If a client had earnings above £30,000 from elsewhere, the top slice would fall within the Higher Rate threshold and create a greater tax liability for the bond surrender. It would also result in £12,500 of those earnings elsewhere being taxed at 20% rather than a zero rate.
The ruling could, however, change this. If this is upheld, it could be a case that the top slice is added to earnings with the Personal Allowance still in place. In this scenario, £30,000 + £7,500 is well within the £50,000 limit to avoid Higher Rate tax. It would seem that the Personal Allowance remains lost for the purposes of taxing other income, but this would at least avoid two elements coming into tax at once.
Regardless of the development of the ruling, it still makes sense to keep a gross bond gain below £100,000 when added to other income. If a bond has more than one segment, it is relatively straightforward to surrender across segments to create the level of gain needed. With only a single segment bond, however, partial surrender (i.e. an excess event) is required and more care is needed here (as the chargeable gain is not necessarily related to economic performance of the investment).
Grant Callaghan – Head of Paraplanning