Unexpected gains on withdrawals

Taking withdrawals from an investment bond can sometimes lead to larger gains than anticipated and an unexpected tax bill. The chargeable event rules can mean that the chargeable gain on a withdrawal bears no resemblance to the actual investment return on the policy.

Most modern investment bonds are multi-segmented. This means that each policy includes a series of identical mini policies. There are broadly two ways in which withdrawals can be made and the calculation of the gain differs greatly.

1. Surrender of full segments - this is where the actual investment gain on each segment surrendered is calculated.
2. Encashment across all segments - known as part surrenders, the gain is the excess over the cumulative 5% allowance. This can lead to a gain being much greater than the actual investment return. Especially if the withdrawal takes place in the early years of the policy.

Reducing the tax when an unexpected gain has been created

Fully surrendering the bond can reduce the chargeable gain where a part surrender has created an unrealistic gain. But to reduce a gain in this way the bond must be surrendered either before the end of the policy year or before the end of the tax year.

Surrender before policy year end

Gains on part surrenders arise when the amount withdrawn in the policy year is greater than the cumulative 5% allowance. If someone withdraws more than their 5% allowance the gain doesn't arise until the end of the policy year, when the total withdrawals for the year are known.

If the policy is fully surrendered before the end of the policy year all withdrawals including those in the final policy year are added back in to the final surrender chargeable event calculation. This will prevent the artificial gain being taxed at the end of the policy year and only the actual investment return will be taxed.

Surrender before the tax year end

If the policy anniversary has already passed, the situation can still be rectified if the bond is fully surrendered in the same tax year as the as the partial surrender gain. The full surrender calculation will sweep up the part surrender assessed in the same tax year and any chargeable event certificate issued for the part surrender can be ignored.

This means if the policy holder receives a chargeable event certificate for part surrender they have a window until the end of the tax year to surrender the policy.

Surrender the policy in a subsequent tax year - deficiency relief

If a part surrender gain arises in a tax year, once the tax year end has passed the opportunity to wipe out this gain with a full surrender will be lost and the chargeable gain will become taxable. However, if there is a loss when the bond is eventually surrendered, a higher rate tax payer might be entitled to obtain some tax relief against higher rate tax.  A person who is resident in Scotland  may also be able to obtain some tax relief against Scottish advanced rate of tax.

The gain calculation on fully surrender is:

• (surrender value + withdrawals) - (amount invested + previous gains)

So where there has been a large gain on part surrender this can result in a loss when the policy is full surrendered.

There is no relief for losses incurred as a result of investment performance. It's not possible to offset such a loss against a gain on another bond, or against any other income.

However, there is a limited form of loss relief for investment bonds where there is a loss on full surrender as a consequence of an earlier part surrender.

Corresponding deficiency relief is available to anyone who has a higher rate  (or advanced rate if living in Scotland),   income tax tax liability on their other income. No relief is given on income which is subject to tax at basic or additional rates.

The amount of relief is capped at the lower of:

• the amount of the previous excess gain(s) on the bond
• the amount of the loss

HMRC recalculation of wholly disproportionate gains

An application can be made to HMRC to have gains which are 'wholly disproportionate' recalculated. This situation will generally only arise where someone has taken withdrawals that are far in excess of their 5% tax deferred allowance.

Applications must be made in writing within four tax years of the gain arising.

HMRC will determine whether the gain is wholly disproportionate and will consider:

• the economic gain on the rights surrendered or assigned
• the amount of the premiums paid under the policy
• the amount of tax that would be chargeable if the gain was not recalculated

HMRC will recalculate the gain if they believe the gain, in context of the premiums paid, will result in excessive or disproportionately large tax charge. The recalculation will be done on just and reasonable basis to determine as closely as possible the true economical gain. There is no right of appeal on the decision or the calculation method.

If a gain is recalculated the policyholder must report the corrected gain on their tax return. They must maintain sufficient records to calculate future gains. The provider will not be notified of the recalculation and future chargeable events certificates will based on the position before any recalculation.

Paying a pension contribution to reduce tax

Making a pension contribution can reduce the tax payable on bond gains. This will apply to equally to gains from full or part surrenders.

A contribution to a personal pension (including SIPP) has the effect of extending the tax bands by the amount of the gross contribution.

If an individual has a chargeable gain from an onshore investment bond, income tax is only payable if the top sliced gain exceeds the higher rate tax threshold. The payment of a pension contribution in the same tax year can ensure that the top sliced gain remains within the extended basic rate band and therefore escapes any liability to higher rate tax.

A contribution made to an occupational pension scheme which operates a net pay arrangement will have a similar effect because, although the contribution won't extend the basic rate tax band, the contribution will reduce the individual's taxable income.

Unlike a pension contribution a gift aid contribution won't extend the basic rate band for top-slicing purposes.

Prevention

Clearly it is better to prevent large unexpected gains from arising by taking withdrawals in the most efficient way possible. For more information on tax efficient withdrawals see our Practical Guide - How to take cash tax efficiently from an offshore bond.