The name is Bond, Insurance Bond

Gains on insurance bonds are taxed in a somewhat unintuitive way. Gains are charged to income tax and the amount taxed is not necessarily related to the economic gain of the bond...

The issue

Up to 5% of the amount invested in the bond can be withdrawn each year, for 20 years, without triggering an immediate tax charge. The 5% allowance is cumulative, and any unused part can be carried forward and used in future years.

However, there are some unexpected results if proceeds are extracted in the "wrong way".

Example (ignoring top-slicing relief)

James invests a £1,000,000 premium in an insurance bond. This is held as 1,000 segments of £1,000 premium.

Four years later, it has grown by £200,000 and James partially encashes £600,000 across all the segments of the bond. 20% of his original premium (£200,000) is available to be removed tax-free as he has accumulated four years of 5% allowances over the lifetime of the bond. However, the remaining £400,000 of the proceeds are chargeable to income tax.

As James is an additional rate taxpayer, this withdrawal has cost him £180,000.

This seems a little unfair. After all, the bond has only grown by £200,000 and James is being taxed on £400,000 on encashing only half of it.

The position would be even worse if the bond had made a loss. Essentially, James could be taxed on a large gain when the economic reality is that he has lost money.

Alternative encashments

If, instead, James had encashed one or more whole "segments" of the bond, the tax is calculated differently. In this case, it is only the economic gain in each segment that is taxable.

In the above example, James’s bond had 1,000 segments, so each segment would have a gain of £200. Encashing 500 segments to realise £600,000 would only realise a gain of £100,000 (500 x £200), on which he would suffer tax of £45,000 – a difference of £135,000 in tax.

Recalculation of gains

If James had not sought advice before encashing his insurance bond, then he might end up in a similar scenario to above.

However, all is not lost.

Following on from a court case of Joost Lobler, it is possible to apply to HMRC to recalculate a gain that is “wholly disproportionate”. Wholly disproportionate is key here. It is not possible to recalculate a gain for only a small benefit. Their view is this is more likely to apply during the early years of a policy, as in James’s example.

If HMRC agree, they will recalculate on a “just and reasonable” basis. This could be under the part disposal method:

Part surrender amount: £600,000

Less: proportion of premium relevant to encashment: £(500,000)*

Actual economic gain: £100,000

*being 1,000,000 x 600,000/1,200,000

In our case, this is the same as would have applied in the full segment encashment method, simply because we kept our calculation simple, with full segment encashments realising the full value. This wouldn’t always be the case.

Hamilton Rose's view

Bonds are a specialised and complex area. I think it’s safe to say that no-one really enjoys dealing with the tax issues on bonds! However, it is essential that professional advice is sought before making encashments as the results can vary, depending upon how money is taken.

HMRC have indicated in their manuals that they have set a high threshold for any recalculation being made, and it will only apply in limited circumstances, even if the "wrong method" gives rise to a hefty tax charge.