The impact of chargeable gains on the personal allowance

personal allowance

Encashment of single premium bond. Calculating income tax on the chargeable event gain. In calculating tax does the whole chargeable event gain or only the top-sliced gain count in determining whether the personal allowance is available?

It is well known that when calculating income tax on a chargeable event gain arising on a life policy (typically a single premium bond), top-slicing relief is available. This can be useful in cases where the whole chargeable event gain can take the policyholder into higher bands of income tax yet the top-sliced gain will keep the policyholder within the basic rate tax band. The common short-cut route to determine the reduced tax due to the relief is to add the top-sliced gain to the policyholder’s other taxable income, calculate the tax on that top-sliced gain and then multiply by the top-slicing factor to determine the tax on the whole gain. The underlying legislation provides a more complex basis of calculation (see below).

When calculating the tax liability on the top-sliced gain it has, for a long time, been accepted that the full chargeable event gain is still included in the calculations to determine whether the policyholder is entitled to a full income tax personal allowance. As is well known, the personal allowance is reduced by £1 for each £2 by which a person’s adjusted net income exceeds £100,000. So, in 2019/20 when the personal allowance is £12,500, entitlement to a personal allowance will be totally lost when adjusted net income is £125,000 or more.

So, in the past, if a policyholder encashed a single premium bond that he had owned for 10 years which gave rise to a chargeable event gain of £100,000, this full chargeable event gain would be taken into account in determining entitlement to the personal allowance, even though the top-sliced gain was only £10,000.

This approach has been found to be wrong in the recent First-tier Tax Tribunal case of Marina Silver v The Commission for HMRC (2019) UKFTT 0263 (TC). Here the Tribunal Judge, Barbara Mosedale, found that, both on the basis of the legislation in sections 530, 535 and 536 ITTOIA 2005 and Parliament’s presumed intention, only the top-sliced gain should be included as part of the client’s adjusted net income to determine whether the personal allowance is available when calculating top-slicing relief,. The top-sliced gain is known as the ‘annual equivalent’

The law

Top-slicing relief (which is given by section 26(1)(a) ITA 2007) works as follows:

a. Calculate the income tax liability on the chargeable event gain based on the policyholder’s adjusted net income taking account of the whole chargeable event gain under section 535(3) ITTOIA 2005. A deduction is then made for deemed basic rate tax paid on the tax on the chargeable event gain under a UK policy (section 530(1) ITTOIA 2005).
b. Calculate the income tax liability on the top-sliced chargeable event gain based on the policyholder’s adjusted net income taking account of the top-sliced chargeable event gain instead of the full (unreduced) chargeable event gain (section 536 ITTOIA 2005). A deduction is made for deemed basic rate tax paid on the top-sliced gain (the annual equivalent) under a UK policy (section 536(1) ITTOIA 2005).

This gives the tax on the annual equivalent. This is then multiplied by the number of years the policy has been in force to determine the total liability under section 536.

The top-slicing relief is the tax calculated in (a) less the tax calculated in (b).

The facts of the case

• Mrs Silver invested £55,000 into a life insurance bond in October 1993.
• Withdrawals of £46,616 were made from the bond over 21 years.
• Mrs Silver surrendered the bond in May 2015 for £119,105.
• The chargeable event certificate showed a gain of £110,721. Mrs Silver accepted that this was correct.
• In tax year 2015/16 (when the bond was encashed), Mrs Silver had other income of £31,101 on which a tax liability of £4,059 arose.
• The case reports that in 2015/16, the income tax personal allowance was £11,000 (whereas it was in fact £10,600 with the basic rate tax band of £31,785 giving a higher rate threshold of £42,385).

The question was whether in calculating the tax on the top-sliced gain in section 536, did she qualify for the full personal allowance or was her personal allowance abated because the full chargeable event gain was included for these purposes?

HMRC took the view that Mrs Silver lost all of her personal allowance in 2015/16 and so top-slicing relief did not help her.

Mrs Silver argued that this was a hypothetical calculation and as her hypothetical income was £36,373, section 35(2) ITA 2007 was not applicable as the hypothetical income did not exceed £100,000. Therefore, in this hypothetical scenario, Mrs Silver was entitled to a personal allowance.

Mr Silver represented his wife and the Tribunal preferred Mr Silver’s interpretation of the legislation. Section 536 clearly directed a hypothetical tax calculation to be carried out on certain assumptions. It would be wrong to carry out the calculation without using those assumptions consistently. Consistently applying the assumption that Mrs Silver’s income was only £36,373 meant that she was (in this hypothetical scenario) entitled to a personal allowance in this calculation.

Moreover, Parliament’s intent with top slicing relief was obviously to allow a person who has taken income over a number of years to have relief when provisions taxed them to the entire income in a single year, as here. The relief was intended to make the tax liability approximate to what it would have been had the income been taxed in the year it was actually received. So when carrying out the hypothetical tax calculation it made every kind of sense that the taxpayer should be treated as entitled to the reliefs that that hypothetical income would have entitled her to.

HMRC’s interpretation, on the other hand, is clearly inconsistent with Parliament’s presumed intent. HMRC’s interpretation would result in someone who was a basic rate taxpayer in the year of realisation and who would not have had any higher rate tax to pay on the withdrawals from the bond had it been taxable year by year, nevertheless having to pay higher rate tax on the entire gain. Top slicing relief would be denied to those it was intended to help.

So applying the legislation, both literally and in accordance with Parliament’s presumed intent, results in the steps set out in section 23 ITA 2007 being applied in full to the hypothetical situation postulated by s 536(1). And that means that, at Step 2 of the section 536 tax calculation, Mrs Silver, hypothetically, was entitled to a personal allowance.

The result of that is that her liability to tax on the annual equivalent was nil. This is because deducting her hypothetical personal allowance of £11,000 (actually £10,600) resulted in her total hypothetical income at the end of Stage 3 being £26,373.43. That is well below the basic rate limit of £32,000 (for tax year 2015/16). Therefore, the annual equivalent of £5,272.43 would have been taxable only at the basic rate; and as Mrs Silver was given credit for the basic rate, her relieved (ie hypothetical) liability would be £0.

The decision in this case is clearly contrary to HMRC’s previous views on how the legislation should work.

We do not know if they will appeal the decision. They may well be inclined to request a change of law in order to provide more certainty.

Those clients encashing bonds, who may be affected by a loss or reduction of personal allowance, should clearly bear this Tribunal decision in mind. It will, we believe, still be appropriate, where possible, to arrange encashments so that adjusted net income (taking account of full chargeable event gains) does not exceed £100,000.

Until we know how HMRC will react to this Tribunal decision, we suggest that clients who are encashing bonds whose tax position means they might be affected by this different interpretation should still plan on the basis that the full chargeable event gain counts for the purposes of calculating adjusted net income for the purposes of eligibility to the personal allowance. This may involve encashment planning so that the chargeable event gain is spread across different tax years.