Consultation on taxation of life insurance policies

Following the Government’s announcement in the Budget that a consultation would take place on the taxation of life insurance policies to prevent excess tax charges arising, the consultation document has been issued.

The problem with the current rules

At present a policyholder can surrender part of the policy for twenty years and suffer no immediate tax charge provided the surrenders do not exceed 5% of the original policy premium. Instead any tax due is deferred until the policy comes to an end. Any withdrawals in excess of the 5% are charged to tax at the next policy anniversary date. These rules are easily understandable and, as the consultation document states, popular with policyholders.

However, the problem with the current rules is that they can lead to an excess charge to tax if a large withdrawal is made in the first years that the policy is held. This is because the gain then chargeable to tax is calculated by reference to the amount withdrawn in excess of the 5% deferred allowance and this is likely to have no reference to the actual gain on the policy at that time. For example, if an individual paid a single premium of £50,000 for a policy, a withdrawal of £20,000 a year after the policy was taken out would lead to an assessable gain of £17,500 which is highly likely to be in excess of the actual economic gain on the policy.

Options for change

In considering the options for change the Government states that it wishes to tackle this problem but retain a tax deferred allowance. It also wishes to make the changes as simple and cost-effective as possible for the financial services industry to process.

They put forward three options:

1. Retain the current 5% allowance but, when withdrawals are made in excess of this allowance, in calculating the gain then arising deduct a proportionate amount of the premium from the amount withdrawn.
2. Change the current cumulative 5% tax deferred allowance to a lifetime 100% deferred allowance. Once all premiums paid have been withdrawn, withdrawals would be taxed in full so the assessable gain would equal the economic gain.
3. The third option is to calculate the gains as at present but defer any gains above a specified amount of the premium (the consultation document suggests 3%) until maturity or full surrender of the policy when they would be taxed.

Responses

The Government has requested responses to the consultation which can be found here by 13 July 2016.

For more information, please call us on 0800 915 7732.