A series of recent tax cases have focused on the “outrageously unfair tax results” that can arise on withdrawals from investment bonds. But bonds play a much greater role in saving and deferring tax. And the difference between an unfair tax result and tax saved is ongoing financial advice.
Advice is crucial
It’s easy for a prospective client to recognise the need for advice when they have a cheque in hand ready to invest. Faced with a variety of tax wrappers and a seemingly infinite number of funds, the choices can be daunting. Turning to an adviser who can make sense of it all is the logical solution.
Of course, ideally clients will understand the need for regularly reviewing their investments. But there will always be some with the view “it’s my money and why do I need to see an adviser to get at it?”
Arguably the need for advice is even greater when taking money out of investments. All the valuable investment advice provided at the outset can count for nothing if there are tax charges as a result of taking withdrawals in the wrong way. This is clearly highlighted in a string of recent court cases involving withdrawals from offshore bonds.
The wrong decision
These three cases all have striking similarities. All invested in an offshore bond. All withdrew money from their bond relatively soon after investment. None of them took advice on how to make the withdrawal.
The results were:
- Captain Cleghorn vs HMRC – chargeable gains totalling £58,700.
- C Shanthiratnam vs HMRC – chargeable gain of £42,500.
- J Lobler vs HMRC – chargeable gains totalling $1,296,055 (his offshore bond was denominated in US dollars).
They all challenged HMRC in the courts. Only Mr Shanthiratnam questioned HMRC’s interpretation of the chargeable gains legislation. The others questioned the fairness of the result. They had received, at best, only modest growth over the short period the money was invested and had withdrawn less than they had originally invested. But ultimately they all failed.
In each case the result would have been so different if they had received the right advice before making the withdrawals. How the money is taken from the bond can make a huge difference to the eventual tax position.
In the case of Joost Lobler, the bond provider’s surrender request form offered three options for withdrawing some of the funds invested in the bond.
1. Part surrender across all segments and funds.
2. Part surrender across all segments from specific funds.
3. Full surrender of individual segments.
Without advice Mr Lobler was playing Russian roulette and only one chamber was empty. Mr Lobler chose option 2 and was left with a tax bill of over half a million US dollars.
In each of the three cases, had the withdrawal been taken as full surrender of individual segments the tax due would have been a fraction of what was actually paid. But that doesn’t mean it will be the right choice for everyone and that is why advice is so important.
The right choice
Bonds are often structured as a series of identical policies or ‘segments’.
There are two options when withdrawing money from an investment bond, with hugely different tax results. It is important to understand the differences and to give clear instructions when requesting withdrawals. Choosing the wrong one or relying on a provider’s default option can prove disastrous.
1. With a partial surrender, money is taken equally across all the segments. A chargeable event will occur at the end of the policy year if the amount withdrawn exceeds the cumulative 5% allowance.
2. Surrender any number of segments in full. This will be an immediate chargeable event, with any gain relating directly to the investment growth.
The circumstances which lead to an unexpected tax bill are often similar. A relatively large amount of money is needed in the early years and the withdrawal is processed as a partial surrender. This leads to an ‘artificial’ gain that bears no relation to the actual investment performance of the bond.
Bonds and tax planning
It’s easy to get carried away by the tax charges suffered by the unwary and overlook the positive role offshore bonds can play in tax planning. Offshore bonds offer great flexibility when it comes to tax management as they enjoy unique properties and reliefs that are not always available in other forms of investment.
They offer an opportunity to time when tax charges arise and to switch who will be taxable. But this potential is only truly maximised with professional advice.
The 5% cumulative allowance that caused so much pain for these individuals provides many more with relief in the form of a regular stream of tax-deferred withdrawals.
Tax deferral can be extremely attractive to those who pay tax at the higher rates. This is especially true should they expect to become basic or non-taxpayers in the future, perhaps in retirement.
Keeping within the allowed 5% can supplement existing income without generating an immediate tax charge or tipping income over those key tax thresholds. The age allowance, personal allowance and child benefit are all withdrawn once income exceeds certain thresholds. Replacing taxable income with 5% withdrawals can maintain these allowances and benefits without reducing the overall household ‘income’.
Assigning the bond or individual segments will shift the taxation on to the new policy owner. This can be a valuable planning opportunity for spouses and civil partners especially if the new owner pays tax at a lower rate. And for trustees, assigning to a beneficiary can avoid tax at the trust rate.
Other retirement income
For members of defined benefits (DB) schemes, offshore bonds can also act as a ‘bridging pension’, allowing early retirement without benefits being actuarially reduced.
A DB scheme member can cease working before their normal retirement date and defer taking benefits.
Withdrawals can be taken from the bond to provide income until their scheme pension commences. If they have no other source of income, any gain which arises as a result of the withdrawals may escape tax if they fall within their available personal allowance.
Drawdown users can adopt a decumulation strategy involving both pension income and offshore bond withdrawals that can be exceptionally tax efficient. Both full and part surrenders can be taken to replace pension income in certain tax years. Timing this to coincide with tax years when little or no drawdown income is taken can mean that little or no tax is paid on the chargeable gains.
Chargeable gains arising from part surrenders in this way may also be deducted when calculating the gain on final surrender. This could be the case even where no tax was paid on the part surrender as drawdown income was reduced to zero and the chargeable gain was within the personal allowance.
Deferring designating funds for drawdown by relying on bond withdrawals for retirement income can also improve the pension death benefits that can be paid to loved ones. Uncrystallised funds can be paid as a lump sum on death prior to age 75 without suffering the 55% tax charge.
Accidents can happen
Even with financial advice, mistakes do happen. In Downward vs HMRC, Roger Downward contacted his adviser to make two separate withdrawals. Mr Downward’s IFA completed the surrender request form for the first withdrawal on his behalf and asked Mr Downward to sign it. Unfortunately, it left Mr Downward with a £7,886 tax bill.
The judge confirmed the court was powerless to change the basis on which the withdrawal was taken even if it was a simple error and not what was intended.
They echoed comments in the Lobler case. “It is more repugnant to common fairness to extract tax in these circumstances than to permit other taxpayers to avoid tax on undoubted income. But with heavy hearts we dismiss the appeal.”
A quick fix
While the courts may not be able to overturn mistakes, advisers can. There is a relatively small window to take corrective action but it must be done swiftly.
Where a partial surrender results in a large gain, this can be wiped out by surrendering the whole policy before the end of the policy year. If the policy anniversary has already passed, the situation can still be put right if the full surrender can be made in the same tax year as the partial surrender gain.
These actions are not ideal but they may at least solve the immediate tax problem. In some circumstances, it may be possible to make a pension contribution within the same tax year to reduce the amount of the tax charge.
If these opportunities are missed, the only other relief that can be hoped for is in the form of corresponding deficiency relief.
In short, where a loss arises on full surrender and previous part surrenders have resulted in a chargeable gain, the investor may be able to reduce any higher-rate income tax liability in the year of surrender.
While these remedies may be a useful way of reducing the pain, prevention is always better than cure.
