REV BN 24: Life Insurance - Policyholder Taxation
1. This Budget Note deals with proposed revisions in Finance Bill 2003 to the tax rules affecting life insurance investments. These changes will end four anomalies that lead to inappropriate tax charges and close three tax loopholes that allow avoidance of tax.
2. Changes are being made:
- to remove the tax charge on certain group life policies;
- to correct anomalies to remove or reduce the tax payable on policies held by charitable trusts, qualifying policies insuring against an exceptional risk of disability and annuity contracts sold by friendly societies;
- to close two loopholes in connection with policies held on trusts; and
- to prevent misuse of the `5% tax-deferral rule' on withdrawals from policies.
REMOVING THE TAX CHARGE ON CERTAIN GROUP LIFE POLICIES
Who is likely to be affected?
3. Those who may benefit from these changes include:
- members of trade unions, professional associations and partnerships that hold group life policies;
- credit unions; and
- life insurers.
General description of the measure
4. The proposal will ensure that there will be no tax charge on death benefits paid under group life protection policies so long as they meet certain conditions.
Operative date
5. The measure will take effect on 9 April 2003. It removes retrospectively all tax charges which arose before 9 April 2003 as a result of gains on group policies. It gives insurers and policyholders until 5 April 2004 to vary existing policies that do not meet all of the conditions in order to bring them within the exemption as from 9 April 2003.
Current law and proposed revisions
6. A group life policy is one that insures the lives of a group of individuals and pays benefits on each death. Multiple payments of death benefit can lead to unintended charges to tax on either the insured members or the policyholder.
7. The retrospective relief that this measure offers will apply to all group life policies whether or not they meet the conditions necessary for exemption in the future. This will wipe out the tax charge on all past gains. Insurers have reported very few, if any, such gains. Any person who has paid tax on a gain arising in connection with a benefit received under a group life policy may be entitled to a repayment of that tax. A person who considers that he or she has paid income tax should contact the tax office dealing with their tax affairs in the first instance.
8. This proposed revision will remove the tax charge that could arise on or after today when benefits are paid on second and subsequent deaths, provided that the policies in question meet certain conditions. One of the conditions is that the only benefits which may be paid under the policy are death benefits, so policies which have a surrender or maturity value do not fall within this measure. The conditions are necessary to prevent such products being used for avoidance.
9. Any group life policy in existence at 9 April 2003, which does not meet the conditions, may still benefit immediately from the new measure provided its terms are changed to meet all of the conditions by 5 April 2004. This will apply only if no benefits under the policy other than death or disability benefits are paid out from and including 9 April 2003. Then the policy will be treated as having met the conditions from 9 April 2003, ensuring that any death or disability benefits which are paid between 9 April 2003 and the date of change are not taxed.
GAINS FROM POLICIES HELD ON A CHARITABLE TRUST
Who is likely to be affected?
10. The change will benefit trustees of charitable trusts and the donors to charitable trusts.
General description of the measure
11. The measure will ensure that trustees of charitable trusts do not have to pay any tax on most UK policies and will reduce their tax charge on gains from foreign policies to tax at the basic rate.
Operative date
12. The measure takes effect on 9 April 2003.
Current law and proposed revisions
13. Most gains made on policies held by trustees of charitable trusts are strictly taxable on the donors to the charity, who are entitled to reclaim any tax they pay from the charity. It is extremely onerous for donors, charities and the Inland Revenue to administer this correctly and may lead to the charity having to bear the equivalent of higher rate tax. Where exceptionally the trustees of the charity are taxable on the gain, they are liable at the rate applicable to trusts (34%).
14. The proposed revision to the law will have the effect of switching the tax charge on any gain on a life policy from the donor to the trustees of charitable trusts. At the same time, it will reduce the tax chargeable on a gain to tax at the basic rate. As most gains from UK policies are treated as having already suffered basic rate tax the charity will normally have no tax to pay. This brings the treatment of life insurance gains closer to the treatment of the other investment income of charities.
GAINS FROM POLICIES HELD ON A NON-CHARITABLE TRUST
Who is likely to be affected?
15. Trustees of certain will trusts, and trustees of a small number of trusts created either by other trusts or by non-corporate foreign institutions.
General description of the measure
16. Loans taken by trustees in connection with life insurance investments, where the trustees are liable for tax on any gains, will be taxed as if they have made part surrenders of the policy. Where a policy is held on trust and no other person is liable for tax on gains arising from it, the trustees will be liable to tax at the rate applicable to trusts (34%). This measure brings the tax treatment of loans taken by trustees into line with the tax treatment of other policyholders.
Operative date
17. The measure takes effect on 9 April 2003.
Current law and proposed revisions
18. Where a loan is made by or by arrangement with an insurer and either an individual or a company is taxable on any gain arising in connection with a life insurance investment issued by the insurer, the loan is treated as a part surrender made by that individual or company. This is not the case where the trustees are taxable, for example, because the person who created the trust is dead.
19. The proposed revision ensures that a loan made in the same circumstances will also be treated as a part surrender when trustees are taxable on any gains.
20. In a few cases there may be some doubt about who is taxable on a gain made by a trust when the source of the funds settled on the trust is another trust.
21. The proposed measure will ensure that a gain on a policy held on trusts will be taxable on the trustees if not taxable on any other person.
QUALIFYING POLICIES CHARGING FOR AN EXCEPTIONAL RISK OF DISABILITY
Who is likely to be affected?
22. The change will benefit holders of qualifying policies who pay or have paid more for their life insurance cover because of an exceptional risk of disability.
General description of the measure
23. A policy will not lose its qualifying status when the insurer removes either a charge on the policy proceeds or a premium loading that was imposed because the insured person has an exceptional risk of suffering a disability or critical illness.
Operative date
24. This relieving provision will be fully retrospective.
Current law and proposed revisions
25. When the terms of a qualifying life insurance policy are improved because the insurer discovers after it has sold the policy that it is not appropriate to charge for an exceptional risk of disability, the change in the policy's terms can cause it to lose its qualifying status. This has never been the case where there is a charge for an exceptional risk of death.
26. The proposed revision ensures that any extra cost, or charge on the disability benefits payable under the policy, is disregarded when determining whether a life insurance policy is a qualifying policy. This means that removing the cost or charge will not cause any policy to lose its qualifying status.
ANNUITY CONTRACTS ISSUED BY FRIENDLY SOCIETIES
Who is likely to be affected?
27. Holders of certain annuity contracts issued by friendly societies.
General description of the measure
28. The measure will ensure that the chargeable event gain rules apply consistently to annuities whether they are sold by friendly societies or other insurers. In particular it will put it beyond doubt that the chargeable event gain rules do not apply to annuities sold by friendly societies which are purchased under or for the purposes of an approved pension scheme or contract.
Operative date
29. The measure takes effect on 9 April 2003.
Current law and proposed revisions
30. The chargeable events rules apply to certain annuity contracts. The rules at the moment are inconsistent and apply to some annuities sold by friendly societies that would not be covered if sold by other insurers.
31. The proposed revision will make the rules consistent and will put it beyond doubt that annuities sold by friendly societies which are purchased under or for the purposes of an approved pension scheme or contract do not give rise to chargeable event gains.
MATURITY OPTIONS
Who is likely to be affected?
32. Holders of life insurance policies who exercise an option to re-invest the proceeds of a maturing policy in a new policy, instead of opting to extend the existing policy.
General description of the measure
33. This measure ends the rule allowing an investor to re-invest the policy proceeds into a new policy without the gain on maturity being immediately taxable.
Operative date
34. The measure will apply, subject to transitional provisions, to policies which mature on or after 9 April 2003.
Current law and proposed revisions
35. Under the current law, there is no tax charge when a policy matures if the policyholder exercises an option to re-invest all the proceeds of the maturing policy in a new policy with the same insurer.
36. Some policyholders have used this rule in conjunction with the 5% tax-deferral rule to defer tax on the gain at maturity even when they have made part withdrawals before they exercise the option. It was never the intention of the current legislation to allow this. (The 5% tax deferral rule allows a policyholder to withdraw up to 5% of the premiums paid, each year for 20 years without triggering an immediate tax charge.)
37. The proposed revision repeals the rule that allows the gain arising on the maturity of one policy to be deferred when all the policy proceeds are re-invested in a new policy under a policy option. It ensures that the policyholder may never use the 5% tax deferral rule to withdraw more than the original premium without a tax charge.
38. A transitional measure ensures that policyholders who exercised a maturity option before 9 April 2003, or whose policy matures before 1 May 2003, may defer the gain on maturity provided the insurer retains all sums payable under the old policy on or after 9 April 2003 for re-investment in the new policy.
39. Life insurance investors will, as now, be able to defer any tax liability until they obtain value from the policy by extending the policy and so deferring maturity.
40. This is a simplification. There is no good reason for investors to have two different methods they can use to defer their liability to tax when they want to keep their money with the same insurer. There is evidence that this extra layer of complexity and unnecessary choice has led to policyholders becoming confused about their tax obligations.
Further advice
41. If you have any questions about this change, please contact the Public Enquiry Unit on 020 7438 6420 to 6425.
Inland Revenue www.inlandrevenue.gov.uk
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