The Chartered Institute of Taxation has claimed that the tax legislation that applies to partial surrenders of life assurance and capital redemption policies is complex, disproportionate and opaque.
It is true that the operation of the rules on part surrenders can give odd results.
A case in point
Take a hypothetical case involving Samantha, a UK resident who invested £100,000 in an offshore life assurance policy.
She can withdraw 5% of the premium (£5,000) each year, based on policy anniversaries, without triggering a tax charge.
After three years, Samantha decides to fully surrender the policy, which at the time is worth £125,000.
She pays tax on a gain of £25,000, which is her economic gain.
However, if she decides to withdraw only her original investment (£100,000) the tax consequences could be catastrophic.
Assuming the withdrawal is made in year four, her taxable gain is calculated as:
Withdrawal £100,000
5% x 4 x £100,000 £20,000
Taxable gain £80,000
The taxable gain bears no resemblance to her economic gain.
This tax trap is well-known to advisers but individual clientsare generally oblivious to its operation.
In the actual case of Joost Lobler v HMRC, Joost Lobler fell into this trap and he was not the first so to do.
In 2004, Lobler came to England to work.
He sold the family home in Holland and invested the proceeds in US dollar-denominated offshore life insurance bonds.
He later borrowed $700,000 from a bank and incremented his bond.
By March 2006, his bond was valued at $1,406,000.
In 2007, he withdrew $746,485 from the bond to repay his bank borrowings and, in 2008, he withdrew a further $690,171 to partly pay for a recently purchased family home.
These withdrawals amounted to 97.5% of the amount originally invested.
Advice on redemption
Although his original investment was ‘advised’, Lobler did not seek advice in respect of these partial surrenders – he did not think he needed to.
The tax consequences were disastrous.
The partial surrenders triggered an income tax chargeable event.
In both 2007 and 2008, the 5% tax-deferred withdrawal limit was significantly exceeded.
Each year’s taxable gain was the amount received less 5% of the premium originally paid.
Lobler had made no substantial profit from the investment but had managed to generate taxable income of $1.3m, with a consequent $560,000 tax liability.
He was facing bankruptcy.
Details of these part surrenders were not included on his self-assessment returns as he had assumed that no gain arose.
When HM Revenue & Customs received chargeable event certificates from the life office, enquiries were opened and eventually the tax liability was established.
Lobler appealed to the First Tier Tax Tribunal but his appeal failed; the tax liabilities had been determined correctly on the basis of the relevant legislation.
The tribunal was sympathetic but powerless to arrive at a different conclusion, stating:
“Though we have struggled so to do, we can find no way to give a different interpretation to the legislation. This is legislation which does not seek to tax real or commercial gains.
“Thus it makes no sense to say that the legislation must be construed to apply to transactions by reference to their commercial substance. The legislation adopts a formulaic and prescriptive approach. No overriding principle can be extracted.”
Lobler then appealed to the Upper Tribunal.
His lawyer had to accept that the tax analysis advanced by HMRC was correct.
However, he advanced new arguments based on contract law.
The lawyer argued Lobler had made a ‘mistake’.
A ‘mistake’ operates to negate the ‘consent’ that is at the heart of all contracts.
The mistake rescinds the contract, and the mistaken action is ignored.
Mistake as a legal concept is far removed from a simple error.
To be ignored the mistake has to be: “An erroneous assumption of such a fundamental character as to constitute an underlying assumption without which the parties would not have made the contract they in fact made.”
Lobler adopted a method of withdrawal that gave him a tax liability – despite his having made no significant investment gain.
He could have met his financial requirements by fully surrendering the bond.
He would then have been taxable on his ‘real’ investment gain.
There was no doubt that Lobler would not have made the part surrenders if he had fully appreciated the tax consequences.
The judge said that nobody would willingly contract to pay an amount of tax that would effectively lead to bankruptcy if there were a choice not to do so.
The mistake made was of a sufficiently serious nature and the fundamental or root element of the transaction was affected by the error.
The seriousness of the mistake meant that the contract could, in effect, be ended.
The judge held that Lobler’s tax position was to be determined as if the part surrenders had not taken place.
Unexpected tax liabilities flowing from poorly planned bond surrenders are not uncommon.
However, it cannot be assumed that the Upper Tribunal’s decision will allow every inappropriate tax charge to be negated.
Each case depends on its own unique facts, meaning that careful planning of bond withdrawals should always be undertaken.
