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Life insurance policies: recalculating gains on part surrenders

The draft Finance Bill 2017 offers a possible solution to the unjust taxation of the part surrender of a life policies.

Life policies are not used simply to provide life insurance, but are often used as an investment wrapper. They usually provide the policyholder with the ability to surrender all or part of the policy at any time

For example, Paloma invests £50,000 in a single premium life policy.  After a year, the benefits payable under the policy may be £53,000. Paloma wishes to access £4,000, so she surrenders £4,000 of the policy, a partial surrender. She is therefore taxed using a formula that treats the full value of the rights surrendered as income but only allows a deduction of 1/20th of the total amount of premiums paid under the policy for each year that that premium has been. So, as Paloma paid a premium of £50,000 and one year has elapsed she is entitled to deduct 1/20th of £50,000, which is £2,500, leaving a taxable income gain of £1,500.

Restricting the deduction to 1/20th of the total premiums paid a year can mean that income tax is paid on an amount which is higher than the income earned within the life policy. Thus, if Paloma had instead withdrawn £10,000 after one year, her income would be £10,000 but the deduction would still only be £2,500. This would leave her with an income gain of £7.500, despite the policy having increased in overall value by only £3,000.

We now come to the infamous case of Lobler v HMRC [2015] BTC 515. . Mr. Lobler and his family moved to England in 2004. After selling their house in the Netherlands, Mr. Lobler invested the proceeds) in a series of life insurance policies. The total amount invested was $1.4m. .In 2007, Mr. Lobler withdrew about $746,000 to repay a loan and, in 2008, he withdrew a further $690,000 to buy and renovate a new house.

Mr. Lobler should be taxed on income equal to each of the amounts withdrawn less, in the case of each withdrawal, only a small fraction of the amount originally contributed by way of premium, and HMRC sought to tax him that way. This was the case even though overall he had made a loss on the policy. The tax bill was so high that it would have bankrupted him.  The First Tier Tribunal felt that the result was totally unjust but based on a strict interpretation law they had to find for HMRC. Fortunately for Mr. Lobler, the Upper Tribunal overturned the decision and allowed rectification in his case. It however, still left tax legislation that can lead to grossly unfair results.

Clause 13 of the draft Finance Bill 2017 seeks to redress this. For partial surrenders on or after 6 April 2017 which give rise to a wholly disproportionate taxable gain , the taxpayer can apply to HMRC to have the gain recalculated on a “just and reasonable” basis. The application must usually be made within two years of the end of the insurance year that the gain arose. Whether or not the taxpayer and HMRC will be able to agree as to what is “just and reasonable” remains to be seen. In addition HMRC’s guidance note ominously states “it is considered that wholly disproportionate gains will arise very infrequently”. Therefore though the change is to be welcomed, the subjectivity of the proposals makes it far from a satisfactory solution. 



Date: 12th December, 2016
Author: David Hadley


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