UK Taxation for Non-Domiciled UK Residents

Main Tax Advantages of Life Policies

There are three main tax benefits of using offshore life assurance policies when you are considered a UK tax resident, but do not maintain ‘domiciled status’ in the UK. These include tax free investments, no capital gains tax and Tax Deferred Withdrawl Allowances.

Tax Free Investments

First, all of the premiums paid to the life company are invested tax free. The money that is earned by investing those premiums is also tax free. This accomplished when the offshore jurisdiction does not charge taxes on life companies, as opposed to the UK where 20% taxes are charged.

No Capital Gains Tax

Second, no Capital Gains Taxes (CGT) are charged on selling or switching funds inside the life insurance policy (wrapper). Again, this is because no taxes are applied to life company funds in offshore jurisdictions. This compares with investing in the underlying funds directly on which gains realised on switching are subject to Capital Gains Tax.

Tax Deferred Withdrawl Allowance

UK tax resident policyowners can withdraw up to 5% of their original premium annually. This is a cumulative amount, i.e. if it is not used one year it can be carried forward to later years. the 5% allowance can be used for the first 20 years – that is, until 100% of the premium invested has been returned to the policyowner. This is treated as a return of capital.

Example: How to make the most of the 5% rule

Mr Andrews invested £500,000 on 1 March 2010 while working in Qatar. His Life Insurance policy (or Life Insurance Bond, as its usually called) is now worth £750,000. He plans to retire to the UK in 2020 and use his bond to supplement his pension. If he waits until he moves to the UK before taking action, he can take up to £25,000 a year for 20 years without any immediate liability to tax.

However, if he takes advantage of his favourable tax status in Qatar before he comes to the UK to cash his bond and reinvest in another bond, the 5% allowance will be based upon the new premium of £750,000. This will give him £37,500 a year for 20 years or extend the period during which he could take £25,000 a year to 30 years.

Taxes on Encashments Above 5%

In the UK, gains on these life insurance investment policies are subject to income tax at the policyowner’s marginal rate and are calculated at the point of what is deemed to be a chargeable event, i.e. full and partial surrenders, the death of the assured, or the maturity of the policy.

Chargeable gains are calculated as follows:

  • If partial withdrawals have been made from the policy, then the chargeable gain is calculated as at the end of the relevant policy year, at the point when they can be totaled. The chargeable gain is the sum by which the total withdrawals in the period exceed the allowance available (i.e. 5% for the current year plus any unused allowances from previous years, carried forward).
  • When the policy is finally encashed, the total value at that point is added to the total of any withdrawals made previously. From this sum the initial premium invested is deducted, plus any previous chargeable gain. The net result is the final chargeable gain. This sum is taxable as if it were an addition to the policyowner’s income.

Example: Howto manage excess withdrawals

Mr Andrews moves to the UK in January 2020, after cashing and reinvesting his Bond on 1 April 2019, and decides to take £25,000 a year, well within his 5% allowance. However, he is keen to upgrade his car, which will cost him £20,000.

In taking a withdrawal of only £25,000, he still has £12,500 unused allowance but if he withdraws another £20,000 for a car, the excess of £7,500 will be deemed a chargeable gain. This will be added to his income in the relevant tax year. This could be taxed at the basic rate of 20%, the higher rate of 40% or additional rate of 45%.

However, he has the foresight to consult his adviser before he puts in the withdrawal request. He learns that the relevant tax year is the tax year in which the policy year ends. As he took out his new policy on 1 April 2019, the relevant tax year is the tax year in which the policy year ends. The first policy year ends on 31st March 2020. Any chargeable gains arising up to 31st March 2020 will fall to be taxed based upon income taxable and at rates applicable within the 2019/20 UK tax year.

As Mr Andrews only became subject to UK income tax on his arrival in January 2020, his taxable income for the 2019/20 tax year may only comprise 3 months pension, so the chargeable gain may not be at the highest rate.

However, if he were to defer the excess withdrawal until the second policy year, i.e. after 1st April 2020, it would fall within the 5% allowance and not be counted as a chargeable gain.

Top Slicing Relief

If the addition of a chargeable gain to a policyowner’s income takes them over the threshold into a higher-rate tax band, then a principle known as top slicing can be used to mitigate the ensuing tax liability. With top slicing, the chargeable gain is divided by the number of relevant years, to produce an average gain. This is treated as the top slice of income in the tax year in which the gain actually arises. If any tax is payable on that top slice, it is then multiplied by the number of relevant years, and the result is the total arising income tax liability.

Example: Top Slicing Relief

While Mr Andrews planned to take withdrawals of £25,000 a year, after receiving his valuation on the 4th anniversary the investment growth within his bond has exceeded expectations so he decides to cash the growth of £100,000 and buy a boat.

Tax free allowance for 5 years5 x 5% x £750,000 = £187,500
Amounts supplementing pension5 x £25,000 = £125,000
Unused allowance   = £62,500
Excess withdrawal   = £100,000
Chargeable gain   = £37,500

Under top slicing rules, the chargeable gain is divided by the number of relevant years. i.e. 5. Therefore, £37,500 /5 = £7,500 is the top slice.

Thus, instead of adding £37,500 to income to determine the tax payable on the gain, £7,500 is added to determine the rate payable on the whole gain, with the prospect of reducing the total amount of tax payable.

Final Chargeable Events

If there is a loss on the final surrender, maturity or death, relief from tax on the deemed gain is available under what is known as deficiency relief.

An individual will be entitled to deficiency relief if:

  • Total benefits on the final chargeable event fall short of total deductions plus previous gains;
  • One or more of the gains arose on ‘excess events’ or ‘part surrender or assignment events’ in earlier tax years on which the individual was liable; and
  • The individual is the liable person, that is, would have been liable to income tax on a gain on the final chargeable event, had the calculation shown a gain.

Relief is only available against basic and higher rate tax and NOT additional rate tax.

Time Apportioned Relief

When a policyowner has spent time out of the UK, Her Majesty’s Revenue and Customs (HMRC) are prepared to calculate the chargeable gain based on just the period of time during which the policyowner has been subject to UK tax.

Example of Time Apportioned Relief

If Mr Andrews, instead of cashing and reinvesting his bond, simply retained it and took withdrawals at £25,000, these would still be within the 5% allowance. However, the additional withdrawals would be considered chargeable gains and taxed in accordance with the examples above, except that HMRC only tax that part of the gain which is deemed to have accrued while he has been tax resident in the UK. The basis of accrual is deemed to have arisen on a daily basis since ownership commenced.

Therefore, if he withdrew £20,000 in April 2020 to buy the car, this is deemed to have accrued over 10 years, at the rate of £20,000 over say 240 months, that is the equivalent of approx. £80 per month. However, if he only became subject to UK tax from January 2020, only 3 months at £80 i.e. £240 is added to his income. [Note: Months are used here to simplify the example. In reality this would be calculated on days of UK/Non-UK tax residence, not on months]

Life Policies in Trust

The 5% tax deferred allowance also applies where the trustees of trust make a distribution to beneficiaries within the allowance amount.

However, when a chargeable event occurs and a policy is in trust, any tax liability will fall on the creator of the trust (the settlor) up to a maximum rate. If the settlor is dead or non-UK resident the liability will fall to the trustees at the trustee rate of up to 45%.

A simple way of passing the trust property (the proceeds of the insurance investment bond) to a beneficiary is by assignment. Assigning a policy absolutely to a third party is not a chargeable event for tax purposes as long as the assignment is done by way of a gift. Assignments for money or other items of value are taxable in the UK.

Once the policy has been assigned, the assignee, as the legal owner of the policy, can surrender the policy, providing of course that the assignee is over 18. If the beneficiary is a basic-rate or non-taxpayer, this is a simple way of passing on the benefits to the beneficiary in a tax-effective manner. This works well for grandparents setting up university education plan for UK resident grandchildren as the grandchildren can cash a policy to pay for university costs. They would typically be non-taxpayers so no tax would be due.