Most taxpayers would probably assume that if they sell an investment for a large profit, they may have some tax to pay; the larger the gain, the higher the tax bill.
However, in some cases cashing in an investment can result in a substantial tax bill, even though very little profit has been made – or even if there has been a loss. Worse still, by ticking the wrong box in the investment paperwork, a large – and unnecessary – tax bill can be created, seemingly out of thin air.
Remarkably unfair result
In a recent tax case, Lobler v Revenue and Customs  UKFTT 141 (TC)*, Mr Lobler invested his life savings and the proceeds of a loan in a series of life insurance policies.
He later withdrew funds from the investment to buy a house and repay the loan. He had to complete a form to do so. The form contained four options. Mr Lobler put an ‘X’ in the box for the option “partially surrender across all policies from specific funds”. He assumed that because he had withdrawn no more than he had paid for the policies, no taxable gain would arise.
Unfortunately, Mr Lobler’s assumption was incorrect. He did not realise that the effect of making a partial surrender of the life policies was that almost all the amount he withdrew would be treated as taxable income. HMRC assessed him for a substantial amount of tax. Mr Lobler appealed to the First-tier Tribunal on the basis that he had made a mistake (i.e. the way in which he had withdrawn funds from the policies). However, he could not really dispute the calculation of his tax liability. The tribunal appeared to have a great deal of sympathy for Mr Lobler, commenting that a combination of the legislation and the taxpayer’s actions gave rise to a “remarkably unfair result”. However, with “heavy hearts” the tribunal dismissed Mr Lobler’s appeal.
In a subsequent case, Downward v Revenue and Customs  UKFTT 517 (TC)*, the taxpayer also made partial surrenders of a life insurance policy. He claimed that it was only due to mistakes in how the surrenders were made that a large tax liability had arisen. Mr Downward had taken out an investment bond, divided into a number of separate life insurance policies. When withdrawing some of the investment, the wrong box was ticked on the relevant form in error, to partially surrender each of the life policies (he later withdrew further funds but without stating now the withdrawal should be made, and this was treated by default in the same way as the first withdrawal).
HMRC assessed the tax resulting from these errors, and Mr Downward appealed. He sought to correct the mistakes retrospectively, by restructuring the withdrawals in such a way that would have exactly the same financial effect without triggering the tax charge he was appealing against. Unfortunately, the tribunal held that it had no power to amend the mistakes. The tax assessed by HMRC was legally due. Mr Downward’s appeal was dismissed. In doing so, the tribunal echoed the comments of the judge in the Lobler case as to the “repugnance” of the result.
How it can happen
These unfair outcomes result from the rather strange way in which the tax legislation on life assurance policies (in ITTOIA 2005, Pt 4, Ch 9) works. The rules are detailed and complex, and outside the scope of this article. However, in general terms, a life policy is usually divided into a number of smaller, identical policies. When a withdrawal is made, the investor is given a choice whether to make a partial surrender of all the policies, or to fully surrender a sufficient number of individual policies.
The tribunal in the Lobler case summed up the calculation to establish whether any gain has arisen:
“[ITTOIA 2005] s 507 provides for a calculation to determine whether a gain arises, and to calculate a gain if rights under a policy have been surrendered. The calculation requires that the gain is equal to the excess of the value of any part of the policy surrendered over 5% of the premiums paid for the policy.”
The example below is based on a real case, Shanthiratnam v Revenue & Customs  UKFTT 360 (TC)*. Interestingly, in that case the taxpayer’s investment was probably standing at a loss. But sadly, Mr Shanthiratnam still lost his appeal.
Example – The wrong choice
Sam invested £150,000 in a cluster of 50 policies with an offshore life insurance company. A year later, he decided to withdraw £50,000. The investment company sent him a form, which showed different options for his partial withdrawal. Sam ticked the box to request a partial withdrawal across all 50 policies. He assumed that because the investment was not even breaking even, there would be no tax implications, as all he was doing was recovering part of his capital.
Sam was therefore shocked when HMRC contacted him to point out that his partial surrender had resulted in additional taxable income of £42,500, which was calculated as follows:
Partial surrender proceeds50,000
Less: 5% of original premium (1 year)
£150,000 x 5%(7,500)
Changeable gain £42,500
By contrast, if Sam had surrendered the whole of around one-third of the policies, no income tax would have been chargeable, as there would have been no gains on the total surrender of those policies.
Not all bad news?
The ‘gains’ on the partial withdrawals in the Lobler and Downward cases were substantial. The income tax liabilities were also very large. However, the tribunal in the Lobler case pointed out that there is a form of loss relief known as ‘deficiency relief’ (in ITTOIA 2005 s 539), which is potentially available to higher rate taxpayers when the investment is eventually ended and the policies fully surrendered. The relief (if applicable) is calculated as the total amounts received under the policy less the premium paid for it and less any amount which had previously been treated as a ‘gain’.
However, it only relieves tax at the higher rate. If the resulting loss is much higher than the taxpayer’s income for the relevant tax year, no relief may be available. This was the unfortunate outcome in Mr Lobler’s case - the relief was of no use to him.
Be very careful when making withdrawals from investments containing life insurance policies. Seek suitable financial advice before making investment decisions, and professional advice on the tax implications before completing any forms to complete the withdrawals. As the above tribunal cases illustrate, mistakes cannot be rectified later.
*The full case reports for the above cases can be accessed via the British and Irish Legal Information Institute (BAILII) website:
Lobler v Revenue & Customs
Downward v Revenue & Customs (www.bailii.org/uk/cases/UKFTT/TC/2013/TC02905.html)
Shanthiratnam v Revenue & Customs (www.bailii.org/uk/cases/UKFTT/TC/2011/TC01215.html)