What is the Tax Position?

One of the major benefits of investing in TEPs is that they offer an investment vehicle that can be used to improve the tax efficiency of your financial planning strategy.

General rules regarding TEP Taxation

When an investor disposes of a TEP, whether this occurs as a result of a death claim, the policy maturing or the investor deciding to surrender or re-sell the policy via the TEP market, tax potentially becomes payable.

The taxation of the TEP will be determined by whether the policy is ‘qualifying’ or ‘non-qualifying’.

a) ‘Qualifying’ Policies:

The majority of TEPs available are ‘Qualifying’ policies – policies that have not been altered or amended in such a way to make them ‘non-qualifying’. ‘Qualifying’ policies do not attract Income Tax upon disposal. However, under the Taxation of Chargeable Gains Act 1992, the receipt of benefit by the investor in the event of death, maturity, surrender or subsequent sale will give rise to a disposal for Capital Gains Tax purposes.

The following is an example of how the Capital Gain is calculated:

The calculation of the Capital Gain is as follows:

This gain is taxable at the marginal rate applicable to the investor. If the investor had not already used his Capital Gains Tax Exemption (currently for 2003/2004 tax year = £7,900) there would be no tax to pay.

Taper Relief
Taper Relief was introduced on 6th April 1998 as a replacement for indexation allowance and reduces the amount of capital gain subject to tax depending on how long an asset has been held.
The following table shows the percentage of gain liable to CGT, based on the number of years a non-business asset is held after 5th April 1998.

b) Non-Qualifying’ Policies:

‘Non-Qualifying TEPs are normally policies that were originally ‘qualifying’ policies which have been altered or amended in such a way to make them ‘non-qualifying’.

The proceeds from the disposal of a non-qualifying policy are potentially subject to Income Tax calculated by a process known as ‘top-slicing’. The chargeable gain is calculated as the difference between the proceeds from the policy and the total premiums paid into the plan (including those paid by the original owner).

The gain is divided by the number of whole years that the plan has been in force to determine the ‘slice’ which is treated as the top part of the policyholder’s income, and this figure is added to the investor’s taxable income in the tax year in which the chargeable event occurred. If when added to the investor's taxable income, the ‘top-slice’ falls completely or partly above the higher rate tax threshold then the average rate of tax applying to the ‘top-slice’ is calculated, and that average rate of tax (less savings rate tax – currently 20%) will be applied to the total chargeable gain to determine the total income tax liability.

The following is an example: policy has been in force for 20 years

Investors Total Income		£30,000
Add Top-sliced Gain		£1,389
		£31,389
Higher Rate Tax Threshold (2003/04)		£30,500
Tax on Top-sliced Gain		£465.60 (£500 x 22% + £889 x 40%)
Average tax rate on ‘top-slice’		33.52% (465.6/1389 x 100)
Tax rate applied to ‘top-slice’ :		13.52% (33.52% - 20%)
Total tax on Chargeable Gain		£3,702 (£27,380 x 13.52%)

Capital Gains Tax on non-qualifying policies

In addition to a potential income tax liability, the Capital Gain arising from non-qualifying TEPs is taxable under Section 210 of the Taxation of Chargeable Gains Act 1992.

For these purposes the Capital Gain is calculated as follows:

The total proceeds less the amount brought into charge for Income Tax (the whole of the chargeable gain) less the total investment outlay on the policy, e.g.:

Prior to 9th April 2003 the Capital Gains Tax loss generated in the above example could have been offset against any CGT profits generated elsewhere by the investor. However, due to recent tax changes, it is now no longer possible to offset these artificial losses and only real or economic losses may be offset against Capital Gains.

c) TEPs held within pension funds

TEPs are recognised by the Pensions Schemes Office, and as such are permitted investments for both Small Self Administered Schemes (SSASs) and Self Invested Pension Plans (SIPPs), and within these environments attract no tax upon disposal.

d) Tax Planning

There are a number of ways to reduce potential taxation and maximise available allowances:

• TEPs can be purchased jointly by both husband and wife to utilise both annual allowances.
• Purchase TEPs to mature in different tax years to maximise the use of CGT allowances.
• Use non-qualifying TEPs if your taxable income or your spouse’s income is sufficiently below the higher rate tax threshold in this way any gain would be free of tax.

The UKEndowments.com website contains very useful tax calculators which will suggest the most tax efficient way of purchasing any particular policy taking into account an individuals own financial circumstances.

Note: For overseas investors, gross returns on a TEP will be subject to the tax laws applicable to the country in which you are considered to be resident at the time of disposal.

The above tax guidance is based on UK Endowments Limited’s own interpretation of the current tax regulations.
Levels and bases of, and reliefs from, taxation are subject to change. The annual CGT exemption, taper relief and the top slicing relief referred to above are those currently applying.