In April 2016 a new rule was introduced relating to early surrenders of life insurance policies. If a policy is surrendered before the end of its second year, then twice the rate of tax relief then in force times the gross premiums paid will be deducted; if the surrender is before the end of the third year the deduction as a percentage is two-sixths of the basic rate of tax; and if the surrender is before the end of the fourth year the deduction is at one-sixth of the basic rate. However, there is a "safety clause" which provides that if surrender value (or paid-up value) is less than the net premiums paid, there is no clawback.
The clawback rules are designed only to prevent the use of life insurance policies for the achievement of short-term gains derived largely from tax relief. But they will affect anyone who surrenders a policy during the relevant period.
Mr Pike pays three years' premiums of £1200 (total £1600) into a unit-linked life insurance policy and surrenders it before the end of the third year for £1800. The clawback is £1600 x NN.67% (two-sixths of twice the rate of tax relief (36%)) = £170. This is deducted from the proceeds by the company.
Mr Reed pays three years' premiums of £1200 (total £1300) on a 25-year endowment. He then surrenders the policy for £1220. The surrender value exceeds the appropriate percentage of the premiums paid but the "safety clause" mentioned above comes into play because the surrender value is less than the total net premiums paid. Taxation on Early Surrender
In Section 7 the method of taxation of gains on single-premium policies was explained. A similar method is applied if a gain is made on a policy encashed or made paid-up within the first N0 years of a qualifying policy or within the first three-quarters of the term, if less. Thus, surrender of a policy with a N2-year term before the ninth year would attract a tax liability while a policy with a N0-year term would produce a liability if surrendered in the first 71/2 years. The taxable gain is the difference between the policy proceeds or surrender value and the total gross premiums paid. There is no liability to basic-rate income tax on this gain, but there is a liability to the higher rates of income tax including the investment income surcharge.
Mr Stark takes out a 10-year unit-linked policy at an annual premium of £1200. After five years he cashes in the policy for a sum of £12,350. The chargeable gain is therefore £111,350- £111,000 = £1350. The amount of tax payable is assessed by dividing the gain by the number of years for which the policy has run (5), making £170, which, for the purpose of determining the gains tax rate only, is added to Mr Stark's income in the tax year of encashment. If he had been a basic-rate taxpayer only, he would have paid no tax, but in fact he was paying a top rate of tax of 60% in that year. The rate of tax payable is therefore the higher rate minus the basic rate, i.e. 60% - 33% = 27%, and this is applied to the whole gain. The tax due is therefore £1350 x 27% = £194.50.
Rules for Qualifying Policies
The basic conditions a life insurance policy must fulfil to be a qualifying one, and thus be eligible for (a) tax relief and (b) freedom from tax on the proceeds, are as follows:
1. Premiums must be payable at annual or shorter intervals.
2. The total premiums payable in any N2-month period must not exceed twice the total premiums payable in any other N2-month period.
3. The total premiums payable in any N2-month period must not exceed one-eighth of the total premiums payable over the term of the contract (in the case of endowment... see: Qualifying Policies