In September 2009 Richard Curtis (now editor of Taxation) wrote an article (“The heat is on”) in which he questioned the way in which HMRC were applying the rules for top slicing relief on non-qualifying policy gains. It seems that nothing came of Richard’s valiant effort to correct an obvious error. Well maybe the time has come.

Not only do I agree with Richard’s analysis, I have now codified (well – produced an Excel spreadsheet!) what he and I believe to be the correct application of the rules and identified innumerable scenarios were taxpayers with chargeable event gains are being overcharged (in some cases by tens of thousands of pounds) and others where the HMRC calculation is too generous.

Unfortunately it appears that all the commercial tax return software developers follow the HMRC calculation or do their own calculations but with same erroneous methodology.

To illustrate the problem, let us suppose that a taxpayer had no income in 2016-17 other than employment income of £100,000 and a chargeable event gain of £100,000 on the encashment of a UK non-qualifying life policy held for two years (there can be no personal allowance even when calculating tax on one slice – let’s keep it simple).

The HMRC system correctly calculates tax on the employment income as £33,600 (£32,000 at basic and £68,000 at higher rate) and then (correctly) calculates the tax liability on the chargeable event gain as:

Starting rate £0 x 0% = £0

Nil rate £0 x 0% = £0

Basic rate £0 x 0% = £0

Higher rate £50,000 x 40% = £20,000

Additional rate £

Tax on employment income

Income Tax due

But what about the top slicing relief? My reckoning is that the taxpayer can claim relief of £2,900, but the HMRC calculator only gives £2,500. How come?

First, an urban myth needs to be dispelled. The myth is that TSR is only relevant for higher and top rate taxpayers and only where the full gain straddles the divide between rate bands. Not so. TSR is provide for in ITTOIA 2005 s535 and nowhere does it refer to higher and top rate taxpayers. Instead it gives entitlement to the relief (and I quote)

So instead of looking at marginal tax rates we must perform the calculations specified in s535.

In my example TL is clearly £42,500 and BRL is £20,000 giving £22,500.

We now have to calculate the individual’s relieved liability under s536 which has three steps.

Step 1 identifies the annual equivalent or slice. In my example £100,000 divided by five years gives a slice of £50,000.

Step 2 reads:

Step 3 simply tells us to multiply the Step 2 figure by the number of slices.

For the purposes of my example the highest part assumptions are inherent in the treatment of the CEG as being the top part of the total income in all the calculations (although they would be relevant if the taxpayer had dividends or other savings income – that bit was fun to codify).

So that leaves us to

In my example this calculation will compute the tax liability on the annual equivalent (slice) as follows:

Starting rate £0 x 0% = £0

Nil rate (PSA) £500 x 0% = £0

Higher rate £49,500 x 40% = £19,800

Less basic rate on £50,000 x 20% =

Step 2 calculation

Relieved liability (Step 3) £9,800 x 2 =

So the TSR has to be:

S535(1)(a) liability £22,500

Less: s535(1)(b) relieved liability

TSR

I simply cannot see any other way of applying the legislation. HMRC say the taxpayer must pay £53,600 but I maintain that the liability is £53,200. The observant reader will see that the difference of £400 is equivalent to the benefit of two personal savings allowances of £500 at 40%.

Suppose that a taxpayer has no income other than a chargeable event gain of £250,000 on encashment of a UK non-qualifying life policy held for two years (let’s keep it really simple!). The HMRC system calculates the tax liability after top slicing relief (TSR) as follows:

£5,000 x 0%

£27,000 x 20% 5,400

£118,000 x 40% 47,200

£100,000 x 45%

97,600

less: TSR 11,400

notional tax at 20%

Tax due

Note that this calculation correctly applies the £5,000 savings rate band (SRB) to the chargeable event gain.

But how do they arrive at the figure of £11,400?

Answer:

Tax on £250,000 calculated (ignoring SRB!) as: £32,000 x 20% + £118,000 x 40% + £100,000 x 45% = £98,600.

Tax on slice of £125,000: £32,000 x 20% + £93,000 x 40% = £43,600.

Tax on 2 x slices = £87,200.

TSR: £98,600 - £87,200 = £11,400.

But this again is wrong.

The correct amount of TSR is in fact £12,600 and the tax due is £35,000 rather than £36,200. The HMRC calculation adopts a simplified workaround that does not actually follow the legislation (see above). And it means that taxpayers like this will have been overcharged (and should now make amendments to open 2015-16 returns as well as 2016-17 returns).

Here’s the correct calculation following the steps in ITTOIA ss535 and 536:

S535(1)(a) liability: £97,600 - £50,000 = £47,600

(this is the liability ignoring TSR less the notional tax of £50,000)

S535(1)(b) relieved liability given by s536:

Step 1 annual equivalent £250,000/2 = £125,000

Step 2 relieved liability on annual equivalent:

£ 5,000 x 0%

£ 500 x 0%

£ 26,500 x 20% 5,300

notional tax at 20% x £125,000

Relieved liability £

Step 3 £17,500 x 2 = £35,000

Excess of s535(1)(a) over s535(1)(b):

£47,600 - £35,000 = £12,600.

It is simply unarguable that the calculation of £12,600 is wrong. It follows to the letter the legislation. It is unhampered by any consideration of the allocation of any personal allowances or other reliefs or of any other income. The HMRC calculation is wrong because it takes a shortcut and that shortcut does not take account of the savings rate band or personal savings allowance. The difference of £1,200 can be explained by seeing that HMRC ignore the £5,000 SRB once in their calculation of tax on the full gain and then ignore it twice (two slices) in their calculation on the slice as well as ignoring the personal savings allowance that should be available if the income is just one slice. The net effect is (£5,000 x (2-1) + £500 x 2) x 20% = £1,200.

But the plot thickens when the possibility of personal allowances is introduced.

Consider a taxpayer with employment income of £95,000 and a chargeable event gain of £100,000 on a UK policy held for 10 years.

The HMRC calculation is (and this is a screenshot from the HMRC test case generator):

But my calculation would be (I have doctored the HMRC test case generator!):

A difference of £19,000! How so?

The HMRC top slicing relief is calculated using their shortcut as follows:

Tax on CEG £100,000 calculated as: £55,000 x 40% + £45,000 x 45% = £42,250.

Tax on slice of £10,000: £10,000 x 40% = £4,000.

Tax on 10 x slices = £40,000.

TSR: £42,250 - £40,000 = £2,250.

Here’s the correct calculation following the steps in ITTOIA ss535 and 536:

S535(1)(a) liability: £42,250 - £20,000 = £22,250

(this is the liability on the CEG ignoring TSR less the notional tax of £20,000)

S535(1)(b) relieved liability given by s536:

Step 1 annual equivalent £100,000/10 = £10,000

Step 2 relieved liability on annual equivalent:

£ 8,500 x 0%

£ 500 x 0%

notional tax at 20% x £1,500

Relieved liability

Step 3 £100 x 10 = £1,000

Excess of s535(1)(a) over s535(1)(b):

£22,250 - £1,000 = £21,250.

The reason for the staggering difference is that HMRC ignore the personal allowance that comes into play when only one slice of the chargeable event gain is brought into the calculation. Below is the working from my own calculator that shows how (in my opinion) the s535 calculation should be done properly:

What counterarguments could HMRC put to my interpretation and application of s536?

ITTOIA 2005 s536(1) Step 2 says:

My proposition is that the only way of performing this calculation has to be by carrying out the ITA 2007 income tax calculation “on the basis that the gain from the chargeable event is limited to the amount of the annual equivalent”.

Could an alternative interpretation be that the relieved liability is calculated by determining how much of the total tax liability ignoring TSR can be attributed to just one slice? In my last example this would entail looking at the total tax calculation and determining that the first £10,000 of the CEG would be taxed at 40% so that tax on ten slices would be £40,000. This would indeed give TSR of only £2,500. But it is not what s536(1) tells us to do.

The draftsman could just as easily have said something like “calculate how much of the individual’s liability to tax on income charged to tax under this Chapter arises on the first annual equivalent amount of that income”. But he didn’t. If in doing the s536(1) calculation my way the personal savings allowance and/or the personal allowance become available then the taxpayer should in my opinion benefit from this.

I would also opine that the purpose of top slicing relief is to put the taxpayer in the position that they would have been in if in each year they had received just one slice and that my analysis accords with this purposive approach.

But what if the HMRC calculation is actually beneficial in some scenarios? Take a taxpayer with 2016-17 employment income of £18,000 and a chargeable event gain on a UK policy of £30,000 with a term of ten years.

The HMRC calculation gives TSR of £1,000 on the basis that the first £25,000 of the CEG is taxed at basic rate (even though £500 of that is at 0%) and the top £5,000 at higher rate whereas one slice of £3,000 would all be at basic rate. That generates (shortcut method) TSR of £5,000 x (40% - 20%) = £1,000.

But my calculation would work out tax on one slice as £2,000 at 20% and on ten slices this makes £4,000 which is reduced to nil by the notional basic rate credit. The s535(3) calculation is the tax on the £30,000 of £500 x 0% + £24,500 x 20% + ££5,000 x 40% = £6,900 less the basic rate credit of £6,000 giving TSR of £900.

So in scenarios like this the HMRC calculation benefits the taxpayer by £100 (incorrectly in my opinion).

- Don’t rely on the HMRC calculation of top slicing relief.
- Don’t rely on your tax return software – almost all the main brands (my own included) simply clone the HMRC calculation.
- Review all clients who have had chargeable event gains in recent years and file amended returns if possible.
- Consider an appeal to the tribunal if HMRC refuse to accept that their calculation is wrong.
- Oh yes – buy a copy of my spreadsheet. -
**www.Absolutetax.co.uk - Tel. 01869 255797**

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