Life Policies: How A Mistake Nearly Resulted In A Tax Rate Of 779%!

Mark McLaughlin highlights a case in which a taxpayer was allowed to correct a mistake that would have resulted in an unnecessary and substantial tax liability.

The UK tax system is difficult to comprehend, and its tax legislation is voluminous and complex. At times, an event or transaction that appears straightforward on the face of it can have unexpected and very unwelcome consequences. The resulting tax liabilities can be disproportionate and seem unfair.

Very often, if a taxpayer makes a mistake or an uninformed decision in doing something, it cannot be corrected later. This can have unfortunate or even disastrous tax consequence. Fortunately, a tax tribunal recently found that it was possible to rectify a mistake by a taxpayer that otherwise would have resulted in an effective tax rate of 779 per cent, and a tax liability that would have exhausted his life savings and may have bankrupted him.    

In Lobler v Revenue & Customs [2015] UKUT 152 (TCC), Mr Lobler, a Dutch national, came to England with his family in early 2004. He sold the family home in 2005 for approximately £350,000, which represented his entire life savings. He invested all of it in life insurance policies with Zurich Life (‘Zurich’) in the Isle of Man. He then took out an interest-bearing bank loan of $700,000, and invested it in further life insurance policies with Zurich. The total investment with Zurich amounted to approximately $1,406,000, which was invested in 100 life insurance policies.  

In 2006, Mr Lobler bought a house in England. On 28 February 2007, he withdrew $746,485 to repay the bank loan of $700,000 plus accrued interest. On 29 February 2008, he withdrew a further $690,171 to pay for the house and renovation works. Overall, he withdrew from the policies by way of partial surrender of each policy a total of 97.5% of the amount originally invested.

In July 2008, Mr Lobler terminated the policies, and received some $35,000. By the time of termination, the policies generated an excess (i.e. profit) of only $65,656.    

However, for tax purposes Mr Lobler was treated as having realised taxable income of some $1.3 million, and was liable to pay some $560,000 in tax! How could such an extreme and unfair outcome be possible?

It results from the 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. 

In making his partial surrenders, Mr Lobler filled out Zurich forms (without taking any legal, financial or other advice). The form provided the following options:

A - Full surrender; 

B - Partial surrender across all policies and funds; 

C - Partial surrender across all policies from specific funds; and 

D - Full surrender of individual policies

Mr Lobler checked the box for option C on both occasions. However, if he had chosen option D, the tax charge would have been significantly lower. In making partial surrenders, the value surrendered for tax purposes was the amount received. The deemed gain is calculated (in ITTOIA 2005, s 507) as the amount received, less 5% of the premium originally paid. The resulting ‘chargeable event’ was ‘a gain from a policy’ (i.e. not the actual, commercial gain). Tax is charged on ‘the amount of the gains arising in the tax year’ (ITTOIA 2005, ss 462-463). 

The following is a simplified example to illustrate the calculation of a gain on a partial surrender.

John invested £200,000 in a cluster of 100 policies with an offshore life insurance company. One year later, he decided to withdraw £150,000. The investment company sent him a form, which showed different options for his withdrawal. John ticked the box to request a partial withdrawal across all 100 policies. The investment was barely breaking even at that time in real terms. 

John’s partial surrender resulted in the following calculation of taxable income:

       £

Partial surrender proceeds 150,000

Less:  5% of original premium (1 year)

£200,000 x 5%                         (10,000)

Chargeable gain               £140,000

By contrast, if John had surrendered the whole of around 75 per cent of the policies, no income tax charge would have arisen, as there would have been no gains on the total surrender of those policies.

A form of loss relief (‘deficiency relief’) is potentially available to higher rate taxpayers when the investment eventually ends and the policies are fully surrendered. The relief (if applicable) is calculated broadly as the total amounts received under the policy less the premium paid for it and less any amounts that had previously been treated as ‘gains’ (ITTOIA 2005, ss 539-541).

For deficiency relief purposes, Mr Lobler had a deficiency of around $1,230,000, which was available to set against other taxable income for that year. 

However, deficiency relief 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. He could not carry the deficiency forwards or back, and his income was nowhere near the above figure, such that deficiency relief was of no use.

In his tax returns for 2007 and 2008, Mr Lobler did not refer to the partial surrenders. He assumed that they were withdrawals of capital, on which no gain arose. However, following enquiries HM Revenue and Customs (HMRC) amended both tax returns to reflect the tax liability incurred by making the two withdrawals. 

Mr Lobler appealed to the First-tier Tribunal on the basis that he had made a mistake (i.e. in the way he had withdrawn funds from the policies), although he could not really dispute the calculation of his tax liability. The tribunal ([2013] UKFTT 141 (TC)) had 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, the tribunal decided (with “heavy hearts”) that it was unable to interfere with HMRC’s amendment to the tax returns. Mr Lobler appealed to the Upper Tribunal.

Various grounds of appeal were put forward to the Upper Tribunal on Mr Lobler’s behalf (i.e. private law, human rights and public law). The tribunal considered (among other things) the remedy of ‘rectification for mistake’, and referred to case law, including Pitt v Holt [2013] UKSC 26. It was noted from that case that a mistake as to the tax consequences of a transaction may, in an appropriate case, be sufficiently serious to warrant rectification. 

There was no doubt that Mr Lobler would not have made partial surrenders had he known about the devastating tax consequences of his choice of withdrawal method. The mistake was sufficiently serious in nature (i.e. it would have resulted in potential bankruptcy). The withdrawals were so affected by the tax consequences that the effects were entirely different from that which Mr Lobler believed them to be.

In making the partial surrenders, the appellant filled out Zurich forms, which provided the four options listed above. The Upper Tribunal thought that if the appellant had not made a mistake, he would have chosen option D, i.e. to make full surrenders of individual policies. The tribunal therefore found that the appellant would be entitled to rectification, and that his tax position should be determined as if that remedy had been granted.

HMRC had thought that Mr Lobler should have sought advice as to the best means of making withdrawals from the policies. However, the tribunal disagreed, commenting: “One does not seek advice on everything, the legislation is not at all intuitive and no reasonable man would have expected the outcome.” As mentioned, Mr Lobler’s representative argued on other grounds, but the Upper Tribunal allowed the appeal on the ground of rectification alone.   

The fact that selecting the wrong option on a form nearly resulted in an effective tax rate for Mr Lobler of 779 per cent on the actual income generated by the policy suggests that the tax legislation dealing with gains from contracts for life insurance etc is in urgent need of reform. Fortunately, the tribunal was able to find a suitable remedy in Mr Lobler’s circumstances.

The decision will no doubt be welcomed by others in a similar position to Mr Lobler. However, taxpayers should not seek to rely on rectification for mistake. Apart from anything else, it is not known whether HMRC will appeal Mr Lobler’s case (although in the interests of fairness, it is to be hoped not).

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.