HMRC position

HMRC guidance states that ‘Once a surrender or part surrender of a policy has been validly made, it cannot be reversed. The tax consequences must follow from the transactions which have happened, not those which in hindsight a policyholder might have preferred to have happened because they would give a lower tax bill’.

Nevertheless, where a surrender gives rise to tax consequences that do not accurately reflect the investment performance of the bond, there are still some options available.

Surrendering the bond in full

Where a part surrender creates an artificially high tax liability, one way of correcting the situation is to fully surrender the bond. However, this must be done either before the policy year ends or before the tax year ends.

If the bond is fully surrendered in the policy year, all part withdrawals are swept up into the final chargeable event calculation. This ensures that the actual investment gain will be taxed, rather than the notional gain on the earlier part surrender.

If a mistake is noticed after the policy year has ended, but the tax year hasn’t, it is still possible to correct the situation this way. This is because a full surrender in the same tax year will extend the policy year and still sweep up all the past chargeable events into the final calculation.

Example – On 1 July 2022, Erin purchases a bond for £100,000. On 1 May 2026, she makes a part surrender of £70,000. This creates a chargeable gain of £50,000 (£70,000 less 4 years 5% tax deferred allowance of £5,000). At the end of the policy year (30 June 2026), a chargeable event certificate is sent to Erin.

This causes Erin unexpected tax implications. Realising her mistake, Erin fully encashes the bond for £60,000 on 1 October 2026. The chargeable gain on full surrender is calculated as:

£60,000 surrender value + £70,000 previous withdrawal - £100,000 premium = £30,000.

A new chargeable event certificate for £30,000 is issued and since this is in the same tax year, this supersedes the earlier chargeable event of £50,000, which can now be ignored - the final policy year is now 1 July 2025 to 1 October 2026.

HMRC mechanisms

Where the tax year has ended or a full surrender is not desired, there are a couple of methods HMRC offer that can help:

1. Deficiency relief – This is a limited relief available on full surrender for higher rate taxpayers, as well as advanced rate taxpayers in Scotland. Unfortunately, it is not available for additional rate taxpayers, trustees, or companies.

   Deficiency relief can be used where a policy ends and due to an earlier part surrender, the final chargeable event calculation results in a negative amount or ‘deficiency’.

   Example – Abdul purchases a policy for £50,000 and makes a part surrender of £20,000 in year 2. This creates a chargeable gain of £15,000 (£20,000 less 2 years 5% tax deferred allowance of £2,500).

   In year 4, Abdul fully surrenders the policy for £40,000. The chargeable event is calculated as:

   £40,000 surrender value + £20,000 previous withdrawal - £50,000 premium - £15,000 previous gain = a loss of £5,000.

   Deficiency relief is the lower of the loss (£5,000) and the previous gain (£15,000), so is £5,000.

   The £5,000 deficiency relief can reduce any higher rate (or Scottish advanced rate) tax liability to a basic rate liability. If Abdul does not have sufficient higher/advanced rate tax liability, any unused deficiency is lost. It cannot be carried forward or back to other tax years, used to offset against gains on other policies or used when income is subject to basic or additional rate tax.

2. Wholly disproportionate gains – An application can be made to HMRC to recalculate a wholly disproportionate gain on a just and reasonable basis.

   The application should be in writing within four tax years after the gain arose. Generally, HMRC may agree to recalculate the gain if, in the context of the premiums paid, they view it to be greatly excessive and creating a disproportionately large tax charge. To do this, HMRC will assess:

   • the economic gain on the rights surrendered or assigned,
   • the amount of the premiums surrendered and paid,
   • the resulting tax charge.

   HMRC’s decision will be made in writing and there is no right of appeal.

Pension contributions

One further option is to contribute to a personal pension scheme. As well as qualifying for tax relief, the contribution extends the basic rate tax band by the gross contribution. This can often be the simplest way to take a top-sliced gain out of higher rate tax and has the added benefit of increasing pension savings – this tax planning opportunity is covered in more detail in our how pension contributions can boost your clients article here.

Technical commentary

Bonds provide several ways to withdraw funds that can maximise tax-efficiency. However, where the wrong option is chosen, this cannot normally be reversed. Fortunately, there are a few routes available to improve the situation when a mistake is made.

Important information

Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.