CII R05 Taxation of Protection Products 2 — Questions and Answers
Question 1: Under a group income protection scheme, how are the benefit payments taxed when received by the employee?
- They are completely tax-free as they come from an employer scheme
- They are taxed as employment income under PAYE and are subject to both income tax and employee National Insurance contributions (Correct answer)
- They are subject to capital gains tax only
- They are taxed at a flat rate of 20% regardless of the employee's tax band
Correct answer: They are taxed as employment income under PAYE and are subject to both income tax and employee National Insurance contributions
Under a group income protection scheme, benefit payments received by the employee are treated as employment income. They are taxed under PAYE and are subject to both income tax and employee National Insurance contributions. This differs from individual income protection benefits, which are subject to income tax but not NICs.
Question 2: A policyholder has a non-qualifying life assurance policy that generates a chargeable event gain. How is this gain taxed?
- It is always tax-free
- The gain is added to the policyholder's income for the year and taxed at their marginal rate, with credit given for basic rate tax already deemed paid within the policy (Correct answer)
- The gain is subject to capital gains tax at 20%
- The gain is taxed at a flat rate of 45%
Correct answer: The gain is added to the policyholder's income for the year and taxed at their marginal rate, with credit given for basic rate tax already deemed paid within the policy
A chargeable event gain on a non-qualifying policy is treated as the policyholder's income in the year the chargeable event occurs. Basic rate tax is deemed to have been paid within the fund, so only higher-rate and additional-rate taxpayers face an additional liability. Top slicing relief may be available to mitigate the impact of a large gain pushing income into a higher tax band.
Question 3: For inheritance tax purposes, what is the effect of placing a life assurance policy in a bare trust?
- The policy proceeds are automatically exempt from all taxes
- The policy is treated as a gift to the beneficiary — proceeds are outside the estate but the initial gift into trust may be a potentially exempt transfer (PET) (Correct answer)
- The trust attracts an immediate 20% entry charge
- The policy must be surrendered and a new one taken out in the beneficiary's name
Correct answer: The policy is treated as a gift to the beneficiary — proceeds are outside the estate but the initial gift into trust may be a potentially exempt transfer (PET)
Placing a life policy in a bare trust means the policy is held for the absolute benefit of a named beneficiary. The proceeds are paid outside the policyholder's estate, avoiding IHT on the death benefit. However, the act of placing the policy in trust is a transfer of value and may constitute a potentially exempt transfer (PET), which becomes chargeable if the donor dies within seven years.
Question 4: What is 'top slicing relief' and when does it apply?
- It is a relief that exempts the first £10,000 of any insurance policy gain from tax
- It is a method of calculating the tax on a chargeable event gain by dividing it by the number of complete years the policy has been held, to determine the appropriate tax rate (Correct answer)
- It is a relief that allows policyholders to slice their premiums into monthly payments
- It only applies to critical illness policies
Correct answer: It is a method of calculating the tax on a chargeable event gain by dividing it by the number of complete years the policy has been held, to determine the appropriate tax rate
Top slicing relief prevents a large one-off chargeable event gain from being unfairly taxed at a higher rate than would apply if the gain had been spread over the life of the policy. The gain is divided by the number of complete policy years to find the 'annual equivalent'. This annual equivalent is added to the policyholder's income to determine the marginal rate, which is then applied to the full gain.
Question 5: An employer pays income protection premiums for an employee under a group scheme. Are these premiums a taxable benefit in kind for the employee?
- Yes, the full premium is always taxable as a benefit in kind
- No, the premiums are not normally treated as a benefit in kind for the employee, but the benefits when received are taxed as employment income (Correct answer)
- The premiums are taxable but only if they exceed £500 per year
- The premiums are tax-free for both the employer and the employee permanently
Correct answer: No, the premiums are not normally treated as a benefit in kind for the employee, but the benefits when received are taxed as employment income
Employer-paid group income protection premiums are not treated as a taxable benefit in kind for the employee. The employer can deduct the premiums as a business expense. However, when a claim is made and the employee receives benefit payments, those payments are taxed as employment income under PAYE with NICs. This creates a trade-off: tax-free premiums but taxable benefits.
Question 6: A discretionary trust is commonly used with life assurance policies. For inheritance tax purposes, what is a key feature of property held in a discretionary trust?
- It is always completely exempt from inheritance tax
- It is subject to periodic charges (every 10 years) and exit charges, with a maximum rate of 6% of the value above the nil-rate band (Correct answer)
- It is taxed at 40% on every anniversary of the trust
- Discretionary trusts cannot hold life assurance policies
Correct answer: It is subject to periodic charges (every 10 years) and exit charges, with a maximum rate of 6% of the value above the nil-rate band
Property in a discretionary trust is subject to a relevant property regime for IHT. This includes periodic (10-year anniversary) charges and exit charges when capital leaves the trust. The maximum periodic charge rate is 6% of the trust value exceeding the nil-rate band. However, for life policies, the trust often holds only the policy (with negligible value until a claim), so periodic charges are usually minimal.
CII R05 Taxation of Protection Products 2
Under a group income protection scheme, how are the benefit payments taxed when received by the employee?