Taxation of Insurance Benefits

• Topic 01

  Taxation of Insurance Benefits

  51 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A limited company has a key person critical illness policy on its managing director. The premiums are deductible for corporation tax under the Anderson criteria. The managing director is diagnosed with a qualifying critical illness and the company receives £250,000. How are the proceeds taxed?

   • A
     The proceeds are tax-free because critical illness insurance is always exempt from all business taxes under TCGA 1992 s.210
   • B
     The proceeds are treated as a dividend and subject to the company's dividend tax rate
   • C
     The proceeds are taxable as a trading receipt (subject to corporation tax) because the premiums were deductible — the symmetry principle applies
     Correct answer
   • D
     The proceeds are subject to income tax in the hands of the managing director personally, not the company
   Explanation

   The Anderson criteria establish a symmetrical tax treatment: if premiums are deductible as a trading expense (because the policy protects against a trading loss), the proceeds are brought in as a trading receipt and subject to corporation tax. This applies equally to key person life assurance and key person critical illness cover. The company cannot deduct the premiums AND receive the proceeds tax-free — one must apply. Most advisers recommend the tax treatment be confirmed with HMRC or a tax adviser for each specific case.

2. A client's whole of life policy (non-qualifying, with a surrender value) matures. The chargeable event gain is £80,000, the policy ran for 20 years, and the client is an additional-rate taxpayer. Top-slicing gives an annual gain of £4,000. The additional-rate threshold is £125,140. The client's other income is £130,000. What is the effect of top-slicing on the income tax payable?

   • A
     Top-slicing eliminates all tax on the gain because the policy has run for 20 years, giving a 20-year averaging period
   • B
     Top-slicing always reduces the tax on the gain to the basic rate of 20% regardless of the taxpayer's total income
   • C
     Top-slicing means only the annual slice (£4,000) is taxable and the remainder (£76,000) is exempt
   • D
     Top-slicing may not provide significant relief because the annual slice (£4,000) added to the client's income still falls in the additional-rate band, resulting in tax at 45% minus basic rate credit
     Correct answer
   Explanation

   Top-slicing relief works by applying the tax rate determined by the annual slice to the full gain. However, if the client's other income already places them in the additional-rate band, even the small annual slice is still taxed at 45%. In this scenario, the gain of £80,000 is taxed at 45% less the basic rate credit (20%), giving an effective additional charge of 25% × £80,000 = £20,000. Top-slicing only helps where the annual slice brings the total income below a tax threshold — it does not help where all income is already at the additional rate.

3. Are death benefits from a personal term assurance policy subject to income tax?

   • A
     Only if the policy was set up within two years of death, when anti-avoidance income tax rules apply
   • B
     No, but they are subject to capital gains tax if the policy has increased in value
   • C
     Yes, basic rate income tax is deducted at source by the insurer before payment to the estate
   • D
     No, death benefits from a personal term assurance policy are free of income tax
     Correct answer
   Explanation

   Death benefits from a personal term assurance policy are paid completely free of income tax. Term assurance is a qualifying policy and an insurance product with no investment element, so no chargeable event can arise. The correct tax concern with a life policy not in trust is IHT (inheritance tax), not income tax. Students frequently confuse these two taxes in this context.