HMRC considers it prudent for a charity to seek professional advice before purchasing an insurance bond or accepting a transfer of an insurance bond from a donor.
This article relates to both life assurance and (offshore) capital redemption bonds.
Gains on insurance bonds are not tax exempt for charities.
Insurance bonds are not qualifying investments for charities.
The Charity Commission has published investment guidance for trustees.
OEICs are tax efficient investments for charities.
Life Assurance and Capital Redemption Bonds
These notes apply to both life assurance bonds and capital redemption bonds held by charities.
"Charity trustees may... consider it prudent to seek professional advice before entering into an insurance policy or accepting a transfer of an insurance policy from a donor". (HMRC)
Most of the income and gains received by charities are exempt from income tax and corporation tax, provided that the money is used for charitable purposes only. However that statement contains two qualifications - 'most' and 'used for charitable purposes only'.
Charitable exemption - exception for insurance bonds
'Most' implies that certain items do not enjoy exemption. One type of gain that does not enjoy exemption is a chargeable event gain on a life assurance - or capital redemption - bond made by an unincorporated charity. HMRC state the following
Insurance policy assigned to charitable trust or taken out by the trust - chargeable event on or after 9 April 2003
All gains treated as arising on life insurance policies, which are owned by a charitable trust, are treated as forming part of the income of the trustees for the year of assessment in which the gain arose. This is the case whether or not the policy or premium has an identifiable donor.
With regard to a corporate charity, HMRC state the following with regard to insurance policies.
Accounting periods beginning on or after 1 April 2008
...deemed to be loan relationships with effect from accounting periods beginning on or after 1 April 2008. Exemption from tax on non-trading profits in respect of loan relationships is available under section 486 CTA 2010 (previously section 505(1)(c)(ii) ICTA 1988) provided the income is applied to charitable purposes only.
The second leg of the 'qualification' is much easier to understand; why should a charity enjoy tax exemption on its income, if that income is not being used to advance its charitable objectives?
This brings us to question of what is meant by 'used for charitable purposes only'? Expenditure on items such as charitable grants and administration is charitable expenditure and falls within the scope of 'used for charitable purposes only'.
Charitable expenditure does not include investments that the charity has made. This is because the making of an investment is not generally regarded as expenditure. It is, however, appropriate that - where circumstances dictate - charities invest. A charity could be building up a fund for many years with a defined objective, such as building a clinic in a third-world country, and it would therefore be inappropriate to deny tax relief on that ground alone.
The tax legislation sets out categories of 'qualifying investments' which include bank deposits, national savings products, 'gilts', listed shares, unit trusts or open-ended investment companies (OEICs).
An investment or loan which does not fall within these categories is 'non-qualifying'. HMRC does not accept that premiums paid by charities on insurance policies, including policies assigned in favour of charities, are qualifying investments. This restriction covers both life assurance and capital redemption contracts.
If the charity makes a non-charitable (non-qualifying) loan or investment, this is treated for tax purposes as non-charitable expenditure. The charity will lose tax exemption on some, or all, of its income.
How does this work in practice?
Example of a charity purchasing an insurance bond and losing tax exemption on some income
Smiley Faces Ltd. is a charity. It prepares financial statements to 31 March annually. Let’s assume the following:
Gift Aid income (including HMRC tax refund)
Bank interest (gross)
During the year Smiley Faces Ltd. invested £25,000 in a single premium bond.
The tax consequence of this investment is that Smiley Faces Ltd. loses tax exemption on £25,000 of income. It will have a tax liability and will need to complete a tax return.
Example of a charity purchasing an insurance bond, losing tax exemption on some income, and creating a surplus of non-qualifying expenditure
Happy Grins Ltd. is a charity and prepares its financial statements to 31 March annually.
Its financial statements can be summarised as follows:
Gift Aid income (including HMRC tax refund)
Bank interest (gross)
Concerned at the low rate of interest available on bank deposit accounts, the trustees decided to invest £300,000 in a single premium bond.
The tax consequences of this investment for Happy Grins Ltd. are as follows:
The company loses tax relief on its income. It will suffer tax on the £65,000 of income.
But, unfortunately, the tax problems don't end there. There is a surplus of non-qualifying expenditure amounting to £235,000 (£300,000 - £65,000). This is carried back and set against charitable income of the previous year and tax-relief is clawed back. This carry-back process continues until:
(a) There is no longer any excess non-charitable expenditure, or
(b) The accounting period to which the excess is carried back ended more than six years before the end of the period in which the non-charitable expenditure was actually incurred.
If there is a restriction on tax-relief the charity is obliged to self-assess.
Although the above examples refer to an incorporated charity, similar rules apply to charities constituted as trusts.
Gifts of life insurance bonds
Gifts of insurance bonds - or capital redemption bonds - to charities don't qualify for income tax relief (or corporation tax relief) for the donor.
Investment responsibilities of trustees of charitable trusts
The Charity Commission has published CC14 “Charities and Investment Matters: A guide for trustees”.
The guidance contains the following matters which are of particular relevance to financial advisers:
The duties set out in the guidance are based on the law relating to Trust Law, but directors of charitable companies (who are charity trustees) are likely to have similar duties when investing their charity’s assets.
The purpose of financial investment is to yield the best financial return within the level of risk considered to be acceptable - this return can then be spent on the charity’s aims.
In order to act within the law, trustees must:
know, and act within, their charity’s powers to invest
exercise care and skill when making investment decisions
select investments that are right for their charity. This means taking account of how suitable any investment is for the charity and the need to diversify investments take advice from someone experienced in investment matters unless they have good reason for not doing so
follow certain legal requirements if they are going to use someone to manage investments on their behalf
review investments from time to time
explain their investment policy (if they have one) in the trustees’ annual report
Before making any investment decisions, trustees should consider what is the appropriate level of risk that they want to, or are able to, accept. As part of their duty of care, the trustees must be satisfied that the overall level of risk they are taking is right for their charity and its beneficiaries.
Although investments structured as life assurance bonds are clearly inappropriate it would be permissible for investments structured as OEICs and unit trusts to be held by charities. The income from these entities would be free of income tax and capital gains on their eventual disposal would be exempt from capital gains tax. OEICs and unit trusts hold a number of internal investments thus meeting requirements for diversification. They are internally tax efficient; disposal of holdings by managers are capital gains tax exempt. They can readily be converted back into cash (subject to the possibility of funds suspending redemptions).
Trustees must take and consider advice from someone experienced in investment matters before making investments and when reviewing them, unless they have good reasons for not doing so. They may decide not to take advice if they conclude that it is unnecessary, or inappropriate in the circumstances. They may decide not to take external advice if they have sufficient experience within the charity.