What are Purchased Life Annuities and how are they taxed?

See how Purchased Life Annuities (PLAs) provide a guaranteed income normally until death or expiry of a fixed term. 

What is a PLA?

A PLA provides a guaranteed income for life, in exchange for a lump sum.

A PLA is an annuity purchased from an insurer. Its terms must include a life contingency. Usually the annuity will be for life, but it could be for a term ascertainable by reference to life. For example:

• the annuity could end at the earlier of death or the expiration of a fixed term or on some other specified event
  
  
• the annuity could continue after death for a specified term or according to some other specified condition.

Each annuity payment comprises a return of part of the capital plus a sum reflecting, in economic terms, interest.

PLA taxation

PLA taxation uses the terms; 'capital element', an 'exempt sum', or an 'exempt proportion', depending on the circumstances.

The deemed capital element/exempt sum/exempt proportion is free of UK income tax as this is simply a return of the purchaser’s capital.

The remaining portion of each annuity payment is deemed to be taxable savings income.

The approach reflects the amount of exempt capital comprised within each of the annuity payments. In broad terms, the exempt capital amount is obtained by dividing the purchase price of the annuity by the subject's life expectation, determined according to prescribed mortality tables.

This is often described as a partial exemption scheme.

The term PLA is defined for the purposes of the partial exemption scheme as an annuity;

• granted for consideration in money or money's worth in the ordinary course of a business of granting annuities on human life, and
  
  
• payable for a term whose length requires the ending of a human life to be taken account of, even though the annuity may in the event end before or even after the life.

It includes 'guaranteed' and 'temporary' annuities.

Exclusions from the partial exemption scheme

Certain categories of annuity are excluded from the partial exemption scheme.

• pensions annuities
  
  
• annuities the consideration for which attracted life assurance premium relief
  
  
• annuities purchased under a direction in a will
  
  
• annuities purchased out of income of property disposed of by a will or settlement as a result of that will or settlement.

For clarity, for a PLA to qualify as being within the partial exemption scheme (the capital element to be paid tax free) it cannot be purchased because of the terms of a will or settlement

The capital element cannot be paid tax free where;

• the money comes from the proceeds of a will where an annuity has to be bought because of conditions in the will
  
  
• the money comes from the proceeds of a will or settlement where an annuity has to be bought to replace an annuity that was due to be paid under the terms of the will or settlement
  
  
• annuities purchased out of income of property disposed of by a will or settlement as a result of that will or settlement.

However HMRC states, in regards to proceeds from a will, the annuity will not be barred from exemption where:

• a lump sum is inherited under a will with no conditions or terms
  
  
• the gift of a lump sum is received from a settlement with no conditions or terms.

The partial exemption scheme in operation

The legislation prescribes the amount of each annuity payment that is treated as exempt from income tax.

UK tax is charged on the amount of annuity payments arising in the tax year, subject to the special rules on foreign income. It is charged on the person receiving or entitled to the payments, with credit given for any tax deducted by the payer.

No tax is charged under the scheme on the exempt capital element.

Effect of life and other contingencies on term of annuity and on amount of annuity payments

The term of every PLA is dependent on the duration of human life by definition. The amount of the annuity payments may also be so dependent. And either term or amount may or may not be dependent on some other contingency.

If the amount of the annuity payments depends solely on the duration of human life, a constant proportion of each annuity payment is exempt, called the exempt proportion.

If the amount of the annuity payments does not depend solely on the duration of human life, because it is subject to some other contingency, a constant sum is exempt, called the exempt sum.

It is possible in some circumstances, for the exempt sum to exceed a particular annuity payment. In that case, the excess exempt amount is carried forward.

The method of calculating the exempt proportion or exempt sum depends on whether, as will usually be the case, the term of the annuity is solely dependent on the duration of human life, and not on some other contingency.

If the annuity term is solely dependent on the duration of human life, the following formulae are used:

Exempt proportion

This formula applies where both the term and the amount of the annuity payments are solely dependent on the duration of human life and not on any other contingency. This is the most common kind of purchased life annuity. The amount of payment may change, but only in a specified fashion. This might be under a stepped annuity, where the payments increase by a pre-determined fraction at intervals, or, if written on two lives, might reduce on the first death.

In this case:

Exempt sum

This formula applies where

• the term of the annuity payments is solely dependent on the duration of human life, but
  
  
• the amount of the annuity payments does depend on a non-life contingency.

In this situation, the amount of the annuity payment may change in an unpredictable way, which makes actuarial techniques impractical. So the exempt part of each annuity payment is calculated as a constant sum.

A common example of this type of annuity is one whose payments are linked to the value of the retail prices index. It is this type of annuity that may give rise to the situation where the exempt sum may in the early stages exceed the annuity payments.

In this case:

Companies investing in PLAs

UK resident companies investing in a PLA will be taxed under the loan relationship rules.

Deduction of tax at source

UK resident insurers are obliged to deduct tax at source from the income/interest element.

PLAs issued by non-UK providers

A PLA from a foreign payer can still have an exempt capital amount, but overseas payers must meet certain information requirements as to the basis of the calculation. The payment is of course received without deduction of tax and UK tax on the income element is paid through self-assessment.

PLAs and IHT 'normal expenditure out of income'

The HMRC analysis is:

'The capital element of a purchased life annuity within the meaning of ITTOIA 2005/S423 purchased on or after 13 November 1974 is not regarded as part of the transferor's income for the purposes of the exemption in accordance with IHTA84/S21(3).'

Source: IHTM14250

IHTA 1984 section 21(3) states:

(3) So much of a purchased life annuity (within the meaning of section 423 of the Income Tax (Trading and Other Income) Act 2005 as is, exempt from income tax under section 717 of that Act , shall not be regarded as part of the transferor's income for the purposes of this section.