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"Dangerous" offshore inheritance tax solution hits mainstream

Advisers are touting a new "quick fix" inheritance tax solution which takes advantage of an offshore pensions loophole, but is it too good to be true? Investors Chronicle investigates.
October 23, 2013

Thousands of wealthy investors are being sold an unregulated 'loophole' inheritance tax solution that most wealth managers warn will put them at risk of huge financial losses, fines and prosecution.

A number of regulated financial advisers are, for the first time, encouraging people to take advantage of a glitch in the law, which allows them to instantly protect unlimited sums of money from inheritance tax (IHT) by funnelling it into pension schemes in Guernsey and Malta.

But these foreign pensions, known as qualifying non-UK pension schemes (QNUPS), were set up to give UK residents living abroad access to their retirement fund. Never were they intended to help people firmly settled in the country hide from inheritance tax.

Because of this, the vast majority of wealth managers believe HM Revenue & Customs (HMRC) will view it as tax avoidance and is therefore highly likely to close the loophole.

They predict the taxman will collect retrospective taxes from anyone that has ever benefited from it, while nasty fines and even prosecution will be dished out to the worst offenders.

A spokesperson from HMRC said: "A small minority of people try to use tax avoidance schemes to get out of paying their fair share. They should ask themselves whether the scheme they are offered sounds too good to be true. There are serious downsides to getting involved with tax avoidance.

"People need to think very carefully before taking us on."

But, despite widespread concern, in recent months a raft of mainstream investment houses have started selling QNUPS as a 'non-aggressive' strategy to UK investors - specifically those that want to avoid IHT and simultaneously build up their pension pots beyond the newly trimmed annual limit of £40,000, without paying punitive tax on the excess.

Provided they have already used up their annual pensions and carry forward allowance, investors can shift as much cash as they like into QNUPS, and invest it in virtually any asset, apart from their family home.

And as long as they can prove they are using it for genuine pension purposes once they reach age 75 (by taking a 25 per cent lump sum and drawing an income thereafter), the full amount instantly becomes IHT-free because QNUPS don't have to report to HMRC.

Bestinvest, one of the UK's largest financial advice firms, is eyeing up a number of QNUPS providers as potential inheritance tax and pension solutions for its 70,000 UK-based customers.

It has yet to sign on the dotted line with any of them, though.

Tony Welby, a tax expert at wealth management firm Saunderson House, said these foreign pension havens are too good to be true. "The rules are not black and white and HMRC will legislate to change them if they become popular IHT avoidance vehicles.

"HMRC has the power to apply new laws retrospectively, too, which would mean UK residents using QNUPS to IHT plan years before a rule change would be caught and forced to cough up what they owe or face a legal battle," he said.

Simon Denton, managing director at Sovereign Group, one of the many small firms that sell QNUPS, said he has taken phone calls and met with hundreds of interested adviser firms since the start of the financial year.

But because the legislation that created this loophole was only introduced in 2010, he says most are still too nervous around the new laws to sell QNUPS to UK residents.

However, after a recent surge in attention, private investors can now buy Sovereign Group QNUPS through around 20 UK investment managers - a number of which are large national firms.

Mr Denton said: "Advisers should not be selling you a QNUPS if reducing IHT is your main motivation. The reality is that some of them are, but unless it's genuine retirement planning you're doing, you should not go down this road. However, we as trustees do not get involved with managing people's investments."

 

Could you use foreign pensions to your advantage?

As the law currently stands, QNUPS look like ideal places to build an additional pension pot and shelter money from IHT at the same time. Unlike qualifying recognised overseas pension schemes (QROPS), which have to be registered with HMRC before they can benefit from generous tax breaks, QNUPS don't have such reporting requirements to HMRC.

One of the most striking features is the immediate IHT exemption when you transfer money in. This makes QNUPS a 'quick fix' when compared to other IHT planning exercises. For example, you have to wait seven years before money you put in a trust or give as a gift will sit outside your estate. You also have to hold business & property relief qualifying Aim shares for two years before they become IHT-exempt.

And if you have money left in UK pensions when you die, a tax charge of 55 per cent is imposed before your beneficiaries are paid. But a QNUPS fund is exempt from this levy.

There is also no ceiling on the contributions you can make, or the fund size of these schemes and the source of funding need not come from employment-related income. QNUPS are classed as an overseas pension and are therefore subject to the foreign income pension rules.

This means you can take a lump sum payment of up to 30 per cent of the fund size, you don't have to buy an annuity and there are no reporting requirements to HMRC. You will also be free from capital gains tax on investment growth (other than withholding tax).

But to benefit from all this, you need to show you're genuinely using the pension to save for retirement income. Financial advisers selling QNUPS will make sure you can prove this by advising you:

■ Have already used up your annual pensions and carry forward allowance for the years in which you contribute to the scheme.

■ Are not using QNUPS for death-bed planning (if you know you are terminally ill)

■ Take a 25-30 per cent lump sum from the QNUPS when you reach age 75

■ After age 75, you must prove you are using the fund to supplement a regular pension income

■ You can invest almost any asset in the fund, including residential property, but you must not hold your primary home within a QNUPS, and you cannot transfer a UK pension into a QNUPS (unlike a QROPS).

 

Why foreign pensions could cause havoc with your estate

The problem is that most wealth managers think the loophole that allows you to avoid IHT through QNUPS as a UK resident will be closed - if it gets popular (it looks like things are going that way). This means you'll have the hassle of finding somewhere else to invest your money, and if they apply a retrospective rule change after you've passed away, your beneficiaries could be left with a massive tax bill.

Investors Chronicle calculations also reveal the high charges often associated with QNUPS could cancel out the inheritance tax relief all together, meaning you'd lose out even if HMRC continues to turn a blind eye to it.

Take, for example, a 45-year-old investing £100,000 a year for five years in a QNUPS. They receive a gross investment return of 6 per cent a year for 30 years and don't withdraw any money (at age 75 they have to start drawdown.)

The QNUPS is subject to 5 per cent initial costs on contributions, and 3 per cent a year ongoing costs. The pot would be worth £1,063,000 when they turned 75 and would not be subject to inheritance tax, so the full amount would be left to their beneficiaries if they died.

Now take exactly the same scenario, except instead of a QNUPS, the individual invests in a portfolio of taxable onshore investments subject to zero initial charge and 2 per cent a year average ongoing costs. Even if they are taxed 40 per cent IHT on the full amount, they'll still have £1,134,000 after tax to leave to their beneficiaries.