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Roll up for the offshore bond

If you've used your lifetime pension allowance, the offshore investment bond could offer an attractive solution.
May 15, 2015

With the pensions lifetime allowance of £1.25m set to fall to £1m in 2016/17 tax year, those who have accumulated that amount or are near it will need to consider other tax-efficient options for their retirement savings. An option could be offshore investment bonds. These are investment wrappers set up by life insurance companies in an offshore jurisdiction with a favourable tax regime such as the Isle of Man, Dublin or Luxembourg.

While the bond is invested you do not pay tax on it and this is known as gross roll up. This allows the investments to grow unhindered by tax, though withholding taxes may apply, potentially enhancing the overall return on the investment. You incur income tax at your marginal rate when you take out the capital if you are a UK resident. If, for example, your marginal rate of income tax falls in the future because you have retired, then it could be cheaper to encash at that point.

You can draw down small amounts each year, up to 5 per cent of the amount of the original capital sum, and defer the tax bill on that until the end of the contract. If you do not take your 5 per cent in some years you can use that allowance in future years.

Being able to take regular amounts without upfront tax can make these useful for structuring a retirement income stream.

Over and above the 5 per cent annual allowance you pay income tax. Offshore bonds are divided into a number of segments, often 100, each of which is regarded as a whole policy in its own right. Whether you encash a whole one or partially can make a difference to the amount of tax your ultimately pay, depending on your individual circumstances. Sarah Lord, director of wealth planning at Killik & Co, suggests that you get advice if you are looking to draw down more than your 5 per cent annual allowance.

 

Multiple uses

Offshore bonds are highly beneficial investments for discretionary trusts. Unwrapped assets in a trust pay 45 per cent income tax and 28 per cent capital gains tax (CGT), but if the trust invests in an offshore bond then it does not.

These bonds can be used for estate planning: if you gift a unit trust to someone you have to pay capital gains tax on the profits, but if you assign an offshore bond you do not pay tax on the gains at that point. Rather the recipient will pay income tax at their marginal rate on it when they draw it down. If they are non tax payers they could cash it in slices to stay within the personal allowance, which for the 2015/2016 tax year is £10,600. And if you survive for seven years the recipient will not incur inheritance tax.

Investment bonds are non-income producing assets for UK tax purposes so details of the bond do not have to be included on a tax return until a taxable withdrawal is made.

If you live abroad for some of the time you hold the bond you do not incur tax for those years. For example, if you live outside the UK for five years of a 10 year investment bond, only half the gain is taxable.

If you plan to retire or move abroad an offshore bond could be useful as when you encash you will not incur UK taxes. On realising the investment, any potential tax charge is dependent on your country of residence. If you plan to do this it may be worth checking that the bond you have in mind will pay you in a currency other than Sterling.

HOW TO PAY 7.8 per cent TAX ON £50,000 INCOME

Peter has retired following the sale of his business and is looking for £50,000 net income a year. He has pension assets of £800,000, venture capital trusts (VCTs) worth £70,000, an offshore bond worth £200,000, an Isa worth £70,000 and unwrapped investments of £80,000.

His VCTs produce approximately £3,500 tax free, his Isa produces £2,800 tax free, and he will be drawing a combination of tax free cash and taxable income from pensions to total £40,000 which amounts to £24,000, as £10,000 is tax free and £30,000 is taxable.

This can then be supplemented by £10,000 from his offshore bond. After his personal allowance of £10,500, on £50,000 net income he will have paid £3,900 tax. This is even before he has used his CGT allowance on any additional withdrawals on his unwrapped arrangements which can then be used as and when necessary.

Source: Kingsfleet Wealth

 

Use Isas and pensions first

You should not consider offshore bonds instead of an individual savings account (Isa) or pension, cautions Danny Cox, chartered financial planner at Hargreaves Lansdown. Only use an offshore bond once you have used up your annual Isa allowance (£15,240) and annual pension allowance (£40,000) and your annual CGT allowance which is £11,100 for the 2015/16 tax year. Offshore bonds should only be considered by wealthier investors with more than £100,000 to invest.

Even then, these should form part of your solution rather than all of it. You could also consider other tax efficient products such as venture capital trusts (VCTs), though these are high risk as they typically invest in early stage companies so are not suitable for all.

"Offshore bonds should be considered as part of structuring a retirement income portfolio," says Colin Low, chartered financial planner at Kingsfleet Wealth. "In a mixed structure of investments which includes a drawdown pension, Isa and VCT portfolio, offshore bonds can provide a steady level of regular withdrawals but can be invested in line with the client's attitude to risk."

Offshore bonds are not suitable if you are going to pay higher or additional rate income tax on your way out, or if you expect your marginal tax rate to rise at the time you plan to encash the bond and are staying in the UK.

 

How to choose a bond

Some offshore regimes have better protection and regulation than others, and the Isle of Man and Ireland are among the better regulated ones.

Some bonds have a minimum or maximum age so you should check this.

Offshore investment bonds are different to portfolio bonds. The former allow access to funds from a wide range of providers, whereas the latter are more restricted in their choice of investments.

"Individual shares are theoretically possible but are taxed in a very draconian way to deter investors from holding them," says Mr Low.

Open-ended funds are the main options for offshore bonds, though non UK residents can hold equities and Gilts.

Defaqto rates offshore bonds with one- to five-star ratings according to a number of criteria including financial strength, plan currency, trust facilities and choice of funds.

Mr Cox likes products offered by AXA Isle of Man and Standard Life International.

Mr Low suggests products offered by Old Mutual International and Canada Life International because these providers offer a very wide choice of funds.

Defaqto five-star rated investment bonds

BondFinancial strength ratingNumber of funds availableTrust facilitiesOnline fund switchingPlan currencyMaximum age attained (life assured)
AEGON Ireland Wealth Management Portfolio B+unlimited6yes£,$,€85
AXA Isle of Man EvolutionB+unlimited9yes£,$,€unlimited
AXA Life Europe SelectionB+unlimited6yes£,$,€unlimited
Canada Life International Delta AccountB+1616yes£,$,€79
Prudential International Investment BondB+557no£,$,€, and others89

Source: Defaqto

Costs of offshore bonds

Offshore bonds can be expensive: some providers impose an entry charge which is typically around 1 per cent, or an establishment charge of about the same level which is spread over a number of years. With the latter structure there can also be exit penalties. There is an annual administration fee of £400 to £500 a year, and you also have the costs of the investments held within the bond.

"Offshore bonds make more financial sense the more you invest and the longer the period," says Danny Cox at Hargreaves. "This is due to the additional administration charges over and above the fund charges, so the benefits of gross roll up have to exceed these extra costs. You should have about £100,000 as a minimum investment over at least seven years."

Offshore bonds are only available via financial advisers so you have their fee to consider.

Some providers charge for switching funds within the bonds.

Everything that goes into the bond moves into the income tax rather than capital gains tax regime.

Once your money is in the bond you cannot access it without incurring your marginal rate of tax, with the exception of 5 per cent a year. Some offshore bonds also levy a penalty for early encashment.

You could assign it to someone who is not a taxpayer to cash in, but the bond becomes their property rather than yours.