HM Revenue & Customs (HMRC) is looking under every last stone for tax avoiders. Its latest crackdowns have left many scared to touch any investment with the term 'offshore' in its name. But offshore investing is not always synonymous with hiding money from the taxman. In the case of offshore bonds, your investment can roll up without income or capital gains tax being deducted and you can draw five per cent tax free, each year, perfectly legally.
Tax planning experts are touting these vehicles as the new 'holy grail' of tax-efficient investing. Their argument: with offshore bonds, the tax treatment is based on specific legislation, so the position is clear and beyond HMRC's challenge. This is tax mitigation, not tax avoidance.
Appetite for wrappers
David Kilshaw, partner in the private client advisory division of accountants KPMG, says that as tax rates continue to rise, so too has the popularity of 'wrappers'. "Clients have moved this topic to the top of their agendas. Investments can grow tax free within a 'wrapper' with the tax charge deferred until the wrapper is encashed. Offshore bonds are perhaps the most popular form of wrapper," he comments.
Offshore bonds, or offshore life insurance bonds in full, involve a single premium paid to a life company. "These investment vehicles pay a lump sum on surrender or on death. Typically wrappers of various assets, usually mutual funds, the investor buys a unit in the bond itself (rather than a direct holding in the underlying investments). The performance of the bond is linked to the underlying investments. The investor can switch between funds as they go through different life stages without suffering a tax charge," explains Lucy Hardwrick, a director in the private clients practice at Deloitte.
Once you make your single premium payment, you can draw five per cent from the bond each year without suffering an immediate tax charge. If you don't make annual withdrawals, the five per cent carries forward, so, for example, if in the first three years you did not make any withdrawals from your offshore bond, then in year four, you will have cumulative 15 per cent available for tax-free withdrawal. You are also not taxed until you surrender the bond.
Offshore vs onshore
"In essence the main difference between an onshore bond and an offshore bond is the taxation, however, typically offshore bonds have more investment flexibility. Both offer a simply tax efficient wrapper for investments," explains Dion Lindskog, head of life and pensions products at RBC Wealth Management.
In both onshore and offshore bonds the funds accumulate within the bond and up to five per cent per annum can be withdrawn tax free. The main difference with offshore bonds is that the income and capital gains can roll up gross within the fund. Within onshore bonds, the underlying funds are subject to tax on income and gains as they arise.
"When funds in excess of five per cent per annum are withdrawn from onshore bonds, there is a 20 per cent tax credit that satisfies any liability to basic rate tax of the investor. Higher-rate tax payers will pay any extra 20 per cent or 30 per cent but non-tax payers cannot recover the tax credit. With an offshore bond there is no corresponding tax credit on withdrawals in excess of five per cent per annum so a higher-rate tax payer will be taxed at their marginal rate on the total gain," explains George Bull, head of tax at accountants, Baker Tilly.
As the tax bill on an offshore bond only arises when the bond is encashed, the bondholder can choose their tax day. Tax payers love this flexibility, says Mr Lindskog, adding that the choices are many. For example, you could:
• Encash in a year when tax rates have fallen;
• Encash in a year when your other income is such that you pay at lower rates.
• Move offshore – possibly for as short a period as one year and encash the bond tax free.
"Offshore bonds are also able to offer a wider range of investments than onshore bonds owing to the different regulation offshore," adds Mr Bull. "This different type of regulation can mean less security but, on the other hand, the more varied nature of the investments which can be made in an offshore bond may mean that risk is minimised."
Non-doms and others
Following tax changes announced in October 2007, non-domiciled UK tax residents need to pay a subscription fee of £30,000 per annum to the taxman to make sure their offshore income and gains does not fall prey to UK taxes. For many, the £30,000 is not justifiable relative to their offshore income, and this is where offshore bonds come in useful.
"Non-domiciled but UK resident individuals who wish to declare worldwide income could invest in an offshore bond and leave the funds to roll up (or only take the 5 per cent withdrawal per annum). They would thus be able to have funds outside the UK but avoid paying the £30,000 unless they take out more than 5 per cent per annum. They may also be able to avoid a UK inheritance tax liability as offshore bonds are non-UK assets," explains Mr Bull.
Other investors to whom offshore bonds may be suited to include:
• Investors planning to live or retire abroad who would be subject to local rather than UK tax on policy gains;
• Investors who will be non-tax payers at the time of a chargeable event (as mentioned above if they invest in an onshore bond, the 20 per cent tax credit cannot be reclaimed);
• Investors who are investing for the long-term so there is more opportunity for the bond to offset the effects of tax and charges and perhaps outperform an onshore equivalent.
Family finances
Offshore bonds can also play an important role in your family financial planning. For example, for higher-rate tax payers it may be tax efficient to assign the bond, or segments of the bond, to a spouse or a civil partner who is a non-tax payer, to lower the amount of tax paid on encashment.
Parents can take out an offshore bond on behalf of a child and then assign it to them when they go to university, which is a useful way to put money away for education, and tax efficient as most students don't pay tax.
Offshore bonds also have a role to play in inheritance tax (IHT) planning. Assignment to a spouse or civil partner would normally be exempt from IHT, while assigning a bond into trust can allow the beneficiary to make withdrawals or cash in the bond when the trust is wound up. This could save tax if the beneficiary is a basic or non tax-payer.
The caveats
If this all sounds too good to be true, here's the bad news: there are a number of disadvantages and risks inherent to this investment vehicle.
For example, on disposal of the bond, chargeable-event gains can suffer tax up to 40 per cent. As withdrawals from a bond are assessable to income tax it's not possible to use personal or trustee CGT allowances to reduce gains.
The death of last of the lives assured on whole-of-life contracts will create a chargeable event (even if bondholders themselves are still alive).
If you suffer investment losses these cannot be offset elsewhere, and on death, income tax and inheritance tax may be due.
Other issues to be wary of include the high commission on these vehicles - so make sure your financial adviser is selling you an offshore bond for the right reasons. Also look out for high charges that often cancel out the benefits of gross roll-up. To ensure the bond's roll-up outweighs the charges, it is usually better not to encash your bond too early.
In terms of choosing a suitable offshore bonds, Ms Hardwrick advises you take a good look at the charges for running the bond, which tend to be around 0.5 per cent of the amount invested, but there are other annual charges to be wary of as well. Also compare the underlying funds the bond is invested in - does this suit your risk profile?
Typically, investors most suited to offshore bonds are higher-rate tax payers who anticipate being lower-rate tax payers in the future, perhaps in retirement. These vehicles could also be useful if you have already used up your CGT allowance, and other allowances such as Isas and pensions.
• For more tax planning strategies and tips see this week's Golden Rules Of Investing supplement.
