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Why do people use offshore investment bonds as a financial and tax planning tool

Source: International Adviser June 2023

In 1988, the Conservative chancellor Nigel Lawson aligned capital gains tax (CGT) rates with those of income tax, and in turn gave the UK one of the highest rates of CGT in the world (40%). These rates remained for 20 years until Labour chancellor Alistair Darling moved to a flat rate of 18% for all.

Now, as then, ISAs could be used to shelter some spare cash, but what if the sum exceeds the £20,000 ($,€) per person, per year ISA limit? An option could be something else that was popular back then – offshore investment bonds.

An offshore investment bond is an insurance policy provided by a non-UK insurance company commonly based in an international jurisdiction such as Ireland, Luxembourg or the Isle of Man. The rules for offshore bonds are such that they are treated as single premium life insurance policies, as they pay a small element of life insurance upon death, but they are really a tax wrapper-investment product.

A single or more regular lump sum investment (deemed a ‘premium’) in most cases will be used to acquire a discretionary investment fund portfolio for the medium to long term, much as a client would if they directly handed their capital over to a discretionary investment manager.

But the life policy provides unique tax efficiencies. No tax is payable on any investment growth unless a withdrawal, or ‘chargeable event’ occurs. If the client had no need to access the funds for a number of years, then gross roll-up of income and gains can considerably benefit the ongoing value of the investment.

This means they can time the tax liability to when it best suits them, which might be when they are a lower rate taxpayer, or when they are living somewhere more tax efficient. This is also the opposite of a personally held investment portfolio, where tax would be due on interest, dividends and gains that accrue annually.

In most cases, a policy will be divided into 1,000 segments. They can choose to wind up whole policy segments or withdraw a percentage of each segment across the board. The best option might depend upon the sum required, whether this exceeds 5% of the cost of each segment, and the availability of any 20% tax band.

The former basis means tax is due on the profit over and above the capital invested in each policy segment. So, if they invested £100 in a policy with 10 segments, which in year two is worth £110, it has roughly gone up in value by 10%. If they withdraw £11 in year two, they will be taxed on £1 of gain, as it represents the 10% profit in one segment (and not the £10 of profit if they took £11 from a directly held portfolio).

The tax can be reduced even further if the policy has been in existence for more than one year. This is called ‘top slicing relief’ where the gain on the withdrawal is divided across the years, with one year’s worth added to the income of the year of withdrawal. The tax on this sum is calculated, and then multiplied back up by the number of years to get the actual tax due.

It might sound like you should end up with the same amount as if you simply taxed the whole profit, but not if the year of withdrawal happens to be one where you have some or all your 20% rate band to spare, which might be the case if you are in retirement.

Retiring abroad

Let’s now include the added complication of retiring abroad – how does this affect how the offshore bond is taxed? Luckily enough, most EU states where UK nationals like to retire have their own offshore bond legislation, and again there are various tax efficiencies to benefit from.

Though it depends on the country, the basic tax deferral position continues to apply, with gross roll-up and the possibility of timing when it is best for the client to take a tax liability. While policy segmentation is irrelevant abroad and there is no top slicing, the fundamentals of only taxing the profit percentage within a withdrawal remains.

In addition, in Portugal the gain is reduced by 20% after the policy has been in existence for five years and then by 60% after eight years. There is also a choice as to whether to pay tax at a flat 28% or through the scale rates in Portugal.

In Cyprus, there is no tax payable on offshore bond withdrawals, and similarly in Malta, a UK national would not normally suffer any tax on a withdrawal from an offshore bond.

Both France and Spain only tax the increase in value contained within the sum withdrawn, while France includes significant succession tax benefits and the policy is French wealth-tax-free. In Spain, the bond could fall outside of Spanish succession taxes if the beneficiary is not Spanish resident.

If we take our example even further and assume at some point they decide to return to live in the UK, this can be hugely beneficial when they make a subsequent withdrawal or wind up the policy. Any gain is averaged across the whole period of ownership, and the years of residence overseas are deemed exempt, with HM Revenue & Customs (HMRC) only taxing the years when they lived in the UK.

The financial and tax planning issues are very different for non-resident Brits, referred to as part of the "off-shore" market, as compared with UK residents. It is critical to always receive advice from licensed offshore advisers.

Whenever you have any questions, we urge you to talk to your adviser within the Just Service Global Network.

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The Just Service Client Service Team

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