Offshore solutions Offshore bonds versus collective investments making your options clear For advisers only. Not for use with customers.
Background You will be aware of the debate over whether it is better to invest in collective investments directly, or via an offshore bond wrapper. At Friends Provident International we do not think it is a case of which one is better. We believe it is a matter of which is more appropriate, given an individual s personal circumstances. There are situations when it may be more beneficial to invest in the collective investment directly and other times where it will be advantageous to hold the investments within an offshore bond. The debate centres around the tax treatment of collective investments and offshore bonds. Whereas gains arising from disposals of Financial Conduct Authority (FCA) authorised collective investment schemes and many offshore funds are subject to Capital Gains Tax (CGT), on encashment gains from offshore bonds are subject to income tax. Where a customer decides to adopt an investment strategy based on growth focused collectives which do not generate income, it will often make sense to invest in the collective directly. The benefit of this is that certain attractions of the CGT regime could potentially apply, including: Rates of 18% and 28%, with the rate payable determined by an individual s total income and gains.* The annual CGT exemption, currently 11,100.* The ability to carry forward losses indefinitely.* Gains on death effectively being washed out.* Holdover relief on gifts to discretionary trusts and deferral relief when gains are reinvested into an Enterprise Investment Scheme (EIS).* * The tax information included in the guide is correct at August 2015 2 Friends Provident International Offshore bonds versus collective investments making your options clear
Income generating portfolios Many advisers would deem a strategy based purely on growth focused assets as unsuitable for a large proportion of their clients, given that such assets tend to have a higher element of risk attached to them. Also many investors require income generation within their investment portfolio, either to supplement their income needs or to provide investment growth over the long term by reinvesting investment income. This latter point is significant during this sustained period of stock market volatility. Many investment managers are seeking to generate investment income to provide long term growth through dividend generation, with attractive, consistent dividend yield widely available. Where income producing investments are a feature of a portfolio, an offshore bond should at least be considered, particularly when considering that additional rate tax payers face tax rates of 45% for non dividend income and 37.5% (rising to 38.1% from April 2016) on dividend income. Offshore bonds are structured as either Whole of Life assurance policies or Capital Redemption contracts, and are often segmented to provide additional flexibility. They enable the investor to roll up the investment income and gains generated by the underlying investments until a point when they choose to take money from the bond, or where the life assured on the policy dies (if it is a Whole of Life policy). Rolling up income and gains in this manner gives the investor control over when they pay tax on the overall offshore bond gains, which results in some attractive tax deferral opportunities. Perhaps the most well used deferral strategy is to delay encashment of the policy until the investor falls into a lower tax band on retirement, when they may also have the ability to control their other income; for example during income drawdown in relation to their Self-Invested Personal Pension (SIPP). Where income producing investments are a feature of a portfolio, this is when an offshore bond should at least be considered. 3
Lowering tax liability Business protection requirements for partnerships There are a are number twofold: of other features of offshore remaining bonds partners which without allow undue investors financial strain. to lower the effective rate of tax paid on policy gains, which will now be examined: Top Slicing Relief To ensure that if a partner leaves the business for any reason, the business can continue under the control of the Ensuring that when a partner leaves the business their family is adequately provided for. These problems may arise when a partner dies, retires or becomes incapacitated as the following sections demonstrate. Policyholders can benefit from Top Slicing Relief where a gain on a chargeable event takes the investor from one tax band into another. The purpose of this relief is to effectively spread the bond gain over the number of years the bond has been in force. The example in the table below illustrates how Top Slicing Relief works, reducing the effective rate of tax payable on the gain. Assumptions 20 policy segments out of a total of 100 are fully surrendered. This produces a gain of 40,000 with the policies having been in force for 20 years. Income in the year of encashment (after personal allowance) is 26,785. Basic rate band is 31,785. 5,000 of the basic rate band remains With top slicing relief 40,000 gain sliced by 20 years = 2,000 slice. This does not cause total income to exceed the basic rate band: Position if top slicing relief did not exist 2,000 @ 20% = 400 5,000 @ 20% = 1,000 0 @ 40% = 0 35,000 @ 40% = 14,000 Total tax 400 x 20 years = 8,000 Effective rate of tax = 20% Total tax = 15,000 Effective rate of tax = 37.5% Policy assignment Offshore bonds are usually segmented into a series of individual policies. One of the main benefits of this is that the policyholder is able to assign some or all of the policies to another individual, who then becomes the new legal owner of the policy. This is often attractive where an investor has a lower tax paying spouse. The assignment must be outright and unconditional. For example, an assignment would not be effective for tax purposes if it was made from husband to wife, who then encashes the policy and returns the proceeds to her husband s bank account. The same outright and unconditional requirement exists where an investor transfers ownership of a directly held collective to their spouse. If the transfer is outright and unconditional it would not be subject to taxation at the time of the transfer, by virtue of the CGT spousal exemption. However, the situation with a collective and an offshore bond policy differs significantly when the transfer is made to someone other than the investor s spouse. In the case of a collective investment scheme, the transfer is classed as a disposal and any gain which does not fall within the annual exemption of 11,100 or can not be offset by any available losses would be subject to CGT. However, an assignment of an offshore bond policy (provided it is not for money or money s worth) is not a chargeable event and therefore would not be subject to income tax. This leads to some attractive opportunities, particularly when it comes to university fees planning. A higher or additional rate tax payer can assign policies to their children, who can then encash the policies taking advantage of their personal income tax allowance and the starting rate tax band. 4 Friends Provident International Offshore bonds versus collective investments making your options clear
Lowering tax liability continued 5% withdrawal allowance Investors can also benefit from an offshore bond s 5% annual tax-deferred withdrawal allowance. The allowance represents a return of the bond s capital and is a tax-deferred (rather than tax free) benefit. Therefore, thought needs to be given as to how this can be most effectively utilised. It may well be that certain investors are attracted to this allowance because they are prepared to eat into capital to provide a fixed regular income stream in retirement, with the added convenience of not having to account for it in their annual tax return. Other investors will want to use it to effectively defer the tax liability on the income they take from the offshore bond, to a later point in time, when they will fall into a lower tax band. Effective use of the 5% allowance can also be achieved by taking an income from the bond and then assigning policies to a lower tax paying spouse or adult children at a later date. Time apportionment relief This relief is unique to bonds and can be used by investors who have any periods of non UK residency. The advantage of Time Apportionment Relief is that it reduces the offshore bond s chargeable gain on encashment, in proportion to the period of non UK tax residence. This is particularly attractive in a world with an increasingly mobile working population. For example if an investor made an overall gain of 100,000 on an offshore bond which had been in force for 10 years, and during that period had been non UK tax resident for five years, the taxable gain would be reduced to 50,000. If we contrast this with an investor who holds investments in a number of collectives directly, they may look to bed and breakfasting the collectives they hold, to achieve a similar result. This means selling the collectives before they become UK resident and buying them back once they have become UK resident. Some of the issues this presents however includes: Potentially paying charges on sale and the re purchase of the collectives Being out of the market between selling and re-purchasing (an issue potentially exacerbated during times of market volatility) The inconvenience of having to do this Whether the sale of the collective is taxable in the country they are leaving. 5
Non reporting funds formally known as non distributing funds Towards the beginning of this article, we stated that FCA authorised collective schemes and many offshore collectives are subject to CGT on disposal. Many other offshore funds are subject to income tax. The determining factor as to which tax applies depends on whether the fund is a reporting or non reporting fund under UK tax law. The general tax position on reporting funds is that gains made by UK residents are subject to CGT, with income generated within the fund being taxed as income tax. Under the reporting funds regime, it is important to note that income does not have to be distributed to the investor to be taxable. Income which is not actually distributed by the fund is reported to the investor and taxed annually. The situation with non reporting funds is different. They do not distribute or need to report income, as all income rolls up within the fund, with the advantage of this being that income is sheltered from immediate taxation on the investor. The disadvantage is that the disposal proceeds are subject to income tax, rather than CGT. It therefore follows that any offshore bond versus collectives debate is not relevant to non reporting funds, as the gains from both are taxed under income tax. Most hedge funds and fund of hedge funds are non reporting funds. This means there is a very strong case for wrapping such funds within an offshore bond, as this allows the investor to switch funds without creating a disposal, therefore providing the investor with additional control over when they pay tax on disposal proceeds. It also opens the door to the offshore bond advantages considered in this article. These advantages would not be available where non reporting funds are invested in directly. 6 Friends Provident International Offshore bonds versus collective investments making your options clear
Conclusion Investing directly into collectives can be attractive, especially where a purely growth focused investment strategy is adopted. However, where portfolios comprise income producing collectives and/or non reporting funds, wrapping these investments within an offshore bond should be considered by advisers seeking an overall lower effective rate of tax for their clients. For more information on how offshore bonds can help your clients please contact your usual Friends Provident International sales consultant or one of our chartered financial planners within the technical services team. technical@fpiom.com 7
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