Offshore finance: Broadening the appeal of offshore bonds

Offshore bonds are still shrouded by mystery in the eyes of many advisers. Despite the continuing momentum in sales of offshore bonds, as many as 27% of advisers avoid using them, with a further 20% saying that they do not know enough about offshore bonds to recommend them¹.

However the advantages of offshore investing are clear – namely tax efficiency, tax control and estate planning flexibility. In fact in a recent survey by YouGov for The Hartford, 15% of consumers said that they would consider offshore bonds, rising to 34% if they had more control over their income and the ability to pass on wealth to dependents with an income guarantee.

So what is this valuable business opportunity advisers are missing out on, and why are half of advisers choosing to ignore it?

The facts

As many readers will know, the main advantage of an international bond over an onshore bond is that the international bond is based outside of the UK, so the investment will grow virtually tax free, subject to a small element of withholding tax. Over the long term this could prove to be a valuable benefit.

Below we’ve provided a more detailed comparison of onshore and international bonds.

But ...

This means that when an investor encashes an international bond, they will be liable to 20% basic rate tax on gains, plus an additional 20% on any gains within their higher rate tax bracket.

As with onshore bonds, the determining factor will be individual client circumstances that enable them to potentially take advantage of the preferential tax treatment of the bond. A higher rate tax payer taking 5% tax deferred withdrawals, then encashing the bond at a time when they are no longer a higher rate tax payer, indicates a very tax efficient use of a bond, whether onshore or offshore.

The figures

The table below shows an example of how an international bond compares with an offshore bond over 5, 10, 15, 20 and 25 years. For simplicity, charges have been disregarded and a growth rate of 7% gross per annum has been assumed.

In order to make this a fair comparison, we have assumed that a 20% tax charge is applied to the holder of the international bond on encashment and that the tax in the onshore bond is incurred at 15% annually. However, as you can see from the table, when investing over 15, 20 and 25 years an international bond can offer a distinct advantage. The initial investment is assumed to be £100,000.

Why select an international bond?

Gifting to non tax payers. An international bond may be an attractive proposition for married couples and civil partners, as well as parents and grandparents, looking for a tax efficient method of supporting future expenditure, for example educational costs.

The investment will grow virtually tax free, and then, when required, the bond can be assigned to a non tax payer, such as an adult child in full time education. The new owner can then encash the bond and will be subject to tax based on their circumstances, thus potentially minimising taxation.

This may also be effective when a non or basic rate tax payer realises a gain that pushes their overall income into the higher tax rate bracket. In this scenario top slicing relief can be applied.

However, unlike an onshore bond, the bond owner can utilise all completed years since policy inception, regardless of previous chargeable gains or ownership changes, to calculate the tax liability. Potentially this can have a significant impact on tax savings and possibly even remove a tax liability at the higher rate.

Inheritance Tax planning. An international bond written in trust permits the settlor to retain control of the investment during their lifetime and leave a tax efficient legacy upon death.

Using an Inheritance Tax (IHT) efficient trust, the bond won’t be included in the investor’s estate for IHT purposes, as long as they live for at least seven years after placing the asset in trust.

By investing in an international bond and putting it in trust for children or grandchildren, the investor can be a trustee. This means the investor will have control over the asset for as long as they live.

Generational planning. Often, an individual will be keen to retain assets within the family. This may be for wedding expenditure, education fees, a first property, or even simply a tax efficient method of passing family wealth down the generations.

In these instances an international bond may prove attractive as not only will the asset grow virtually free of tax, but the bond can also be written on a ‘multi-lives assured’ basis. This means the bond won’t be forcibly encashed, and a potential tax liability generated, until the death of the last life assured—giving them greater control when a tax event takes place.

Retirement planning. As an international bond has an almost identical tax position (in the fund) to a pension, it could be an attractive addition to a client’s retirement plan.

As well as virtually tax free growth, the investor also retains full access to the capital value. What’s more, should an investor subsequently decide to encash their international bond and reinvest into a UK pension plan, any tax liability may be offset by the availability of tax relief on the pension investment. It should be noted that the earnings for that tax year would need to be at least the amount of the investment in order to be eligible for full tax relief.

Those leaving or coming back to the UK. An international bond can be an attractive investment, due to gross roll-up, for investors who would not otherwise be subject to UK tax. This applies to those that are going to leave or have already left the UK.

For those intending to leave the UK in the future, it is important to consider the length of time required to be a non UK resident. An investor cannot be certain of being classed as a non UK resident until they have been abroad for at least four years.

For those considering returning to the UK they will have the option to encash their international bond which has been growing virtually tax free, without any tax to pay on the chargeable event gains, subject to any local taxation. They could then invest the lump sum they have accumulated into a new bond upon returning to the UK, for the purposes of 5% tax deferred withdrawals.

Alternatively, they could retain their original international bond and upon encashment the investor can use Time Apportionment Relief, and thus not pay tax for the proportion of time they were outside the UK. For example, having held the bond for a total for six years, and if the investor was non-UK resident for four of those years, they are only liable for UK tax on one third of the chargeable event gain.

Excluded Property Trust for a non UK domiciliary. A person will be deemed as UK domiciled if they have been resident in the UK for 17 out of the last 20 tax years. By placing an international bond into an Excluded Property Trust, prior to being deemed domiciled, the investment will remain as ‘excluded property’.

Broadening the message

20% of IFA’s, researched as part of Defaqto’s report, said that they didn’t know enough about international bonds to recommend them². Certainly there’s a responsibility for advisers to be familiar with offshore bonds, but providers themselves play their part in this. One way they can do this is to demonstrate that the benefits of offshore investing are not limited to just a relative handful of wealthy investors.

As we’ve already mentioned, international bonds are ideal for tax control and estate planning. However the introduction of income guarantees, which can give people added peace of mind, could help to broaden the product’s appeal to a wider mix of IFAs and consumers alike.

The Hartford has recently taken this step and launched its own international investment bond - Hartford Diamond - which comes with the optional Hartford SafetyNet and SafetyNet for life, a 20 year guarantee and a lifetime guarantee respectively. Not only do investors gain the reassurance that their income is guaranteed – whatever market conditions – but they can also lock-in a percentage of the investment growth, which benefits from the gross roll up, to increase their guaranteed income over time.

In its ‘Calmer Waters’ Offshore Bond Report 2008, Defaqto said that it believes that ‘the time is right for this kind of product’. This type of innovation will go some way to overcoming the remaining ambiguity surrounding offshore investing. However advisers also play an important role in helping their clients to understand the benefits to them, before they can in turn benefit from this valuable business opportunity themselves.

1 Defaqto ‘Calmer Water’ Offshore Bonds Report 2008.
[2] Defaqto ‘Calmer Water’ Offshore Bonds Report 2008.

Defaqto are a research company for IFAs and brokers.