How do offshore bonds differ from onshore bonds? How do they compare in cost?Steel: Onshore bonds are taxed within the funds as they go at 20 per cent, which is the equivalent of the savings rate. For a basic-rate taxpayer there will be no more tax to pay on a chargeable event. A higher-rate taxpayer will pay the difference at 20 per cent.
Offshore bonds are not taxed as they go and roll up gross. This means that when there is a chargeable event, tax will be due at the taxpayer’s appropriate rate. Shop around and you can find comparable costs although, if you do not, offshore will sometimes be more expensive.
McDermott: Offshore bonds, as the name suggests, are based outside the UK to take advantage of tax breaks. Most UK clients set up offshore bonds with companies based in UK-dependent territories such as the Isle of Man and the Channel Islands or EU member states such as the Republic of Ireland and Luxemburg.
Offshore bonds can be marginally more expensive than onshore. However, this small difference is more than offset by the tax advantages that are gained.
Jago: Offshore bonds will be based in jurisdictions where there is no domestic tax on policyholders’ funds. This means that offshore bonds benefit from what is generally known as gross roll-up although, in fact, the funds are only gross in the same way as pension funds in that any dividend income within the fund may have suffered tax. So, for an offshore bond, the investor is getting growth on money that with an onshore bond has gone to the taxman.
Holders of offshore bonds pay tax at their full marginal rate when a taxable event occurs – normally when benefits are taken. The planning opportunity is to manage when and where benefits are taken, for example, at retirement when a lower-rate taxpayer, so avoiding a higher rate of tax – the so-called tax control.
What are the advantages of using offshore bonds? What are the disadvantages? Should offshore bonds be used for inheritance tax planning rather than onshore bonds?Steel: If the investor is a non-taxpayer, then the offshore bond means there is no tax to pay or reclaim. The roll-up is working for the investor and should add to the performance. It doesn’t always and I have seen onshores do just as well through very good fund management. Both allow 5 per cent of the original premium tax-deferred. For an older investor, this can mean extra income without it affecting age allowance. Care should be taken, however, as if you exceed the 5 per cent, not only does that give a chargeable event for the bond but it will also impact on age allowance, producing a double whammy.
The structures are roughly the same and fund investment flexibility can be achieved with both although the offshore wrapper usually gives the wider choice.
The disadvantages are that offshore bonds are taxed to income tax not capital gains tax and therefore should be used in conjunction with other assets which will enable the investor to use their capital gains tax exemption if possible.
Onshore fund choice can sometimes be limited. As far as inheritance tax planning is concerned, offshore bonds should be used because any inheritance tax planning as the planning usually involves a trust. Onshore bonds are not suitable investments for the trust as they cannot use the 20 per cent credit mentioned above. It is therefore better to use the gross offshore structure.
McDermott: The obvious advantage is their tax treatment. Onshore bonds are subject to income tax of up to 20 per cent depending on the source of income. The same is payable on any gains made within the fund. Offshore bonds are tax-free with the exception of irrecoverable withholding tax, which may be deducted from dividends and interest received by the fund. Also, as well as giving the investor access to many top UK fund managers and their funds, they also give wider access to international funds and asset classes that are not available onshore.
The bonds, however, are generally subject to the regulation laws of the country in which they are based. Some will therefore offer more protection and others less.
Both onshore and offshore bonds are useful in inheritance tax planning. The tax advantages are obviously attractive with offshore bonds, as they enable you to mitigate or avoid altogether taxes due when transferring wealth. Tax must be paid, however, when money is brought back onshore.
Jago: Offshore bonds are ideal for policyholders who are nonor 10 per cent taxpayers because the policyholder can take advantage of their own tax profile, whereas with an onshore bond they would be unable to recover the tax suffered within the fund. Also, holders of offshore bonds who are geographically mobile benefit from a relief that exempts from tax that fraction of their bond gain that represents their days of non-residence in the UK for tax purposes divided by their total days of ownership.
Policyholders who are intending to emigrate from the UK may benefit from having an offshore bond, since the fund tax on an onshore bond is unlikely to be recognised when they are paying tax in a different jurisdiction. This can result in double taxation. Holders of offshore bonds benefit from tax-free switching of funds or collectives within their bond wrappers.
A disadvantage is that the minimum premium is usually higher than for an onshore bond so they are not accessible to the whole market.
There is an argument that offshore bonds are particularly suitable for inheritance tax planning. It is over the longer term that the compounding effects of the virtually tax-free fund should start to be appreciated. Further, the tax rules applying to trust-held bonds mean tax liabilities may be incurred by the settlor, the trustees or beneficiaries at their own rates, including rates lower than basic rate – another example of tax control.
What are the different types of offshore bonds available and how should investors choose between them?Steel: There are only two types of offshore bond in structure – bonds (whatever their name) and highly personalised structures. Due to changes in the law a few years ago, the latter should be avoided for a UK investor as they attract an extra rate of 15 per cent. The others are simply variations on a theme.
The differences will be mainly in the permissible investments and whether or not it is simply the funds of the provider or whether at the other extreme the provider simply provides a wrapper for a small fee and investments can be made pretty much with anybody. The investor chooses the flexibility which suits them. Do not pay for more than you want to use.
McDermott: An investment bond is the overall name given to a bond of this type as they hold a variety of investments. Portfolios can be put together by the provider or an IFA to suit the client’s needs. Hence, they are sometimes referred to as portfolio bonds. The wide scope for investment allows a very diversified portfolio to be built.
Jago: Investment bonds have a similar approach to onshore bonds, having a choice of insured funds offered by the insurance company. Many will include attractive ranges of managed funds. In general, the choice is more extensive than an onshore bond, having greater access to external fund managers. Portfolio bonds (the original fund supermarket) allow the investor to choose from an very extensive range of collective investments including almost all offered by well-known names like Fidelity, Newton and so on.
For which types of clients are offshore bonds appropriate? Are offshore bonds only for wealthy clients? Are clients wary when offshore products are mentioned?Steel: Offshore bonds may be appropriate for any type of client depending on the risk structure. I would tend to avoid them for basic-rate taxpayers as there is no point in bringing someone into the self-assessment regime when they would otherwise be outside it. They are fine for corporate investors although I would sometimes use a capital redemption bond instead as they do not need any lives assured.
Cost structures also give some guidance as to who they are appropriate for. You do not want a client paying for an investment which he perceives as expensive for his needs. There can be wariness over investor protection but people are far more aware of these types of investments and less wary than several years ago.
McDermott: We only deal with private clients so I would not like to speak for corporate ones. However, offshore bonds are appropriate for just about anyone wishing to mitigate some of their tax liability. UK residents, ex-pats and foreign nationals living in the UK are all eligible to invest. One of the great myths about offshore bonds is that they are only for the very wealthy. That is not true. They are commonly used to mitigate tax for inheritance tax purposes and some offshore investments can start from as little as £10,000. I do not think most IFAs who understand the advantages of offshore investing are wary but many clients can be.
Jago: Those looking for inheritance tax planning and companies could all benefit, as well as those considering retirement planning beyond pensions. They are not only for the wealthy as inheritance tax is more common a problem than ever before, especially with growth in property prices, and investment in offshore bonds can be from as little as £15,000.
Why are offshore bonds not viewed as a mainstream product? Is this changing?Steel: I think offshore bonds are viewed as fairly mainstream, it is just that they are not suitable for everyone and therefore will never have the awareness of, say, Isas.
McDermott: I think most people are wary of the unknown. If a client has never invested offshore, they have certain tax and regulatory worries and will not even want to dip their toes into offshore products. Offshore investment, as a whole, is approached a little too tentatively by many clients when essentially they are onshore bonds with better tax advantages and a wider access to funds. Offshore investment as a whole has certainly become more popular over the past few years but this is mainly with the more sophisticated investor rather than those wishing to mitigate inheritance tax.
Jago: This may be because the offshore industry has still to convince IFAs of the instances where offshore is best advice and that it feels more complicated. Recent initiatives like the Association of International Life Offices’ Why Buy? (a guide explaining the advantages of offshore available at www.ailo.org) should be commended.
Are there too many insurance companies offering offshore bonds? Do you expect consolidation? How does service quality vary between providers?Steel: There may well be consolidation among the insurance companies. It remains to be seen what effect the new changes on polarisation will have in the longer term. It may well be that with the rise of wrapper providers (those who make a small charge to provide the basic bond structure but the investments are dealt with by someone else), some insurance companies will focus on providing the funds. It will be interesting to see if there is any kind of split between those who concentrate on service provision and those who concentrate on fund/product provision.
If I were being cynical, I would say service quality goes not vary – it can all be pretty bad. But, seriously, yes, there are variations in the quality of service and overall costs have to be weighed up against this.
McDermott: I think consolidation is unlikely. The number of providers is not particularly large and is certainly much lower than the number of onshore providers. Quality of service does differ from provider to provider but generally most are good. Some of the best administrative teams are at Zurich and Skandia.
Jago: For the UK market there are only about 10 providers and so you could say there are too few. Rather than consolidation, it is expected there will be new entrants next year and there have been press reports about Standard Life and Legal & General actively considering entering. Service quality may vary between providers but in general they have the advantage of being smaller, more focused teams than the big onshore companies.Alan Steel, managing director, Alan Steel Asset ManagementDarius McDermott, managing director, Chelsea Financial ServicesMargaret Jago, technical manager, Scottish Equitable International