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Danby Bloch: The relative merits of on- and offshore bonds

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The problem: The risk committee of Smith Jones Financial Planning were arguing about the differences between UK and offshore life assurance bonds and their relative merits. The committee’s aim was to try and set an advice standard for when each product would be most suitable for different situations.

Everyone agreed on the main difference between these relatively similar products. When an investor encashes an offshore bond, it is potentially subject to basic rate, as well as higher and additional rate, tax. In contrast UK bonds are not subject to basic rate tax when they are encashed.

This reflects the tax position on the underlying funds: the income and gains on the investments held in an offshore bond are tax free but the income and gains on UK bond investments are mostly taxed.

Offshore bond funds can be subject to an element of double taxation, for example with UK equity funds, because the offshore bond investor gets no benefit from the tax credit, unlike the UK bond investor.

Tax charge vs profit

The issue is mostly the extent to which the extra basic rate charge on the offshore bond profit offsets the lower tax on the underlying funds. This largely depends on the assumptions one makes about the tax treatment of the respective underlying funds and how they are invested. However, the risk committee concluded that the negative effects of the tax charge on encashment generally outweigh the beneficial impact of gross roll-up of the underlying funds.

This aspect of the debate was enough to cause hours of merry disagreement and there was much material in Taxbriefs Advantage to fuel both sides of the discussion.

The most obvious use of offshore bonds is for investors who can be reasonably sure that they will neither be UK resident when they encash the policy or subject to tax on the investment in some other country. UK clients who are seriously thinking of retiring or working abroad are one obvious category of client for whom offshore bonds might be suitable.

Another large market would be UK resident non-domiciliaries.

It is easy to think that this is the only difference between the two types of bonds. The Smith Jones risk committee, however, was keen to ensure that all its advisers knew the other important tax features of offshore bonds when giving advice and drew on the resource of Taxbriefs Advantage to identify these distinctions.

Understanding the top-slicing effect

The top-slicing rules for offshore bonds can sometimes be more beneficial than they are for onshore bonds. The top slicing calculation for the offshore bond is always taken as the number of full policy years from the start of the policy. In contrast, when a policyholder surrenders a UK bond, the top slicing is taken from the date of the last part surrender (although on death, the top slicing for a UK bond is taken from the start date of the policy). It is almost always wise to avoid part surrenders, but sometimes they happen.

Top slicing can make a considerable difference to the tax charge on both types of bonds if the policyholder is on the cusp of being a higher rate taxpayer or an additional rate taxpayer. The top slicing relief makes no difference to the outcome for investors who fall squarely into being 40 per cent or 45 per cent taxpayers before taking any bond profits into account.

Some advisers are under the impression that top slicing relief can help take the tax charge on an offshore bond from being subject to basic rate tax down to a nil tax charge. It can’t. Top slicing relief can only determine how much higher rate or additional rate tax is payable.

UK bonds catch up

New UK bonds recently caught up with offshore bonds in one helpful respect.

t has been the case for many years that the chargeable gain on an offshore bond is reduced by the number of complete policy years the policyholder has been a non-UK resident in relation to the total number of policy years the bond has been in force. The same privilege applies to the overseas life assurance business (OLAB) of UK life offices, although this is relatively uncommon. So if an investor has spent five complete policy years as a non-resident out of 10 complete years of ownership, half the gain would be tax free.

For UK policies taken out after 5 April 2013, it is broadly speaking the case that gains are also subject to this tax relief for non-residence. This new benefit for UK bonds was introduced with effect from the same time that the Government brought in the new statutory residence rules.

 Offshore bonds can be attractive for non-UK domiciled investors. They can use the 5 per cent withdrawals to take income whether or not they have elected for the remittance basis. But Taxbriefs Advantage reminds readers that the remittance basis does not apply to chargeable gains from offshore bonds. These gains by non-UK domiciled UK residents are taxable whether they remit them to the UK or not.

Danby Bloch is editorial director of Taxbriefs Financial Publishing 

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Taxbriefs Advantage is a new online content resource aimed at giving financial advisers, planners and paraplanners a clear business advantage. Advantage provides you with unbiased, independent answers to your technical queries. Marrying Taxbriefs’ quality content with focused functionality, Advantage allows you to build up your own library of regularly updated content to export and share – visit www.taxbriefsadvantage.co.uk and find out more.

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