But a setback in one direction is an opportunity in another and offshore bonds can offer a range of possibilities for those caught by the new tax rules.
50 per cent tax rate
From the 2010/11 tax year, earnings over £150,000 will be subject to a new tax rate of 50 per cent. This replaces the measure announced in the pre-Budget report which would have seen a 45 per cent tax rate applying from 2011/12. The corresponding tax rate for dividends will be 42.5 per cent.
The 50 per cent tax rate will apply to earned income and investment income that is taxed as earned income – but not, of course, to 5 per cent withdrawals from bonds.
As a result, the tax deferral available on offshore bonds will become even more valuable, especially where the investor is subject only to basic rate – or even a non-taxpayer – at cash-in.
Even if the investor is not taking withdrawals, an offshore bond benefits from gross roll-up, whereas a collective that is producing income (whether interest or dividends) will be taxed year on year, even if the income is reinvested. Over time, this can make a considerable difference to the value of the investment and the new 50 per cent tax rate will make this even more marked.
For example, comparative cash-in values will be:
Investment term: 10 years
Offshore bond: £163,268
Collective – all growth from interest: £134,392
Investment term: 15 years
Offshore bond: £211,725
Collective – all growth from interest: £155,797
This is based on an investment of £100,000 with a net annual growth rate of 6 per cent, investor liable for 50 per cent tax during the investment and 20 per cent at cash-in. All income tax charges are assumed to be funded from the investment in each case. The figures do not include any withholding tax on the offshore bond or plan/policy charges.
The new tax rate will also apply to income accumulated within discretionary trusts – for instance, where a trust invests in collectives that produce income through interest or dividends.
Bonds, on the other hand, are non-income-producing assets and hence will not be liable for tax until there is a chargeable event gain.
Time apportionment relief will also be more valuable for high-earners, as it reduces the gain that is subject to tax. This is only available on offshore bonds so if an investor might spend time abroad, an offshore bond should always be considered.
If the person stays abroad for a full tax year or more, it can be cashed in with no liability to UK tax and if they return to the UK while still owning the bond, the eventual gain will be reduced for tax purposes in proportion to the amount of time spent abroad.
Clients who might benefit include those with property abroad (who might retire to it) and those who work for multi-national companies.
In addition, the 50 per cent tax rate may well spark a brain drain – already some celebrities are declaring an intention to leave the country. Time apportionment relief could be very valuable for anyone who leaves to escape the tax charge but eventually returns.
Loss of personal tax allowance
From tax year 2010/11, anyone with income over £100,000 (after certain adjustments for pension contributions, Gift Aid and so on) will lose personal allowance at the rate of £1 allowance lost for every £2 excess income. So, if the personal allowance next year is, say, £7,000, anyone earning over £114,000 will lose all their personal allowance.
This means that the marginal rate of tax on earnings where the allowance is lost is 60 per cent:
The measure only applies to earned income and investment income that is taxed as earned income – 5 per cent withdrawals from bonds will not count towards the £100,000 income limit.
Income produced by collectives, as interest or dividends, will count towards the investor’s annual income even if it is reinvested. However, interest or dividends on funds held within an offshore bond do not count as personal income.
For example, suppose a client has £100,000 earned income and £100,000 invested in a corporate bond unit trust or Oeic, which is producing 5 per cent annual interest. The effect is:
Instead, he could hold £100,000 in an offshore bond, in the same corporate bond fund:
For clients affected by the £100,000 income limit, collective investments producing interest or dividends will suffer a marginal tax rate of 60 per cent, even if the income is reinvested.
Holding the same funds within an offshore bond will avoid this extra tax and the client can still take 5 per cent withdrawals if they want to, with no loss of personal allowance and no immediate tax to pay.
Pension contributions – limits on tax relief
From 2011/12, tax relief on pension contributions will be restricted for those earning over £150,000. The relief will be tapered down to 20 per cent for those earning more than £180,000.
As an “anti-forestalling” measure – to prevent people from increasing contributions in the current year to compensate – there will be a special annual allowance and associated tax charge for 2009/10 and 2010/11. This applies where:
There will be a tax charge of 20 per cent on the increase in pension contribution. Where the normal contribution was previously less than £20,000 a year, the charge will apply only to the excess over £20,000.
The special £20,000 annual allowance will apply in addition to the existing annual allowance, although it will be adjusted if necessary to avoid double taxation.
The restriction on tax relief means that higher-earners will need to increase the amount they pay into a pension plan to make the same level of grossed-up contributions.
Currently, for example, for every £1,000 of gross contribution, a 40 per cent taxpayer would pay £600. With only basic-rate tax relief, this will rise to £800. Taken in conjunction with the new 50 per cent tax rate, the pre-tax earnings needed to fund this will be considerably more.
For a gross pension contribution of £1,000:
Net payment required: £600
Equivalent in pre-tax earnings:
40% taxpayer £1,000
50% taxpayer N/A
Net payment required: £800
40% taxpayer N/A
50% taxpayer £1,600
As a result, while pension contributions will still be tax-efficient, they will be less so than at present. For clients looking for greater flexibility, offshore bonds can be an attractive complement to pension planning, as the loss of up-front tax relief will be less significant.
There are benefits in terms of accessibility – withdrawals can be made at any age and in any amount – and portability – the investment can be added to or cashed in anywhere in the world. In fact, for clients planning to retire abroad, offshore bonds may be more attractive than a pension from 2011/12 – the loss of up-front tax relief could be outweighed by the back-end benefits of there being no UK tax on the proceeds.
Offshore bonds could also be a suitable home for additional contributions for higher-earners in 2009/10 and 2010/11 where the anti-forestalling measures apply.
Freezing of pension allowances
From tax year 2010/11, pension allowances will be frozen for five years until tax year 2015/16. The annual allowance will be fixed at £255,000 and the lifetime allowance at £1.8m.
The freezing of the lifetime allowance means that higher- earners and those with big pension funds could hit the limit sooner than they expected. If they exceed the limit, they will be taxed at 55 per cent if taken as a lump sum or 25 per cent if taken as pension.
As an example, take a client retiring in six years:
Note that anyone who does not already have the lifetime allowance protection can no longer apply for it as this facility ended on April 5, 2009.
Offshore bonds can provide a tax-efficient complement to pension saving for clients who are affected. There is a wide range of benefits:
So, although the Budget delivered a blow to high- earners, careful planning can ease the effects and offshore bonds are set to have a wider role in the future.