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How will Derek’s dominos fall?

Derek is about to move abroad for a few years and expects to be non-resident for UK tax purposes. One of his concerns is that he has a with-profits bond that has a big gain on it.

He thinks he might need to surrender the bond in the next year or so to release finance for his new venture. He has access to other funds but is concerned about the merits of keeping the bond going as an investment in the medium-term. He has also been advised that he may be taxed on the total profit abroad and understands that the potential charge could be 14,000 and possibly more. What is his best course of action?The bond has been going for 10 years and the gain is 50,000. Derek is a higher-rate taxpayer in the UK and knows that if he surrenders the bond here, there will be a charge to higher-rate tax of around 10,000. There are two angles to consider – investment and tax.

We looked at the implications of surrendering the policy from an investment perspective and agreed that with-profits funds have served extremely well over the years. The concept of these huge funds that invest in a wide range of assets on a reasonably conservatively basis has always been attractive. However, the last few years have shown how vulnerable these funds are and volatility in the markets has resulted in many people being unable to release cash without being penalised, reflecting the fact that the underlying assets have fallen in value.

The problem is that as these assets recover in value (assuming that they do so) one is likely to get a more immediate benefit from direct investments. There is uncertainty over returns and bonus rates and we feel that direct investment may be a more attractive approach.

With-profits managers are going to have to husband their assets very carefully over the next few years to build up their reserves and surpluses to healthy levels. They do not want to find themselves in the sort of situation again where they cannot pay annual bonuses, let alone terminal ones. A lot of the terminal bonuses that have been notionally built up so far have disappeared and the risk is that any still left will also be cut back.

So returns over the next few years are likely to be thin. This is going to be further compounded by the Government’s announcement that it will further hit the funds by raising the tax rate on the surpluses that with-profits funds have been working so hard to build up. These funds are worth tens of billions of pounds and they will probably survive but the managers are going to find it tough and changes to the workings of the funds will undoubtedly be made. In investment terms, there is a very good argument to take profits already built up.

But what about the tax? It seems the tax liability that Derek might face abroad will be worse than in the UK, so any chargeable event should be created while he is a UK resident. One needs to be sure about the tax treatment of such assets abroad because, as a non-resident for UK purposes, there will be no higher-rate liability in the UK and one does not want to create a charge here if it is not necessary. In this case, Derek seems to have been advised that there will be a charge abroad so creating the tax bill here would be the better option. It has been necessary to ask him to check the details of the taxation of bonds in his new country of residence just to ensure that nothing he does now conflicts with the taxation and residence rules there.

Part of the work we have done for Derek over the last few years has been to build up his pension funds and a contribution in the current tax year would have an enhanced benefit. By making a payment of 12,000 gross, he would, through the wonders of top-slicing relief, be able to mitigate the tax charge on the whole gain. Not only would he get the tax relief that normally applies on a pension contribution, he would also save himself the extra tax charge on the bond. A payment like this would kill a lot of birds with one stone.

Having decided there is a good investment and cashflow reason for surrendering this bond, we find there is a way of mitigating the tax charge so that he can go abroad without worrying about being hit with a penal tax charge.

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