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Lost in translation

A question of interpretation on offshore portfolio bonds could see a tax shock for investors.

UK investors are facing the threat of a 15 per cent annual tax charge on their offshore portfolio bonds for contravening Inland Revenue rules on acceptable investments within life wrappers.

The Association of International Life Offices is in talks with the Revenue to resolve the issue without investors having to pay any extra tax. Ailo has argued in a meeting with the Revenue that the problem has arisen because of confusion over the interpretation of the legislation and not because of intended tax evasion.

Rules governing offshore portfolio bonds were changed in 1998 and implemented the following year to distinguish them from personalised portfolio bonds. These Revenue rules set out which investments could be held within an offshore portfolio bond by a UK investor. Offshore personalised portfolio bonds are unattractive to UK investors because they are subject to a 15 per cent annual tax on the bond.

Ailo says it raised the issue with the Revenue six months ago and this was not because of an investigation of any client investments. Ailo chief executive Stuart Fairclough says these discussions are continuing and is waiting for the Revenue to come back to the insurance industry after a recent meeting.

There are seven main categories of investments which can be held in an offshore bond but it is the last one that has caused the confusion.

The categories are: authorised unit trusts, UK investment trusts, shares in open-ended companies, cash, life policies, non-UK unit trusts and interest in a collective investment scheme which is defined as a company, is not an open-ended company and is domiciled outside the UK.

Insurers say they presumed the last category meant closed-ended funds outside the UK.

Why has it taken so long for this issue to crop up after the change in the rules in 1998? One view is an insurance company probably sent a prospectus to the Revenue for a fund based outside the UK.

The Revenue may have responded by saying the fund was ineligible because it was a closed-ended vehicle. This would have alerted that insurer and then the rest of Ailo.

Fairclough says: “Insurers have worked to the principle that closed-ended collective investments could be included in portfolio bonds because the individual investor has no control over how the fund is managed. It therefore could not be classified as being a personalised investment. This has been caused by confusion over the wording of the legislation and not because of intended tax evasion. One reason why it may only have come up now is because there are many new types of funds on the market that were not around in 1998.”

Friends Provident International technical services consultant Brendan Harper says examples of offshore closed-ended funds potentially caught are property and capital protected products. “These funds have grown in popularity and number since the downturn in the stockmarket in 2000,”he says.

Fairclough plays down the extent of the problem and the likelihood of a 15 per cent tax being imposed. Most insurers appear to have some bonds with non-UK closed-ended funds but Ailo suggests there are only a few cases for each company. “There has been no mention of the Revenue imposing a tax at this stage. We have gone to the Revenue saying we have this problem and have asked them how it can be resolved,” says Fairclough.

He says some insurers have recommended that investors move out of any non-UK closed-ended funds held in an offshore portfolio bond. Scottish Equitable International, technical manager Margaret Jago says the firm has yet to make a decision on whether to make the same recommendation. She adds that the problem has arisen partly because UK regulations have changed since 1998. She says: “Insurers took collective investments to include non-UK closed-ended funds. We did this in good faith. It was not helped by the fact that we could not find any other type of funds to fit into the last category.Furthermore, the change in the rules in 1998 was designed to make people go into collective investments.

“But the problem is that a sub-regulation in the Financial and Markets Act 2000 states that closed-ended vehicles are not collective investments. Obviously, this was released after the change in the portfolio bond rules in 1998.”

Assistant law firm Reynolds Porter Chamberlain Daisy Raven says investments in non-UK closed-ended investment companies appear to fall within the rules for offshore portfolio bonds “provided the opportunity to select such investments is available to one or more classes of policyholders of the insurance company. It is unclear where this new concern has arisen from”.

Others, however, believe the regulations are clear that non-UK closed-ended funds should not have been included in portfolio bonds. One London lawyer says the regulations state that “it must be possible for bondholders to sell out of funds with a corporate structure quickly and for new investors to come into the funds. One of the structures that this rules out is a company holding property. It appears that the Revenue is on firm ground in this debate.”

Despite the discussion between offshore insurers and the Revenue, there are a number of advantages for investors in using offshore bonds. Investors do not pay income or capital gains tax until they redeem their money. This allows funds within an offshore portfolio bond to grow virtually free of tax and to benefit from reinvestment of growth that would otherwise be taxed. Investors can take an annual 5 per cent income on which they do not pay tax until the portfolio bond is cashed in. Money can be switched between funds within a bond without triggering a capital gains charge.

When the bond is cashed in, gains and income will be taxed at the investor’s rate of income tax. But with planning this tax bill can be reduced. For instance, if the bond is cashed in when an investor has retired or moved abroad, the amount paid in tax is likely to be less.

Offshore bonds do not need to be registered on a self-assessment form until there is a chargeable event. Invest-ors just need to ensure that they do not contravene the rules on what can be included in portfolio bonds.

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