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Slave to the algorithm

Investment Only by considering all the variables can an informed decision be made on choosing an onshore or offshore investment, says Prudential taxation and trusts manager Paul Kennedy.

What factors should advisers and clients take into account when considering investing offshore? Many intermediaries simply look at charges and conclude that offshore is more expensive than onshore. This is because it has always been a premium product and is often more complex and more expensive to administer.

But offshore products offer a wider choice of options to advisers who are seeking medium- to long-term returns for their clients. The range of permitted funds is typically wider than onshore bonds, giving exposure to diverse international equities and alternative investments. Offshore products can also give access to specialist funds in jurisdictions beyond the UK.

The critical thing about charges is that they are just one of many variables that need to be taken into account when considering offshore. Only by looking at all the variables can informed decisions be made.

With offshore policies, UK investors do not pay tax for the proportion of time they spend outside the country. If an individual invests in a bond for 10 years, of which five are spent abroad, they will only pay tax on half the total gain. This does not apply to onshore policies.

One factor that dramatically affects the offshore/onshore algorithm is that the longer you invest, the better offshore becomes, due to the effect of gross roll-up. Investment in an international bond grows virtually free of year-on-year income and capital gains tax, unlike onshore bonds.

The higher the return, the more the effect of gross roll-up is felt by offshore products. For example, where the return is 9 per cent gross rather than 5 per cent gross, the investor gets a higher compounding factor. So returns and duration have a similar impact on the onshore/offshore decision.

Taxation issues affect different asset classes to differing levels. You need to see how asset classes are taxed within a UK fund, factor in any differences between the two funds created by irrecoverable withholding tax and this will give a broad gross margin for the offshore fund.

It is quite common to be taking an income of 5 per cent a year. If you are taking it from an offshore vehicle, you are taking it from gross return. If you take the same 5 per cent from an onshore contract, you are taking that from the net return. Again, this affects the algorithm.

It is crucial to remember the importance of the investor’s tax rate when money is taken out. The lower the rate of UK tax paid by the investor, the bigger the advantage of investing offshore.

Non-taxpayers or starting taxpayers are generally better going offshore because they will not be paying life fund tax on any of the growth whereas the UK policy is taxed at source and this cannot be recovered.

For higher-rate taxpayers, it is more complex. If you are a 40 per cent taxpayer and have an onshore bond, you get a notional credit for 20 per cent and pay an additional 20 per cent tax. If you havean offshore bond, you do not get the tax credit and you pay 40 per cent tax.

You might think these two would be equivalent if a life fund is paying 20 per cent tax but this is not so. For example, if you take a 100 gross return and subtract 40 per cent, you get 60. But if you take a 100 gross return and subtract life company tax at 20 per cent, you get 80. The further 20 per cent personal tax is taken off the 80, giving you 64.

But that is not the end of the story. It is the higher-rate taxpayer who is more likely to retire abroad in a tax-favourable regime, it is the higher-rate taxpayer who is more likely to have a non-working spouse with a nil-rate band to utilise and it is more likely that the higher-rate taxpayer has children at university to whom they can assign parts of these policies to use their children’s tax allowances.

In some respects, it is the higher-rate taxpayer who is facing the biggest dichotomy. It may take them longer to get the benefit of offshore but, since they are investing so much money, they could get the biggest advantage.

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