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Sum of the parts

This week sees the continuation of our investigation into the wonderful yet often unexplored world of offshore funds, especially offshore roll-up funds. You will recall, I hope, that this series was sparked off by the commencement of consultation on the taxation of offshore funds. Understanding how funds are taxed currently is essential to understanding how any new system will work and the dynamics underlying the possible changes.

As I have said before, the offshore roll-up fund would appear to many to perform a similar tax-deferring job to the offshore insurance bond. However, the tax treatment of gains when realised is different. Gains under both are subject to income tax (corporation tax if the investor is a company). But while the offshore bond qualifies for top-slicing relief for higher-rate tax purposes and the investor (individual, trustee or company) can use the 5 per cent withdrawal facility (to name but two of the key features of a bond), gains under an offshore roll-up fund are calculated based on capital gains tax principles but without the benefit of taper relief and indexation and the gains are subject to income tax (or corporation tax if appropriate) without use of the annual CGT exemption.

Offshore bonds, then, would seem to have a few more interesting features for the tax-deferring investor including top-slicing relief (admittedly for higher-rate tax purposes only) and 5 per cent withdrawals. It is also possible by effecting the bond on a multiple-life, last-survivor basis to defer any chargeable event on the death of the policyholder.

There is, however, also the undeniable fact that insurance companies have been more focused in promoting their investment products on what those products can do rather than cannot do. Combining the offshore bond with an appropriate trust is an obvious example of this when considering inheritance tax planning.

Offshore bonds are also advanced as suitable trustee and corporate investments. These are just some of the ways in which the insurers attempt to help advisers to see how a particular product can be used in ways that are focused on achieving financial and tax-planning objectives. In my opinion, they undoubtedly contribute to greater awareness of bonds in the UK market.

Recently, I looked at an example where an offshore roll-up fund was being gradually stripped to provide the investor with additions to income on a yearly basis, much in the same way as an individual might take withdrawals or regularly encash whole policy segments under an investment bond. The part-disposal rule for CGT is used to calculate the gain.

Our example concerned an investor who invested £20,000. At the end of the first year, the investment in our example had increased in value to £21,400 and the investor wished to withdraw £1,000. We determined that the gain subject to income tax was only £65. We arrived at this by use of the formula A/(A + B) x C to determine the amount that could be deducted from the amount received as a result of the encashment to determine the gain chargeable to income tax. A is the total amount encashed (£1,000), B is the value of the remainder after encashment (£20,400) and C is the original value of the investment (£20,000). The formula gave a deductible amount of £935 so the gain subject to income tax was £65.

This week, I will continue this example through to the second year, with the investor still needing to take £1,000 from his investment. When we calculate the offshore income gain on the encashment of £1,000 at the end of year two, we need to deduct from the original investment the acquisition value taken into account in working out the offshore income gain in year one (£935). Therefore, the year two calculation applies the formula to an acquisition value of £19,065 (£20,000 – £935). This is shown in C as the original acquisition value less the amount taken into account when the previous gain was calculated. The calculation would thus be as shown in the table (left).

So, having read and digested all I have written over the past few weeks, are you any the wiser when it comes to the taxation of gains made under offshore funds? I hope so as taxation is one of the key determinants of product suitability.


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