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Take the right exit

Over the past few weeks, I have been looking at the proposals in the consultation document on offshore funds.

Those involved in providing and using offshore funds will, no doubt, monitor and contribute to developments with interest. Anyone advising clients where an offshore investment may be appropriate also has to make decisions now regarding the suitability of any particular investment based on the law as it is but taking account of the possibility that it may change.

In the light of this uncertainty, some advisers may decide not to recommend offshore funds. Those who continue to recommend such funds should ensure that they are well aware of the tax and commercial implications of exiting that investment should the tax rules change as a result of the consultation. Advisers should also make these consequences clear to the investor before the commitment is made.

The commercial issues surrounding exit should be relatively simple to uncover and explain. The tax implications will, of course, depend initially on whether the fund is a distributor fund or non-distributor (roll-up) fund.

Simply put, gains made under a distributor fund will be taxed as capital gains and gains made under non-distributor funds, known as offshore income gains, will be arrived at based on capital gains tax principles (ignoring the annual exemption, indexation relief and taper relief) but will be subject to income tax.

Of course, if exit is relatively soon after entry (so to speak), gains may not be relevant. Leaving aside the uncertainty, the choice of wrapper for those making an offshore investment that produces no income along the way (also leaving aside, for the moment, entirely growth-oriented distributor funds, that is, distributor funds that have nothing to distribute) the main choice would appear to be between offshore roll-up funds and offshore bonds.

This is an obvious difficult area where advice is essential. On the basis that these two investments (roll-up funds and offshore bonds) are at least conceptually taxed in the same way, what are the differences? The main differences are as follows:

•When an investor wishes to take some cash out of a roll-up fund, this will inevitably involve an encashment of units or shares within the fund.

If there is any gain in the investment, the encashment will trigger an offshore income gain which, although arrived at based on CGT principles, will be subject to income tax at the investor&#39s marginal rate of tax. No indexation relief, taper relief or annual exemption is available.

In the early years, the offshore income gain is, however, likely to be small because investment growth will be limited but this will gradually increase each year in line with investment growth.

With an offshore bond, it is possible for the investor to make withdrawals from the investment without an immediate tax charge arising by use of the 5 per cent withdrawal facility. In effect, this means that the investor can take back 5 per cent of the original investment each year, for up to 20 years, with no tax charge arising at that time. It should, of course, not be forgotten that the withdrawal facility amounts to tax deferral in that such withdrawals are taken into account in working out total profit at a later date.

•With an investment in a roll-up fund, if the investor chooses to switch into shares of another fund offering, for example, a different geographic spread of investment, this will involve a disposal of those original shares and give rise to a potential charge to income tax on any offshore income gain.

There is, therefore, a potential tax penalty to pay for investment flexibility. With an offshore bond, however, it is possible to switch between different investment funds with no tax charge arising. There is, therefore, no tax constraint on the investor wishing to satisfy his investment requirements.

Next week, I will continue to outline the main differences.


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