March 2008

It's a shore bet

From the offshore life assurance industry's point of view, two negative issues arose from the Pre-Budget Report last year. The first of these related to legislation to bring life insurance policies (excluding protection policies) and annuity contracts held by UK resident companies under the Loan Relationships legislation as from 6 April 2008. The second and most controversial issue, related to the Government's announcement that they would introduce a flat rate of capital gains tax (CGT) of 18% from 6 April 2008, simultaneously abolishing indexation and taper relief.

Regarding the first issue, in 2005 the Government had introduced a change in the chargeable event rules so that UK resident companies who owned capital redemption bonds would, subject to the accounting basis adopted by the company, be taxed on an accruals basis under the loan relationship rules. This broadly means that each year the company is taxed on the investment growth of the bond in that year, irrespective of whether the bond is realised. Following the Pre-Budget Report, it is now the case that the government is extending this legislation to all investments in life insurance policies made by companies. These changes basically sound the death knell for UK resident companies hoping to achieve tax deferral through investment in an offshore policy.

In respect of the CGT issue, opposition to the Chancellor's plans had been gathering pace since the Pre-Budget Report. Opposition came from various quarters such as business entrepreneurs and the Alternative Investment Market. The Association of British Insurers (ABI) was also involved in lobbying against the changes on behalf of the life assurance industry.

On 24 January 2008, HM Treasury confirmed that a new CGT relief for entrepreneurs would be launched. This entrepreneur's relief would target the owners of small businesses, and will apply when they sell their business. The relief will also be available to all employees and company directors who invest a material stake in a qualifying company. It will take effect from 6 April 2008 and the relief would exempt the first £100,000 of any chargeable gain upon retirement.

At the time of writing, we are still waiting to see if anything positive will come out of the consultations which have taken place between the ABI and the Treasury regarding the fact that a higher rate tax payer would face a 40% income tax charge on an offshore bond gain as opposed to an 18% CGT charge on a gain from a directly held collective. However, assuming there may be no further developments on this front, what would this mean for offshore bonds?

Basically, it should be remembered that this is not the first time the issue of whether or not a collective should be held in a wrapper has been raised. The fact is that no single investment can suit all individuals and all circumstances and each has its own unique selling points. It is therefore worth revising some popular features of offshore bonds and reminding ourselves why they are extremely worthy of consideration for certain types of investors.

Popular features

A popular feature of offshore bonds is the fact they offer 'gross roll-up'. The underlying funds do not suffer any income or capital gains tax apart from some with-holding tax deducted at source. This feature can make an offshore policy suitable for individuals who are likely to be none or starting rate tax-payer at the time of encashment. Furthermore, since offshore policies are issued with a number of segments, it is possible to stagger the release of gains by surrendering just one or a couple of segments each year.

It is the individual who owns the policy immediately before the chargeable event who will bear the income tax liability. Therefore, it is possible for the policy to have been owned by a higher rate taxpayer and to be assigned to a none or starting rate taxpayer before encashment. Also, a higher rate taxpayer may intend to retire abroad and hence he/she would no longer be liable to UK income tax of 40% upon encashment.

Top slicing is used to average out a gain over the number of years the policy has been in force and the resulting figure is called the 'slice'. Where the 'slice', when added to the client's other taxable income keeps him or her within the basic rate of tax, this relief effectively extends the individual's basic rate band.

Offshore bonds are also excellent vehicles for clients who work abroad for a number of years, intending to retire in the UK. This is because the bonds can benefit from a relief called Time Apportionment Relief' which serves to reduce the gain by the proportion of time the individual has spent as a non-UK resident.

Furthermore, if you had to surrender an offshore policy during a temporary period of non-UK residence, you would have no liability to UK income tax on your return to the UK within five years of leaving.

Another well known feature of offshore bonds is the cumulative 5% rule. Even if an individual is taking their tax deferred 5% every policy year, the payment is deemed a return of capital as opposed to 'income'. This is excellent news for a higher rate tax payer or for those who are in danger of falling into the age allowance trap. There is no need to enter these capital payments on a self assessment tax form meaning the policy will be much easier to manage from a tax point of view. Since offshore policies are non-income producing assets, they also make suitable assets where a trust is being considered. The trustees will not have an obligation to distribute income to the beneficiaries and thus can avoid completing annual tax returns.

Switching between funds within an offshore policy does not trigger CGT. Such switches within a portfolio of onshore direct equity or unit trust investments would incur a CGT charge of 18% in the tax year during which the switches were made. Offshore bonds therefore provide a more tax efficient structure for active investment management and ensure investment decisions are not constrained by tax considerations.

Offshore bonds can often be used to supplement a client's pension provision by taking advantage of the 5% deferred tax rule. Furthermore, the investor will not be restricted in the timing of taking benefits from the bond, unlike a pension arrangement.

Luanne Ahearne
Tax and Estate Planning Consultant
Scottish Provident International