From 6 April 2010, the top rate of income tax will rise to 50% for high earners and will impact the returns for those investments that are taxed as income, such as investment bonds. Consequently high earners are looking for opportunities to boost their investment returns to offset the increase in tax rate. With the range of benefits offered by offshore bonds, more people than ever are using these investments to hold assets in a tax efficient investment environment.
How do offshore investment bonds work?
An offshore investment bond allows a wide range of different asset types to be held such as cash deposits, investment funds and discretionary investment portfolios. By holding investments within the bond, the tax regime that applies in the offshore jurisdiction will apply to the assets within the bond. These bonds are established in tax efficient offshore jurisdictions. This means that investments within offshore investment bonds can grow virtually free of tax (only withholding tax - the tax paid on dividends from some shares cannot be reclaimed).
For higher rate taxpayers, and particularly those impacted by the increase in tax rate, the ability to invest in a virtually tax-free environment has obvious appeal. The investment within the bond will benefit from ‘gross roll-up’. By way of example, many people hold cash deposits in an offshore bond to benefit from gross roll-up of interest, in preference to holding deposits onshore where income tax will be deducted on an ongoing basis.
By holding an investment within an offshore bond, additional costs will be incurred; this will be the charge for the bond itself. The charges must be considered as they will be offset against any investment gain, and generally mean that investors need to commit to hold the bond for a specific period beyond which the effect of gross roll-up may offset the additional cost.
How will tax rules apply?
When funds are taken out of the bond and brought back into the UK, UK income tax will apply to any gain at the individual’s highest rate of tax. Investors may time the full or partial encashment from a bond to coincide with periods where they are subject to a lower rate of tax, or even assign ownership of the investment to another person, such as a spouse, who is subject to lower tax. For those looking to move abroad, the tax which will apply to an encashment will depend upon the country of residence. Where the tax regime is more favourable than the UK, offshore bonds may be used to shelter funds from UK tax, with the intention of creating the eventual tax liability under the more favourable tax regime. This ability to control the taxation point is a key reason why investing offshore is appealing to many investors.
The range of allowable investments which can be held within an offshore investment bond is broad, which allows diversification and flexibility. As investments in the bond are not subject to tax whilst offshore, investors can switch between different funds and asset types within the bond without a tax liability. Regular income can be taken from an offshore bond up to a specified limit with the tax liability deferred. Withdrawals in excess of the limit, or withdrawals taken as partial encashment rather than income, may be subject to tax. However until funds are taken out of the bond in this way, there is no requirement to report to Her Majesty’s Revenue and Customs by way of self-assessment.
Are offshore investment bonds right for you?
High earners, particularly those subject to the new 50% tax rate, are likely to find these bonds appealing. If your tax rate is likely to change in the future, or if you intend to move overseas, perhaps to retire, then an offshore bond may be suitable.
Generally all investors should use the tax allowances available to them before considering investing offshore. Everyone has an annual Capital Gains Tax (CGT) allowance, representing a gain that can be realised without tax applying. Investment bonds are subject to the income tax regime, not the CGT regime so the CGT allowance cannot be used. Investors should generally invest in assets that produce gains chargeable to CGT, such as a discretionary investment portfolio, where the portfolio manager can ensure the CGT allowance is used on an ongoing basis before considering an offshore investment bond.
If you would like to discuss the impact of the change in tax rate, or whether investing offshore is right for you, please contact your private banker.
Ben Davis, Regulated Products Manager, Tax Trusts and Pensions, Coutts UK
Related publications
