With the new Labour budget in October potentially going to include a rise in capital gains tax rates alongside other forms of wealth tax, offshore bonds are probably going to get a lot of air time in the next few months (for those of us who pay attention to these sorts of things at least).
I therefore figured it was as good a time as any to have a recap of the features of these products, as well as the benefits and the drawbacks.
What is an offshore bond?
Don’t be put off by the name. Offshore bonds are an entirely legitimate and long standing method of tax planning.
An offshore bond is basically an insurance policy issued by a company based overseas - assets are held by the insurance company on behalf of the individual investor (known in the lingo as the “policyholder”) and invested within the bond wrapper.
Why use an offshore bond?
1. Income and Capital Gains Tax planning
Offshore bonds are predominantly used by investors who have already made full use of their ISA and pension contribution allowances and who have large amounts of income coming into their names which make them either higher rate or additional rate taxpayers.
Any investment returns generated within an offshore bond are done so almost entirely tax free. By removing the tax liability on investment growth, you can benefit from higher compounding returns over time - lovely.
The obvious comparison to make I think is with an ISA where returns are also generated tax free. The first difference being that while we are all limited to putting £20,000 into an ISA each year, there is theoretically no limit to what can be invested into an offshore bond.
The second difference is that you can withdraw any amount from an ISA without creating a tax liability. When an investor places money into an offshore bond, they can only withdraw 5% of the original sum invested each year without creating an immediate tax charge - and any unused 5% withdrawal “allowances” can be carried forward to be used in future years.
Once the investor has withdrawn the value of their entire original investment, any further withdrawals trigger a tax liability - an income tax liability. This is an important point, because it is one of the downsides of investing into an offshore bond.
If you are investing into an offshore bond structure in order to avoid paying capital gains tax in future then it is worth reminding yourself that at the moment Capital Gains Tax rates on share sales are, at worst, half of the equivalent income tax rates.
So if you are investing to avoid paying Capital Gains Tax at 20%, and then need to encash a large slab of your bond in an emergency, you will end up paying tax at a marginal rate of 40% or 45%.
Therefore it’s really important to plan ahead and try to work out a strategy for how you are going to withdraw money from the bond.
The fact that offshore bonds allow tax liabilities to be deferred makes them useful for retirement saving purposes. If I am working with someone who is an additional rate taxpayer today, and who will be a basic rate taxpayer in retirement, then moving money into a bond to save tax today and pay it at a lower rate in future makes good sense.
Of course, the money that you put into the bond may not be earmarked for you at all…
2. Estate planning
Offshore bonds have a number of characteristics which can make them useful structures for passing money onto future generations efficiently.
Once a bond is set up, the “segments” of the bond can be assigned onto anyone that the investor may choose. They can then be encashed in the name of the recipient who will pay tax on the gain at their marginal rate.
If the recipient does not receive any taxable income into their name, a bond encashment gain of £18,570 can be realised in their name without creating a tax liability. Bonds therefore offer a way for donors to pass on wealth to others a) tax efficiently and b) in a manner that they can control.
As bonds are regarded as non-income generating assets they can also be particularly useful as an investment structure within trusts. The admin involved in managing a trust can be material, and having a bond in place removes the requirement for the trustees to produce a tax return every year.
As an example, if I wanted to set up the “Henry Family Trust” for the benefit of future generations - I could lob up to £325,000 into an offshore bond held within a discretionary trust and not pay any initial inheritance tax charge. Investment growth is generated (almost entirely) tax free within the bond while it remains in place, and the trustees have control over how they can assign the bond units to beneficiaries in future. After seven years, this gift falls completely outside of my estate for calculating inheritance tax and I can go through the same exercise again if I am feeling particularly generous.
And finally, as offshore bonds are life insurance contracts, they can also be structured to sit outside of the probate process - allowing beneficiaries to access the assets more quickly.
If using a bond for estate planning purposes it is important to consider how it is set up in the first place. On day one there are two options - set the bond up on a “lives assured” basis or on a “capital redemption” basis.
Bonds set up using the former method will cease to exist on the death of the final life assured, and so for folks going down this road it often makes sense to include someone young as a named life assured in order to extend the life of the bond as long as possible. Doing this does not entitle them to any beneficial interest in the bond assets, they are relevant only for determining the life of the bond.
By contrast, bonds set up on a capital redemption basis are not linked to any individual - the bond is set up to last for a fixed term of 99 years, although it can be surrendered and encashed earlier if the policyholders want to.
Setting up a bond on a capital redemption basis, at the margin, provides for a little more flexibility in how the bond is managed moving forwards. There is always some danger, however slight, that some awful event could befall all of the lives assured on a bond at the same time and in this scenario the bond would be automatically encashed.
My main point however is that when using a bond for estate and inheritance tax planning, it is important to be aware of how it is set up so that the eventual surrender date of the bond can be taken into account ahead of time.
Offshore bonds - the disadvantages
As we have seen, offshore bonds offer a bunch of potential advantages. But nothing in life is ever a slam dunk, there are always compromises to be made and it is the same here.
It is really important that clients understand the drawbacks of bonds so that they can make an informed decision. I have seen a few bonds (in my opinion) oversold over the years by advisers who want to make themselves look clever, solving a problem that isn’t really there.
Setting up a bond involves cost, and a lot of these costs are fixed meaning that for investors with lower sums of money to invest a bond will be much more expensive. We must understand the potential tax savings of putting together a bond investment, relative to the costs. Most investors are served perfectly well by simply using the many vanilla tax allowances that we are all afforded.
For clients who have used these allowances in full, bonds can be useful. But again it is really important to remember that tax liabilities on gains within an offshore bond are only deferred, they are not eradicated. I think that it is worth double clicking on this for a moment because, again, I don’t believe that this is truly widely understood.
When you take more than 5% of your original investment out of the bond in a year, when all of your 5% annual “allowances” are used up and funds in excess of the original total sum invested in the bond are withdrawn, or the bond ends - tax will be payable at marginal income tax rates.
“I won’t need to do that” or “not my problem” you may think - but life has a habit of chucking curve balls, and it will be someone’s problem if not yours.
For a client who is a higher rate taxpayer now, and will be a higher rate taxpayer when they make chargeable withdrawals from the bond - there may not be as much point in using this kind of product.
Choosing to set up a bond is a "Type 1" financial decision - irreversible without a load of aggravation, and potentially cost, and it requires you to make several predictions about the future.
Retaining money within a taxable account costs more in terms of tax yes, but you retain flexibility and flexibility is deeply underrated. Who knows, you may not even mind paying tax…
Offshore bonds also restrict the types of investments that you can hold within them - so there is a theoretical lack of investment flexibility. I don’t happen to think that this is a disadvantage frankly, you can build a sensible and simple portfolio within a bond that will do the job perfectly well.
Often the types of investments that are excluded from being held within an offshore bond are the kind of over-complicated claptrap that you should run a mile from anyway.
There we have it - 1,600 words on offshore bonds. Give me strength. If you’ve got this far, the MBE’s in the post.
Executive summary - really attractive for some (wealthy) folks, or for folks who are looking to do some pro-active estate planning. Clients with less money to invest are likely to better served by swerving these kinds of structures because of the costs, and also because the regular vanilla tax free allowances are likely to work just fine.
None of the above represents tax advice for any individual. You may not believe me but I have cut out a lot of the detail involved in these products, and there are a number of potential pitfalls involved, and so when considering one of these things it really does make sense to consult with a qualified adviser.
Comments