|That’s a Wrap|
For many years, the traditional life company seemingly offered little to excite the private client practitioner with international interests. Today, a number of mainstream providers have well-established offshore subsidiaries, competing for complex cross-border work. Most focus on investment alone, with some offering solutions to meet the other traditional core specialities of the life industry: pensions and protection.
What are offshore bonds?
Before contemplating the solutions, what about the product itself? Offshore bonds are typically issued from the Isle of Man (IoM), Republic of Ireland (Dublin) or Luxembourg, with a few normally unfamiliar names further afield. Generally speaking, Luxembourg services the continental European markets; Dublin serves Europe, including the UK; and IOM serves the UK and the rest of the world. Those providers with the strongest cross-border appetites will manufacture in several of these locations.
Investor protection is often better than many anticipate. In the IoM, the government operates a policyholder protection scheme that means, in the event of a life insurance company being unable to meet its liabilities, compensation of up to 90 per cent of the amount of any liability of the insurer under the contract is available. Unlike many protection schemes, this applies to all policyholders, regardless of where they reside.
This does not protect the owner if the underlying assets fail, but it is a last resort should the life company itself fail. In any case, most carry no risk business, and legislation provides for the clear segregation of a client’s assets, with a policyholder’s assets not being available to creditors in the event of winding-up.
While the traditional retail market products offer a prescribed range of funds, most international providers have embraced the ‘portfolio bond’ concept, where the bonds are effectively tax wrappers, providing open architecture, limited only by legislation. For a UK-resident taxpayer, this is defined by sections 515–526 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA). In summary, this allows authorised unit trusts, onshore and offshore open-ended investment companies, exchange-traded funds, investment trusts and deposits, but excludes single lines of stock or individual debt holdings and structured notes. In my experience, most private banks and discretionary fund managers can work within these constraints if need be, and life companies will endorse policy terms to meet these restrictions for a client who becomes a UK tax resident.
Increasingly, life companies do not expect to have custody of the bond’s assets. Instead, these are held in the nominee of the appointed discretionary manager (if one is required) for expedience of trading. If assets are already held and managed by a third party, then very often the investment remit need not change.
Bonds are defined in UK terms as ‘single-premium non-qualifying whole of life’ plans, so they enjoy life policy taxation, with, in most instances, the minimum of life cover, of just 1 per cent. Another version, in the UK charged to tax in an almost identical manner, is the offshore redemption bond. Whereas life bonds only need come to an end when the last life assured dies (IoM abolished insurable interest in 2008, so multiple lives are very common), redemption bonds have no lives assured and only mature after a predefined term – often 99 years. According to the jurisdiction of the taxpayer, one might be more suitable than the other. Where neutral, increasingly the redemption bond is favoured.
Offshore life and redemption bonds separate the owner from the assets that they hold. This allows for gains to be made, and interest and dividends to accrue within the bond, without a liability at that time for the owner. This mechanism of tax deferral, referred to as ‘gross roll-up’, works for bond owners in many jurisdictions.
Because bonds have their own set of tax rules (ITTOIA), they are often misunderstood. While they are non-income-producing assets, the ‘chargeable event’ gains they produce are not normally subject to capital gains tax (CGT), but to income tax in a highly controllable manner.
While an encashment of part of a mutual fund would be subject to CGT under the ‘part disposal’ rules, a UK resident can enjoy up to 5 per cent per policy year of the original premium of a bond on a cumulative basis for 20 years. Thus, the owner can enjoy withdrawals until all the capital is repaid before any tax on profits becomes chargeable. Clearly, this strategy can offer spectacular results where the owner will or can manufacture a lower tax rate, or become tax resident where rates are lower, or where resident non-domiciles are taxed on a territorial basis. Also, bonds, or segments of them, can be assigned to new owners by way of a gift (and not just a resident spouse) without crystallising a gain on that donor. This is a tremendous feature for those with family in higher education, as the author can attest. In this situation, the new owner takes on the liability from the original or previous owner, but only when a chargeable event occurs.
From a practical perspective, bonds are a great fit with trusts. In the accumulation phase, and decumulation (unless more than 5 per cent per policy year is withdrawn per annum), trustees’ tax returns are not required, and the far from favourable tax outcome for discretionary trusts where dividends accumulate can be avoided when the same assets are held within a bond. This nicely lends itself to the UK-domiciled or deemed-UK-domiciled client concerned about inheritance tax (IHT), where bonds fit perfectly under asset-freezing strategies, such as loan plans using discretionary trusts where the transfer is not constrained by the relevant property regime. Also popular is the discounted gift trust. Here, the component of the transfer that the present-day value of the future income represents is immediately free from IHT, with the residue a potentially exempt transfer or chargeable lifetime transfer. Thus an income stream is carved out without interference from gift-with-reservation or pre-owned-asset tax.
The international appeal
Back to our international clients. What might attract expatriate clients planning to eventually return to the UK, such as those working overseas on a contract of employment? The conventional wisdom is to plan early, and rebase investments before re-acquiring UK tax residency, assuming rates of tax are lower where the expatriate has settled or tax is charged on a territorial basis. However, whether this is the case or not, ‘time apportionment relief’, a facility uniquely available to bonds and life policy savings plans, will normally provide a better result. Counterintuitively, this requires the owner to retain their investment until after they return to the UK, encashing only when required. Here, the gain from inception is reduced proportionately according to the time spent overseas. For a bond held for nine years as an expat that is encashed a year after the owner’s return, only a tenth of the gain will be chargeable. Because of the compounding nature of growth, this can often produce a better result than rebasing while overseas, where this can be done tax-free, reinvested upon return, with disposal a time after. Add to this the fact that any top-ups enjoy time-apportionment relief going back to inception of the policy, irrespective of whether the client has returned to the UK or not when topped up, and the maths can lead to surprisingly pleasant outcomes. Even the resultant chargeable gain can be ‘top-sliced’ (using the period since back in the UK), which, for some, can improve the ultimate burden further through reducing the rate of tax charged, by applying a spreading mechanism.
For the resident non-domicile facing the choice of paying the remittance basis charge, wrapping offshore assets within an insurance bond can provide gross roll-up and tax deferral without the need to pay the GBP30,000 annual charge, which also, therefore, preserves the personal allowance for income tax purposes and annual exemption for CGT. It can be particularly efficient where the resident non-domicile ultimately leaves the UK, though tax regulations and rates in their next destination should also be considered. For those planning to expatriate, and, in some cases, those already overseas (expatriate and indigenous), the choice of using bonds comes down to a comparison of the tax for the investment strategy they wish to employ – held unwrapped or within a bond. Here, ensuring the chosen provider has a bond that meets local regulations for distribution and tax law is key. For example, there might be governance on commission levels, a requirement for bespoke life cover, investment restrictions, the need for a local fiscal representative, or language and reporting requirements, to name but a few factors. That said, the ‘right’ bond is favourable in a wide number of international jurisdictions.
What of other investment wrappers, such as international pensions? According to the jurisdiction, these too can be accommodating in terms of investment choice, flexible access and death benefits (as the recent UK ‘Freedom and choice in pensions’ consultation evidences), as well as often being inherently tax-efficient. Although trusts are increasingly, but often wrongly, seen as vehicles of tax avoidance, saving for retirement and creating independence from the state by means of a pension is hardly an objective any government can condemn. But that is a story for another day.
The opinions expressed do not constitute investment advice and specialist advice should be sought about your specific circumstances.
Published on our website on Jan.06, 2015