Introduction to Offshore Bonds

By Sam Ratnage, Chartered Financial Planner

Key facts about Offshore Bonds

  • Tax deferral rather than tax avoidance
  • Tax free investment growth within the offshore bond
  • Access to up to 5% of the original capital per year tax free at the point of withdrawal
  • All gains taxed as income
  • Discretion over when and by whom profits are crystalised
  • Invest within the offshore bond using Tideway’s discretionary investment portfolios
  • Low set up and ongoing costs
  • No penalties to surrender or encash the offshore bond other than tax which may have been due

How do Offshore Bonds work?

When mentioning an offshore bond to a client to help improve their tax efficiency, there is a unanimous negative reaction to the word “offshore”. However, an offshore bond is not a tax avoidance scheme or an aggressive tax planning product. It is a well-trodden financial planning tool, supported by UK tax legislation applying to insurance policies that is well proven and has been used by financial advisers in tax planning for many decades.

Offshore Bonds, or International Bonds as they are sometimes called allow an individual to invest much like a pension, where the investment is rarely taxed whilst in the bond; the bond holder therefore benefits from what is known as gross roll-up rather than having their investment income and gains either taxed at source, or annually through their tax return. Income tax is payable when the bond is ultimately cashed in, either in full or in part.

Unlike a pension account there is no tax relief on contributions to an offshore bond, but like a pension account all profits in an offshore bond whether generated from capital gains or from income are taxed as income.

Unlike a pension account and a key advantage of offshore bonds is that the owner of the bond can withdraw up to 5% of the original capital each year after investing in the bond without any immediate tax liability. This withdrawal allowance is both cumulative i.e. if you don’t draw 5% in the first year you own it, in the second year you could draw up to 10%. It is also limited by the initial investment amount rather than the value of the bond at anyone time up to a maximum of 100%. So, you can have 5% of the initial investment amount for 20 years, or 4% for 25 years etc.

A taxable income is created when the bond is cashed in or surrendered either in full or in part. This will happen when a withdrawal exceeds the cumulative 5% p.a. annual allowance. However, this won’t happen automatically and so can be controlled to reduce the tax due. A method known as top slicing can also be used to where gains are divided by the years invested to ensure large withdrawals can remain in lower level tax brackets. There are several circumstances where the ultimate tax can be lower than would have been paid along the way, for example:

  1. Where an individual’s taxable income will be lower in future (perhaps in retirement) and therefore subject to lower rates of tax
  2. Where an individual may become tax resident in another country where the profit from the bond will be taxed at lower rates or in some cases not at all
  3. Where the bond can be gifted to an individual (eg children) or trust that has a lower income tax rate.

Who can benefit from Offshore Bonds?

Individuals

  • Wanting to invest in income generating investments and wanting to reinvest this income without an immediate tax liability
  • Needing a tax efficient income in the UK now or in the future
  • Who have used up, or are using up their ISA, Pension and Capital Gains allowances
  • Who are a higher rate tax payers
  • Who may have a lower tax rate on income in the future, for example:
    • if their overall income goes down,
    • if they are prepared to gift the investments to someone with a lower income tax rate,
    • or they plan to be non-resident in the UK for tax purposes
  • Plan to pass on pension funds who need an alternative income in retirement

Companies

  • With capital to invest but who wish to defer corporation tax on investment profits

Offshore Bonds are very useful for someone who is a higher rate payer, who wants to invest in income generating investments and would like a no immediate liability to tax income for an extended number of years and happy to address any potential tax liability in the future as part of financial planning exercise to mitigate as much as possible.

For most UK residents they should be considered after first looking at ISAs and pension allowances and using allowances for dividends and capital gains. It is therefore, generally, a vehicle to use for clients after pensions, ISAs and General Investment Accounts have been fully utilised, although each client’s circumstances should be treated individually.

Some companies with surplus cash may benefit from investing in an Offshore Bond to allow them to roll up their investment income and gains without liability to corporation gains tax. Noting that corporation tax would become due when the bond was cashed in, however careful planning may facilitate lower levels of tax on any profits.

What can an Offshore Bond invest in?

There are some rules around what you can and can’t invest in via the offshore bond to protect its tax status. Tideway can keep you on the right side of these rules which allow for investment in any of Tideway’s collective investment portfolios.

The investment funds can be held via Tideway’s custody provider, AJ Bell, so that the holdings can be valued and reported on as part of your overall Tideway Portfolio alongside any ISA, pension or GIA accounts.

Case Studies

1. Increase tax efficiency in retirement

This individual could save up to £100,000 in tax

Mr S is in his early 60s and is moving into retirement.

He has been enjoying an income after tax of £70,000 per year, he is not married and wants to maintain his level of income as closely as possible, at least in the earlier years, as he is fit, healthy and wants to enjoy his early retirement.

He has built up a pension worth £1,000,000 during his career and has taken the tax free cash sum. This combined with other funds, he has £700,000 of cash to invest. He has not invested in ISAs. Only £200,000 can be invested in ISAs over the next 10 years which could be invested, initially for capital growth, leaving £500,000 that, if invested directly for income, would create income taxed at the higher rate of 40%.

By taking an income of £50,000 p.a. from the pension, he can continue to draw from his pension sustainably for a long time without paying higher rates of tax, but any additional income generated would be subject to higher rates until sheltered in the ISAs.

If he was to place the full £500,000 in an offshore bond, he can have an additional £25,000 p.a. of income, which he could withdraw with no immediate liability to tax. He can therefore avoid higher rates of tax of approximately £10,000 each year.

Twenty years on he will have deferred around £200,000 worth of income tax. Now in his 80’s Mr S can drop his pension withdrawals giving him his 20% basic tax bracket back, then he can progressively cash in the offshore bond and ensuring that he only pays basic rate taxes on the profits. Paying 20% tax on the profits versus the 40% payable along the way could make a net saving of £100,000 in income tax.

2. High earner wanting to fund for their children with recent inheritance

This couple could save up to £160,000 in tax

Mr & Mrs W are both higher rate tax payers with two children age 8 & 10. They have recently received an inheritance of £400,000 which they have earmarked to help the children in the future whether through education or help them onto the property market. They are conscious of extremely low interest rates and do not want this money to devalue against inflation over time therefore they wish to invest this money. They shouldn’t contribute this amount to pensions as they cannot access this until they are of pension age. Also, the sum is larger enough that is will take a long to time to fund ISAs or Junior ISAs and very hard to keep tax efficient in a GIA.

By funding this money into an offshore bond they can invest this money, maintain control whilst the children are still young, have access to 5% cumulative withdrawal a year which could fund higher education for the children. They will also benefit from gross roll up of the investment and perhaps in 15 years time when the children are of a responsible age and stage of life, it can be gifted to them to use or encash. The parents are likely to remain higher rate tax payers and children are likely to be lower rate of tax payers when they can encash the bond meaning all profit will be taxed at lower tax rates. The bond can also be split or passed over gradually using segmentation so that each child can encash it at the right time for them.

This allows the parents to plan to continue to earn higher rate of tax, whilst keeping the availability to fund their pensions, ISAs and GIAs from earnings, thus being able to fund their future retirement.

3. Wealthy individual wanting to be in the UK for a period of time but not permanently

This couple could save up to £400,000 in tax

Mr & Mrs C are wealthy individuals and wish to be a resident in the UK for a period of time, perhaps 5 to 10 years but have most of their lives, assets and family outside of the UK. They are therefore considered non-UK domiciled and have no plans to permanently move to the UK and become UK domiciled.

By placing a lump sum of £2M into an offshore bond they can leave their money abroad and benefit from 5% tax deferred cumulative withdrawals and address any future liability at a later date. This 5%pa or £100,000 covers all their income needs whilst living in UK they can withdraw this with no immediate liability to tax. When they move back out of the UK they can encash the bond and pay the associated tax in the country of residence without creating a complex UK tax scenario for their temporary residency.

Risk Warnings

Past performance should not be taken as a reliable indicator of future performance and it should be noted, of course, that tax rates and how taxes are charged will change over time; we can only advise based on what taxes are payable now and how different tax sheltering vehicles work now. There is always a risk tax regimes may change in the future; however without significant costs to encash an offshore bond it’s unlikely an investor would be much worse off cashing in a bond and paying tax than paying tax along the way. Tideway are not tax advisers and so if you have a complicated tax circumstance especially across multiple different countries you should always seek tax advice. This document should not be construed as advice to invest in a bond, you should always seek professional advice based on your personal circumstances if you wish to invest in a bond to ensure it is suitable for you.

Tideway Investment Group comprises the following entities: Tideway Investment Partners LLP and Tideway Wealth Management Limited. Tideway Wealth Management Limited is an appointed representative of Tideway Investment Partners LLP, which is authorised and regulated by the Financial Conduct Authority. FCA number: 496214.

Tideway Wealth Management Ltd
107 Leadenhall Street
London EC3A 4AF

+44 (0)20 3143 6100
info@tidewayinvestment.co.uk

© Tideway Investment Group 2021

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