Single premium non-qualifying life assurance policies issued by non-UK life assurance companies “offshore bonds”, have been in existence since the late 1960’s and today their principal attractions remain the same as they have always been. If the rules on how investments can be made are followed correctly, significant tax benefits can be achieved over a long period.
Firstly, for UK tax purposes offshore bonds are treated as a non-income producing asset and, with one exception, are never subject to UK capital gains tax. Secondly, they offer the opportunity to provide a tax-free source of funding through the ability to draw down up to 5% of the initial premium and any subsequent premiums invested into the policy. This allowance is cumulative so if it is not used or only partially used in one policy year, the unused portion rolls over for use in a subsequent policy year.
This facility is available without giving rise to a UK income tax liability or the need to report it to HMRC so long as no more than 5% or the cumulative previously undrawn allowance is taken in any one policy year.
In effect, the allowance is the return of the premium used to purchase the policy, over a period of twenty or more years.
However, any draw down of funds from the policy in excess of 5% per annum, including a payment on surrender or maturity, will be a chargeable event and subject to income tax. The calculation of the chargeable gain will take into account any withdrawals that have been taken previously and the tax due on the gain is payable at the individual’s marginal rate, which may be determined by using top-slicing relief.
We discuss the use of offshore bonds for non-UK domiciles below, but it is critically important to be aware that chargeable events do not benefit from the remittance basis of taxation. Therefore, if more than the cumulative annual tax-free amount of 5% is drawn by a non-dom, they will be liable for UK income tax even if the funds are not brought to the UK.
While the bond is running all investment returns made on the invested premium can roll up free from UK taxes (subject to any withholding taxes) even though the policyholder is UK resident and domiciled, until a specified chargeable event occurs. With sensible planning it is possible to ensure that no such chargeable event takes place or that if it does, it happens at the most appropriate time and mitigates any tax liability or avoids it altogether. The investment return when the bond is surrendered or matures is chargeable to income tax rather than capital gains tax. However, the top slicing relief calculation means that even when a bond is surrendered or matures on the death of the life assured, large sums can be received at low rates of tax with appropriate planning.
Offshore bonds also present an opportunity for efficient estate planning; the policy, or policy segments, can be gifted without crystallising an immediate tax charge. The gifts are potentially exempt transfers and therefore a UK domiciled donor must survive for 7 years from the date of the gift for it to escape inheritance tax.
Unsurprisingly, investment flexibility and tax efficiency have meant that offshore bonds have proven popular investments with higher or additional rate taxpayers and those responsible, for ensuring that capital and investment returns on that capital are not eroded by tax whilst at the same time being able to provide tax efficient distributions to beneficiaries.
Another feature in their favour is that the charging legislation governing offshore bonds has remained relatively unchanged over the decades so their tax treatment is settled and not under threat of change anytime soon.
Offshore bonds can also be a useful tool for UK resident but non-UK domiciled individuals as they can use non-UK capital to purchase the bond. The offshore bond offers the same benefits to non-doms as it does to UK-domiciled individuals in that investment income and gains within the policy are not subject to UK tax unless a chargeable event occurs; the use of a bond can avoid the need to pay the annual Remittance Basis Charge of £30,000 or £60,000.
Additionally, UK resident non-doms can also draw down 5% of the initial purchase price each year, and so long as the offshore bond was purchased using clean capital these funds will also be free of tax if remitted to the UK.
If the life policy was purchased using mixed funds, i.e. funds that contain overseas income and gains that have arisen since the investor has been UK tax resident and have not been remitted to the UK, it is still possible to draw down 5% of the original premium per annum. However, if these funds are then remitted to the UK they will be taxable at the point of remittance. The amount of the funds taxable in the UK is dependent upon the composition of the funds used to purchase the offshore bond. Determining the composition can become a complicated and sometimes costly exercise and therefore the simplest practice when withdrawing funds from an Offshore Bond that was purchased with mixed funds is to use these funds overseas.
An offshore bond can offer advantages for holding mixed funds once an individual has become deemed UK domiciled after 15 years of residence. This is particularly the case where the deemed domiciled individual is too late to settle a protected trust and will otherwise be taxable on their worldwide investment income and gains.
One of the key tax features of offshore bonds when they are acquired by overseas trustees are that they are non-UK situs assets and therefore excluded property for inheritance tax purposes, but the more immediate benefit is that prior to surrender or maturity the bond does not create any income or gains in the trust.
This lack of income and gains allows asset protection to be secured via the trust whilst providing the opportunity for the trustees to make tax-free distributions over a period of 20 years or more and without the typical tax complications that arise with settlor-interested overseas trusts for UK resident settlors.
In our second article we will focus on some of the pitfalls that can be encountered with offshore bonds and how they can be avoided.
Article written by Chris Poulson and Sinead Mulligan