In our Article in October 2021, we discussed some of the key features of single premium offshore life assurance bonds held by individuals and trusts. In this Article our focus turns to the tax pitfalls that may be encountered with offshore bonds and how they can be avoided.
Personalised Portfolio Bonds
One of the key features of an offshore bond is the ability to draw down up to 5% of the initial premium (and any subsequent premiums invested) each year tax free. However, where a policy falls within the definition of a Personalised Portfolio Bond (“PPB”), there can be some punitive tax consequences.
An offshore bond that gives the investor (or someone connected to them) the freedom to select the underlying investments in the policy, or influence the selection of investments, would be a PPB. In this scenario, the policyholder retains a number of the advantages of direct ownership but without the income tax and capital gains tax exposure due to the “tax-free wrapper” the offshore bond provides. However, anti-avoidance measures impose an annual income tax charge (a “deemed gain”) equivalent to 15% of the premium and the cumulative gains for each year the policy has been in force.
For example, if a 40% taxpayer invests £100,000 into a bond that falls within these rules, the deemed gain for the first 3 years would be:
Year 1 gain: £100,000 x 15% = £15,000 (tax = £6,000)
Year 2 gain: £100,000 + £15,000 x 15% = £17,250 (tax = £6,900)
Year 3 gain: £100,000 + £32,250 x 15% = £19,838 (tax = £7,935)
It follows that regardless of actual growth in the bond, there is an increasing gain and tax liability and there is also no top slicing relief available to help alleviate the tax burden.
For this reason, offshore bonds that are PPBs because the investor chooses or influences the investments should be avoided. However, there are certain selected investments that would be permitted, which include:
- cash,
- shares in an authorised unit trust,
- shares in an approved investment trust (or overseas equivalent),
- an open-ended investment scheme,
- shares in a UK Real Estate Investment Trust (or overseas equivalent), and
- certain non-UK collective investment schemes.
Examples of selected investments that would not be permitted include unlisted stocks and shares, private company shares, certain loan notes and cash held for currency speculation.
The test as to whether an offshore bond would be classed as a PPB is an ongoing test. If this is an issue it should, therefore, be possible to request the provider to change the policy terms to ensure it falls outside of these rules going forwards.
UK RNDs
A number of important points particular to UK RNDs were covered in the previous article, but it is worth reiterating a couple of key things to remember here.
The offshore bond offers the same benefits to non-domiciled individuals 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, therefore, avoid the need to pay the annual Remittance Basis Charge of £30,000 or £60,000 if there are no other overseas income or gains.
However, even if only 5% or less has been withdrawn from the bond annually, care needs to be taken in understanding the composition of the funds used to purchase the offshore bond. If the policy was purchased using untaxed overseas income and gains, then a remittance to the UK of the 5% withdrawal could still lead to a tax charge.
Furthermore, it is important to be aware that when a chargeable event does occur, it will not benefit from the remittance basis of taxation. Therefore, if more than the cumulative annual tax-free amount of 5% is drawn down by a UK resident non-dom, they will be liable for UK income tax when the chargeable event arises, even if the funds are not brought to the UK.
Non-UK Trusts
In our previous article we discussed some of the key benefits of offshore trustees acquiring an offshore bond. As non-UK situs assets, they can be excluded property for inheritance tax purposes (if the trust qualifies as an excluded property trust) and the bond will not generate income or gains in the trust until such a time as a chargeable event arises (subject to the PPB rules discussed above).
It is, however, important to be mindful of some of the issues to consider before deciding to hold an offshore bond via a trust.
If the offshore bond was purchased by offshore trustees using clean capital, you might expect that the trustees could still draw down 5% each year of the initial amount invested and that could always be distributed to the beneficiaries without a tax charge arising.
Whilst this may often be the case, the matter will not be straightforward if the trust also owns other assets that produce income or gains. This could mean that a distribution to the beneficiaries is taxable because the distribution is treated as first being made out of other income or gains of the trust, rather than from the tax free withdrawal from the bond.
It is also important to note that on the eventual surrender or maturity of the policy, any chargeable event gains are firstly assessed on the person who created the trust (the settlor), provided they are UK resident. This is the case whether or not they receive any of the proceeds, although normal top-slicing rules should apply.
Furthermore, as chargeable event gains do not benefit from the remittance basis of taxation, this means that UK resident non-UK domiciled settlors would be liable to UK tax, even though they do not own the bond and the proceeds have not been brought to the UK.
It is only in circumstances where the settlor has either died in a previous tax year, or is not UK resident, that the chargeable event gain is assessed on the trustees (or on UK resident beneficiaries who receive any benefits from the bond if the trustees are non-UK resident). It is also worth noting that the trustees would not be entitled to top-slicing relief.
If this tax treatment could produce unwanted consequences, it should be possible to assign the bond to a beneficiary without triggering a chargeable event. This should allow the bond to be encashed at the beneficiary’s marginal rate of tax and top slicing relief should be available. However, there may be an inheritance tax exit charge to consider on the assignment.
It will, therefore, be important for the trustees to ensure they first understand whether an offshore bond can deliver the intended tax benefits before making the investment decision. The offshore wrapper element often adds an additional layer of cost which needs to be weighed against the benefits it can offer and the tax implications noted above.
We hope this article provides a useful indication of the pitfalls to be wary of in relation to offshore life bonds and if you would like to discuss this topic in more detail, please contact us.