Much has been written about the relative merits of onshore and offshore bonds - there are situations...
Much has been written about the relative merits of onshore and offshore bonds - there are situations that favour the onshore bond and others that favour its offshore counterpart. In a number of scenarios the position is not clear-cut.
The onshore bonds mentioned in this article are policies whose funds are subject to UK corporation tax on an I-E basis. Offshore bonds are issued from tax havens outside the UK. There is little or no tax charged on the insurer's funds. Most offshore bonds are based in the Isle of Man, Dublin, Luxembourg or the Channel Islands.
The onshore bond suffers corporation tax on most of its income at the rate of 20%. Rental and some other forms of income are taxed at 22%, as are capital gains (after the deduction of indexation allowance). The income and gains of an offshore bond fund will normally be free of tax in the relevant jurisdiction. Hence, they are often referred to as 'gross roll-up'.
Gross roll-up is actually something of an illusion for offshore bonds. While there may be no tax in the particular tax haven in which the insurer is based, the fund is likely to suffer some withholding taxes on its underlying investments. This is primarily a problem on dividend income.
Most dividends will be received net of withholding tax or some other tax liability. Some of the tax may be reclaimable under double taxation agreements but it is unlikely an offshore bond fund with an equity content will ever be truly gross. In the case of UK equities one of the main reasons for the introduction of the 10% tax credit was largely to eliminate the ability of overseas investors to reclaim all or part of the UK tax credit under double taxation agreements.
So offshore bond funds will receive the same income from UK equities as onshore funds. The temptation for the offshore provider is to invest in equities that are either low yielding or suffer no withholding tax.
Chargeable gains from onshore bonds receive a credit equivalent to the basic rate of income tax due to the tax on the underlying fund. So the only liability is to higher rate taxpayers at a rate equal to the difference between the basic rate and the higher rate (17% in 1999/2000, 18% in 2000/01). Offshore bond gains are liable to tax at the policyholder's highest rate of income tax. In other words, they suffer starting rate and basic rate tax as well as higher rate. This is obviously to compensate for the lack of UK corporation tax suffered by the underlying life fund.
If the policyholder has been UK resident throughout the life of the offshore bond then the whole gain will be taxed in this way. But if the policyholder has been non-resident for part of the term then the chargeable gain is reduced by multiplying it by the following fraction: the number of days the policyholder was UK resident divided by the number of days the policy was in force.
It follows that if the policyholder is non-resident throughout then the chargeable gain is zero and this not liable to UK tax. Of course, there may be tax to pay in the country of residence.
Slicing relief is available on offshore bonds but can be used only to reduce (or eliminate) higher rate tax liability - it cannot be used to reduce basic (or starting) rate liability. The number of years used for top-slicing is reduced by the number of complete years the policyholder was non-resident. A further difference for offshore bonds is that the number of 'relevant years' used in the top-slicing calculation is always based on the years from commencement. This contrasts with onshore bonds where, for partial surrenders, the number of years is counted only from the previous chargeable event if the part surrender is a second or subsequent chargeable event.
In most other respects the taxation of onshore and offshore bonds is no different. The same events are chargeable events. The ability to defer tax applies to both as does the 5% annual allowance on partial surrenders.
On the face of it the overall tax position is similar for UK residents who are either basic rate or higher rate taxpayers whether they go offshore or remain onshore. Onshore investors suffer tax broadly equivalent to basic rate in the fund and are then taxed at 18% on any chargeable gains that are liable to higher rate tax.
Offshore investors benefit from tax-free(ish) roll-up in the fund but then pay their highest rate of income tax on the chargeable gains from the bond. But it is an over-simplification to say that the overall result is the same for UK basic rate and higher rate taxpayers.
The ability to defer tax is greater for the offshore bond. So the longer it is held the greater the compounding effect of the tax deferment. An offshore bond will obviously create a greater return than an onshore one. Whether this will be sufficient to counter the greater tax payable at the end will depend partly on how gross the offshore bond fund is.
The greater the level of withholding or other taxes suffered by the offshore bond the more the pendulum swings in favour of the onshore bond. Another consideration is that the onshore bond fund will generally be able to deduct management expenses from its income.
An offshore bond fund will have no tax from which it can deduct its management expenses, which will lessen the impact of gross roll-up.
It is also important to consider the effective rate of tax suffered by the policyholder. Offshore bond investors receive no tax credit for any tax on the fund. The investor then pays his/her highest rate of tax on the chargeable gain with top-slicing relief available for higher rate purposes only. So the higher rate taxpayer will pay tax at 40% on offshore bond gains regardless of how much tax the underlying fund has effectively suffered. In contrast, the onshore bond investor receives a basic rate tax credit (now 22%) even though much of the fund's income will have been taxed at 20%.
Another key factor is tha
Partner Insight Video: Advisers have had to adapt to the changing investment landscape.
Investment trust savings scheme