David Burrows explains why offshore bonds are still the right investment tool for many scenarios
The offshore bond has always had a mixed relationship with the IFA community. There are those advisers who swear by them as a truly flexible, tax-friendly addition to a client's investment portfolio. Then there are those who see the offshore bond as a limited-value product loaded with expensive charges.
And what of the recent changes to the CGT regime? There have been fears that offshore bond sales would tail off after the UK government's capital gains tax (CGT) changes made direct investments appear more attractive.
Chancellor Alistair Darling announced the changes in his pre-Budget report last year, and since then a single CGT rate of 18% has been introduced (from April 2008), with no indexation or taper relief. However, investments within offshore bond wrappers will still be taxed on encashment at rates up to 40% for high income earners.
Arguably all insurance bonds now look less attractive relative to unit trusts thanks to the changes, but as Julie Darlington, financial planner with national IFA 2 Plan Wealth Management explains, this is far from the end of offshore bonds.
"There has been a lot of press comment since the CGT changes and there has been much speculation around an age-old topic - investment bonds vs mutual funds. Even before the tax changes the position was under debate and I think the changes have simply raised the profile and created more points for consideration."
She adds: "I don't think the changes make investment bonds, including offshore, less attractive; the position remains the same that the choice of product wrapper - be it onshore or offshore - should depend on the client's needs, and a good financial adviser will work through their clients' needs and personal circumstance to select a wrapper that is appropriate for them. There are many factors to consider, including whether the client is investing for income or growth; current and future tax position, requirement for fund management or control over the portfolio; simplicity of administration, and fund choice."
Peter McGahan, managing director of Worldwide Financial Planning (a Cornwall-based IFA that conducts a high percentage of offshore/expat business) believes the case for offshore bonds is as strong as ever and is amazed so many IFAs fail to utilise them more.
"I think the first thing to say is that your first port of call is going to be tax-free investments in an Isa and use of collectives, but for clients with around £200,000-plus to invest you also want to start looking at offshore bonds," he says.
Missing a trick?
There is a feeling that some IFAs overlook offshore bonds as a viable option for clients. A survey by Defaqto back in June showed that a large proportion of IFAs said they did not 'know enough about offshore bonds' to give advice. So are advisers missing a trick in not utilising offshore bonds?
"Without doubt," McGahan insists. "I think many advisers don't really understand them and do an onshore versus offshore comparison and come to the conclusion that onshore bonds are simpler and offshore bonds are higher in charges than they really are. Comparing onshore with offshore bonds is like comparing a chicken with a hamster - I fail to see the relevance of a comparison."
McGahan believes the CGT changes have eroded further the case in favour of onshore bonds, but he insists offshore bonds remain a very useful and much underused option for advisers. "I have never understood the attraction of onshore bonds - you pay tax on your investment as it grows onshore; whereas with an offshore bond it may be the same underlying investment but there are flexible tax options. It is true that you have to watch out for charges, which are often hidden in the allocation rate within mirror funds, but overall offshore bonds offer genuine tax planning advantages and onshore bonds do not."
McGahan goes on to dispute the idea that offshore bonds are solely a product for the expat. He insists offshore bonds continue to have a great deal of attraction for UK residents too, particularly income seekers.
He adds: "While we have many expat clients on our books, it is a bit of myth that offshore bonds are in some way only applicable to them. There are huge benefits in using offshore bonds for UK residents too."
McGahan gives as an example a UK-based investor looking to provide income for his three daughters while they are at university.
"The bond is in segments and they are cashed in by the daughter, and as long as the gains on each segment are less than the personal allowance for the year, there is no tax to pay on it. Let's say each segment grows to £7,000, the parent assigns the segment to her and £5,000 is assessed to her on her allowance, so there is tax-free growth and tax-free distribution. This can be repeated as each daughter in turn goes to university. And if after all this the client decides to retire abroad, they can then cash in the lot free of UK tax."
Most financial planners stress the importance of setting up an offshore bond at the outset in a segmented structure. In the application the IFA would advise a client to split £100,000, say, in 50 segments. Money can be taken out in different ways but the general rule of thumb is to avoid partial surrender - it is complicated and creates enormous problems.
Stephen Tucker, managing director and chairman of Sussex-based IFA the Fry Group, agrees there are benefits to UK-based investors in offshore bonds but argues that on the whole the primary market for these products is for those living or working abroad.
"Yes, there are benefits of drawing limited income levels to help university costs or suchlike, but in general I think there are not too many advantages of deferring tax unless you have concrete plans to live or retire abroad in the future. If you don't leave UK shores then you are likely to be slapped with a 40% income tax when you cash in your offshore bond, so in many cases the argument doesn't stack up. Having said that, the number of people retiring abroad is increasing, so it is a growth market of sorts - albeit still a relatively niche one."
One obvious question with regard to product promotion would be 'are advisers taking advantage of the opportunity of offshore bonds to use them for non-domiciled clients?'
Darlington suggests that the level of awareness and usage very much depends on an adviser's client base.
"For those advisers working with non-domicile and international clients, the offshore bond will probably already be a product wrapper that is often considered and used. However, for those advisers that rarely work with non-domicile clients there are opportunities to raise awareness of the new tax position for non-doms and the potential benefits of offshore bonds. But, as ever when working with international clients, not only has the UK tax position to be considered but the tax position in the country of association - this is where a specialist international tax adviser can provide invaluable support and connections."
For expat clients, Tucker thinks the offshore bond continues to offer valuable tax advantages in varying circumstances. "One of the attractions of offshore bonds to expats is that if they were working in Hong Kong, say for Lehman Brothers, for the last four years and they returned to the UK and cashed in their offshore bond after a couple of months, they would only get taxed on a tiny proportion relating to their time back in the UK. Alternatively they could keep the bond, return to the UK and plan to head back to work for another bank in Hong Kong. People are far more mobile in terms of where they work these days and offshore bonds are an ideal investment vehicle for those who spend large periods of time working outside of the UK."
Offshore bonds are often seen as the ideal vehicle for expats for as well as being tax-efficient, they are internationally portable and multicurrency.
There is also the fact that they can be used by those who have already reached their pension cap. So do all these selling points still stack up today?
"Yes," insists Darlington. "We have seen in recent years more clients with international connections, either retiring, moving, working or simply travelling around the world. Whether it's a growing market for advisers is another question; to focus on this market I think an adviser needs to have connections with an international tax adviser so the implications of tax in other countries can be addressed, not simply the UK tax position. There may be no tax liability on an offshore bond for an individual if they are not UK resident at the time of encashment, but there may be a liability in their country of residence and this could well be more than they would have paid in the UK. In addition there is always the possibility that the offshore gross roll-up of a bond is not recognised in the country of association - for example there is the possibility that gains made in any tax year will be taxed on an annual basis. So yes, offshore investment bonds are a good starting point for product wrapper choice, but other factors must be considered for advisers working with international clients - it's a complex area of business."
It is also worth remembering that unless a firm has permission to work within the European Economic Area, all advice must be delivered and finalised in the UK. If working with clients outside the EEA, advisers would need to check the legal and regulatory position in the country of association before advising.
A matter of trust
In terms of usage, one consideration is whether IFAs are more convinced by bonds used in conjunction with a trust structure - such as a discounted gift trust.
"I think they are more familiar with them because product providers have done a better job at marketing the 'package'," Darlington suggests.
"I think advisers are also more comfortable, again probably due to the information provided by product providers regarding the potential benefits of using a bond within such a structure, such as simplicity of tax administration and potential control over tax liability. However, some advisers are less aware of the drawbacks of using an investment bond as a trustee investment, namely that unless the trust allows them to advance capital, a bond cannot be utilised for withdrawals."
One issue that has come into the foreground of late is whether the UK's Retail Distribution Review (RDR) will affect offshore bond business - especially given that in future clients rather than providers will pay the adviser.
Darlington believes the impact of RDR will be negligible. "If we work on the basis that an offshore bond wrapper is one choice among many investment options and that choice should not be determined by the amount of commission earned, I believe that RDR shouldn't affect offshore bond business. If a client agrees to pay remuneration for advice then the product selected will be right for the client regardless of the method of remuneration."
Tucker takes a similar stance. "The offshore bond is not a TCF or RDR issue at all - it is a tax flexibility argument. I think the RDR will mean questions will be asked about onshore bonds - the most obvious one being 'why an onshore bond at all?'. I suspect the answer is commission."
McGahan echoes Tucker's sentiments. "The offshore bond suits some clients' tax planning requirements and not others; nothing has changed there. The CGT changes and RDR really makes no difference to the offshore bond argument. For onshore bonds, it is a totally different story: it is hard to see any advantages to these investments, which have attracted interest in the past because of hefty commissions. I think RDR will represent a parting of the waves - on one side will be collectives and on the other will be offshore tax-efficient products. I think RDR could spell the death knell for onshore bonds and they will be taken out of the equation."
There has always been a belief that Gordon Brown has tended to view tax-efficient products more in the light of tax loopholes. The changes to CGT were arguably an extension of this way of thinking. The overhanging question now is what other rule changes are likely to follow, and is the offshore bond safe from any more tinkering?
Tucker believes the offshore bond is safe for the foreseeable future at least. "When you look at what has been happening in stockmarkets recently, I think the Treasury have got other things to worry about! Tax planning for non-UK residents is such rarefied air that I think the Inland Revenue will leave it be. Advisers can only deal with legislation as it is, and in the current environment offshore bonds still play an important role."
Product suitability is one thing, but accessibility is something entirely different. Anecdotal evidence seems to suggest that offshore bonds on platforms have meant the products have been picked up on the IFAs' radar far more.
"I certainly think this is the case," says Darlington. "Due to the complexity of setting up onshore bonds on platforms, I believe many platforms started with an offshore wrapper - this allowed them to deliver maximum fund choice. They have then gone on to market their wrappers and sell the positives. This has in some ways been a positive as some of the platforms do deliver wrappers with transparent charges, but generally they remain expensive compared with their onshore off-platform peers."
But as McGahan stresses, any possible higher charges of an offshore bond over an onshore bond are more than made up for by the tax flexibility of the former.
"The offshore bond is tax efficient; the onshore bond isn't. How can you possibly say the onshore bond has tax advantages? The charges comparison shouldn't arise, it is about product suitability," he concludes.
The majority of financial advisers (85%) believe the number of self-invested personal pension (SIPP) providers will continue to fall in the coming year, according to Dentons Pension Management research.
Short-term noise or something sinister?
Royal ascent in May
Bought platform for £31m in 2016
History won’t be repeating itself