The offshore life industry has suffered from its association with money-laundering activities and lax legislation. However, a tough approach by the OECD and the Federal Reserve has resulted in a highly regulated industry
The offshore life industry has often been unfairly associated with relaxed legislation and money laundering. The reality is quite different.
Offshore centres, which were already under the scrutiny of the OECD and the Federal Reserve, have found their activities receiving even closer attention since 11 September. Underlying the horror of the attacks was the remarkable realisation that the terrorists involved were well funded, and operated a complicated network of financial operations to fund their activities. Of further alarm was the truly global reach of Al Qaeda's assets, and its capability to move funds internationally. This, in turn, has refocused attention on the activities of offshore financial centres.
Suspected of being money laundering weak spots, and perceived as being overly confidential in their financial dealings, global governments have put immense pressure on offshore financial centres to meet certain standards. Such practices have been magnified by numerous class action lawsuits against the bastions of client confidentiality, the Swiss private banks.
However, such perceptions are misleading. Many of the offshore institutions, in response to these pressures have, in fact, become very highly regulated, particularly Dublin, Luxembourg and the Channel Islands (this is accepted by the G8's financial stability forum). Moreover, the vast majority of investors in international jurisdictions who use life policies do so for legitimate financial planning.
There are numerous interesting products and financial planning solutions offered by international life companies. One of the most popular offshore products is an offshore bond or, more correctly, a single premium non-qualifying life policy issued by foreign life insurance companies, primarily subsidiaries of UK life insurance companies. Interestingly, these are unlikely to be the primary target of money-launderers, since the prospect of investment terms in excess of seven years does not provide the liquidity for those looking for short-term advantage.
These are popular mainly because of the tax benefits they can offer individuals. The underlying funds, which are a form of collective investment vehicle accessed through the offshore bond shell, suffer no internal taxation (other than any dividend withholding tax) and can thus create accelerated growth through gross roll-up.
This creates higher overall growth opportunities helped by the compounding effect of a near tax-free environment. Taxation only becomes a consideration upon encashment and will depend on the tax regime of the investor's country of residence. Offshore bonds are not particular suitable for most UK resident investors, since income tax is charged on any gain arising upon encashment at the highest marginal rate. This is not as attractive, for tax purposes, as utilising the capital gains tax regime where gains can be virtually eliminated through indexation and taper relief.
There are also other tax planning benefits available. There is the option of taking a tax deferred 5%pa return of initial capital invested which, if not taken, can be allowed to accumulate. This withdrawal is accessed by making a partial surrender from the policy and can be very useful to augment an investor's other income.
Where the investor is seeking a larger capital sum, different and more tax-effective approaches can be used. Here, offshore bonds can be arranged as a group of individual policies or segments and a partial surrender from the policy (taking a small piece of each segment) can be used. This may, depending on investment performance, result in a chargeable gain even after taking account of any of the cumulative 5% withdrawals that remain unused.
With-profits products have been under immense scrutiny in the UK especially since the Equitable Life situation came to light. While the smoothing technique used by actuaries in conjunction with the bonuses attaching to with-profits is being put under the microscope, the concept does have attractions, especially in a falling market where historic bonuses are protected by guarantees. A with-profits investment link is often available through an offshore bond.
Estate Preservation Accounts (EPA)
Offshore estate preservation planning products are proving increasingly popular as an inheritance tax (IHT) mitigation tool. These are structured in a variety of ways but always involving a trust arrangement and include a series of single premium endowment policies ranging from one to 100 years of the policy anniversary.
These work by making use of the inheritance tax rules relating to potentially exempt transfers (PETs) which, for gifts above the nil rate band, 'taper' the IHT liability upon investments given away over a four-year period beginning three years after the gift was made. The trust arrangement holds the investments usually for a range of beneficiaries following the policyholder's death while allowing the capital invested to grow tax efficiently. Since PET rules stipulate that donations made seven years before death do not attract a liability to IHT, the realisation of an EPA will be totally IHT exempt after that period.
The fundamental benefit of these is that they provide an inheritance tax mitigation strategy while simultaneously providing an income to the investor via the tax deferred, up to 5% withdrawal mentioned above. The single premium endowment policies mature each year, thereby producing the income stream to the investor which, depending on investment performance, may adversely affect the value of the remaining capital in trust. These withdrawals are subject to the same income tax rules as described above.
Offshore pensions are effectively savings plans that take advantage of international tax benefits for non-qualifying life policies.
These have generally not taken off for UK resident investors since the UK's pension scheme regulations enables, tax on dividends excepted, gross roll-up within the fund anyway. However, for those living outside the UK where there may be less attractive or no pension schemes, offshore pensions come into their own. They are also particularly useful for internationally mobile persons who may not be resident in the same location for long periods of time.
A major advantage of an international pension plan vis-a-vis a UK pension is that investors are not compelled to buy an annuity on reaching a certain age. Given forecast low interest rates and the public backlash against falling annuity rates, this is looking a particularly attractive feature.
International Life Office Products
Outside of the offerings of the international life companies, one enters the realm of international investment. However, UK-domiciled investors rarely ' if ever ' invest directly into offshore funds since the returns achievable are unlikely to outweigh the higher charges and less protective regulatory regime.
Hedge funds, however, are the exception to the rule, but they tend to have high minimum investment criteria and are generally only recommended for high net worth individuals. Furthermore, there are a small number of hedge funds that attract distributor rather than non-distributor status, thereby allowing investors to benefit from any gains being liable to CGT rather than income tax.
Offshore distributor and offshore roll-up funds are not as commonly used as offshore bonds because they offer more features. However, with their taxation status under review they could become a more integral part of offshore planning.
There are a number of potential changes that could hugely affect the offshore industry and its attractiveness to clients.
Sandler, in his report, has been clear in indicating his desire to create a homologous taxation regime for offshore and onshore investment bond products. Simultaneously, the UK Inland Revenue is carefully reviewing the taxation structure behind offshore products, a consultation that is going on until the end of July.
How the new taxation proposals resolve after consultation remains to be seen and this will hugely affect the attractiveness of a number of offshore products. What is more obvious is that the offshore industry must shake off its poor public perception if it is to attract investors to its numerous benefits.
Suspected of being money laundering weak spots, global governments have put pressure on offshore financial centres to meet certain standards.
The offshore industry must shake off its poor public perception if it is to attract investors to its numerous benefits.
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