How to use offshore bonds to help high earners

Richard Leeson, head of UK business development at Prudential International, says high earners can use offshore bonds to sidestep the worst effects of the tax rate changes.

The new income tax rules set out in Finance Act 2009 are about to come into effect. While higher earners may be expecting to be hit hard, offshore bonds offer an excellent opportunity to ease or even bypass the worst effects. There are two main areas where advisers could reassess what products will be most appropriate for their clients:

• The new 50% income tax rate
• The change to personal income tax allowances

The new 50% income tax rate

From this April, earnings over £150,000 will be subject to a new tax rate of 50%. This will apply to earned income and investment income that is taxed as earned income.

However, withdrawals from bonds that fall within the 5% tax-deferred allowance are not treated as income. As a result, the tax deferral available on offshore bonds will become even more attractive, especially when, by the time the bond is cashed in, the investor has become a basic rate taxpayer or even a non-taxpayer.

There is also “hidden” income to consider. A collective that produces income – whether as interest or dividends – will be taxed year on year, even if the income is re-invested. Basic rate tax is paid within the fund and any additional tax due is collected through the investor’s tax return.

Over time, this can make a considerable difference to the value of the investment, compared with an offshore bond which benefits from gross roll-up. The new 50% tax rate will make the difference even more marked.

For example, an investment in a corporate bond fund that is producing an annual return of £5,000, all interest, would incur total tax of £2,500 for a 50% taxpayer, so only £2,500 would be accumulating each year. In an offshore bond, the same fund would be accumulating the full £5,000 every year. Even though the profit may be taxed on cash-in, this gross roll-up will mean the net return is higher.

Corporate bonds were the best selling sector for both retail and institutional unit trusts and OEICs in 2008 and 2009, so there will be many investors holding them who might save tax by moving to an offshore bond.

Corporate bonds, and other lower risk, higher income assets, may be a popular choice with trustees who look to preserve capital. But a discretionary trust with accumulated income will be hit by the 50% tax rate, however small the income actually is.

Bonds, on the other hand, are non-income producing assets, so will not be liable for tax until there is a chargeable event gain. There is also the facility to assign a bond, in full or in part, to a beneficiary and the tax liability will then fall on that person, at their usual tax rate.

Finally, for anyone driven to leave the country to avoid the new harsher tax regime, an offshore bond offers the prospect of no UK tax while resident abroad and time apportionment relief if it is eventually brought back to the UK.

Change to personal tax allowances

From this April, anyone with income over £100,000 will lose their personal allowance at the rate of £1 allowance for every £2 excess income. So, with the personal allowance currently £6,475, anyone earning over £112,950 will lose all their personal allowance.

This gives a marginal tax rate of 60% on earnings between £100,000 and £112,950 – for every £2 earned, there will be the usual 40% tax amounting to 80p, plus a further 40%, or 40p, on £1 of lost allowance, giving a total of £1.20

Interest or dividends from a collective will count towards the investor’s annual income even if reinvested. However, interest or dividends arising in funds held within an offshore bond do not count as personal income. This gives an opportunity to preserve personal allowance by switching investments.

For example, suppose a client has £100,000 earned income and £100,000 invested in a corporate bond OEIC, which is producing 5% annual interest that he reinvests. The effect is:

• £5,000 income over the limit
• £2,500 personal allowance lost
• Effective tax paid on £5,000 @ 60% = £3,000

Instead, he could hold £100,000 in the same corporate bond fund inside an offshore bond. In this case, his income remains at £100,000, he has no immediate income tax to pay nor any loss of allowance and there is no tax payable within the fund. If he wants, he can also take withdrawals within the 5% tax-deferred allowance, still without triggering any immediate tax bill.

Pensions tax relief

There has also been a change to pensions which will also affect higher earners. From the 2011/12 tax year, tax relief on pension contributions will be restricted for those earning over £150,000. The relief will be tapered down to 20% for those earning more than £180,000.

Since last year, there have been “anti-forestalling” rules in place to prevent people paying in large extra contributions in advance of the new rules. In future, a pension plan may not be the obvious choice for a client looking to add to retirement provision. For example, take someone earning £200,000 a year who makes a pension contribution of £10,000 and, to illustrate the point, let’s suppose it vests immediately.

• Net of 20% tax relief the contribution is £8,000
• Of the fund of £10,000, £2,500 can be taken as tax-free cash
• £7,500 is taxed at, say, 40% = £3,000

The total return is therefore £10,000 less £3,000 tax, which comes to £7,000 – £1,000 less than the net contribution!

An offshore bond would have no tax relief upfront, but could perhaps be assigned to a spouse or partner with a lower tax rate, giving a back-end tax advantage. As a complement to a pension plan this could be very attractive.