Note to self: Investing offshore does not mean 'tax free'

Prudential’s Matthew Stephens examines the benefits of offshore products...

Offshore has been a ‘hot topic’ for some time. More recently we have seen consultations on both the taxation of non-domiciles and a statutory residence test. The outcomes of those are expected alongside the chancellor’s autumn statement, in November. The final rules relating to the statutory residence test could be particularly interesting – will it be more or less difficult to ‘lose’ UK residence?

That could be significant when looking at investing offshore. It can be easy to lose sight of what offshore is and why it might be beneficial to certain investors. A perception that may have built up is that offshore investing means avoiding tax completely, but that is not the case.

Offshore is a term generally used to describe where companies can offer customers growth on their funds that is largely free from tax. However, this does not necessarily mean there will not be any tax to pay on the money when the investor receives it.

That depends on the type of investment wrapper and the investor’s tax status – i.e. where they are resident for tax purposes and that country/ jurisdiction’s tax rules.

The offshore bond

Assets and investments can be held in a variety of wrappers, which have various attributes that can help to maximise investment returns. One such wrapper, which can hold most asset classes, is the offshore single premium life assurance policy – commonly referred to as the offshore bond.

Offshore bonds, which are provided by life companies established in overseas jurisdictions, have characteristics making them particularly attractive to certain investors.

Fund growth

The underlying assets held within offshore bonds grow virtually free of tax on the life company. Some of the income received in respect of the investments will, however, suffer withholding tax that normally cannot be reclaimed so the overall growth is virtually tax-free, not completely tax-free. This feature is usually referred to as gross roll up.

Investment flexibility

Depending on the structure of the bond it is possible to link its value to a wide range of asset classes, as well as cash. These ‘links’ can be easily varied through use of a switch facility that allows the policyholder to change investments as circumstances dictate – for example, to lock in growth on a particular asset.

Neither the policyholder nor the life company is liable to capital gains tax on investment switches within the bond.

Control the tax

Tax deferral is a significant feature of offshore bonds. An income tax charge arises only on the occurrence of a chargeable event.

Chargeable events arise in certain situations when money is taken out of the bond: full surrender; partial surrender in excess of a cumulative 5% of premium(s) paid; sale; or transfer in return for some monetary value other than cash.

Tax is potentially payable on a chargeable gain. For partial surrenders the gain is the amount in excess of the cumulative 5%. For other events it is the excess of the amount received (e.g. surrender or sale value) over the premium(s) paid.

The policyholder can choose when a tax charge arises, by triggering of a chargeable event on a partial or full surrender. For example, a full surrender could be deferred until the policyholder is no longer a taxpayer or has changed from being a higher/ additional rate taxpayer to a basic rate taxpayer.

The ability to take withdrawals of up to 5% of the premium(s) paid, on a cumulative basis, gives the policyholder additional tax control. These withdrawals are not liable to tax at the time they are taken, instead being ‘added back’ when a full surrender is made. Thus, although they are not tax-free, they allow the policyholder to defer any tax liability that might arise.