Feasible choices

Offshore bonds could be a viable alternative for people who do not wish to contribute to pensions, says David Gregory

I am quite fortunate in the timing of this article as I am writing this on the night of the Budget where it seems the Chancellor, Alistair Darling, has made pension provision even less attractive for high earners by limiting the tax relief available. Until today, I imagined this article would look at the use of bonds to complement pension funding. However, since tax relief was the most attractive feature of pensions, anyone earning over £150,000 may well now be looking for an alternative.

When the flat rate of tax for capital gains tax (CGT) of 18% was introduced in the Finance Act 2008, many commentators (wrongly) predicted the end of offshore bonds. My understanding of holistic financial planning is that advice is supposed to be all encompassing; examining every option until, taking into account the clients circumstances, requirements and aspirations, a solution or multiple solutions emerge to be the most appropriate. While I am very conscious that offshore bonds are not the panacea to financial planning, I do however feel they have now disappeared completely from some adviser's advice process.

Advantages

I think it may be best to set the record straight for offshore bonds in general with an overview to their continued advantages.

Offshore bonds are a non income producing asset and a wrapper holding investments into collective investment schemes and cash deposits. Any income produced from the underlying investments rolls up without tax, except for withholding tax on dividends - but that is no different from ISAs or pension funds. The wrapper also allows for great investment freedom for advisers, allowing for the movement between investment classes without triggering a tax charge. This allows for the investment decisions to be based purely on investment fundamentals and not compromised by potential tax charges.

Bonds also offer the 5% cumulative allowance which can be highly attractive for clients looking for a known tax deferred 'income' stream which can also be turned off when required. There are many other advantageous features of bonds which do not have an explicit monetary value but nonetheless are of value to different investors. For example, the ability to assign to trusts for IHT planning, generational tax planning, the ability to secure lending facilities and no need for complicated self assessment returns to name a few.

Now, to address the final tax treatment argument. I believe that if we can demonstrate a tax neutral, or better outcome, after final encashment, when compared to non wrapped investments, this should place the offshore bond firmly back on the adviser's table.

Many current mass affluent or high net worth investors, who pay higher rate tax during their working lifetime will naturally become basic rate tax payers in retirement. For these clients, an unwrapped portfolio will produce an ongoing tax liability of 40% per annum on any income as well as a potential tax charge of 40% of any realised gains in non distributor funds (shortly to become known as non reporting funds) and 18% on any capital gains over the current annual exempt amount.

Depending upon the actual asset allocation of a portfolio, the aggregate tax rate on a balanced portfolio can range from 22% pa to 30% pa, with roughly 25% pa being the average, according to our research. Compare this to the offshore bond with virtually tax free roll up each year and an eventual exit at basic rate tax (currently 20%) on any gains. The offshore bond wins, hands down.

Of course, there will also be many high net worth clients that will potentially continue to be higher tax payers in retirement, but it is perfectly possible, especially if using unsecured pension (USP), to manage clients' incomes and keep it to a minimum.

Nil income

Since A-Day in 2006, it is now possible to select nil income from USP and to coincide this with bringing back some, or all, of the offshore bond policies so that either nil, 10% or only 20% tax is paid on realised gains.

Top slice relief is also available and an example may help here. Assume an offshore bond has been held for 10 years and some policies are surrendered in this tax year. Nil income is selected through USP but the client has £10,000 of income that cannot be turned off. The current personal allowance is £6,475 and the basic rate band is £37,400 which totals £43,875. Take off the £10,000 income and that gives a further £33,875 available before paying 40% tax. Because the offshore bond has been held for 10 years, the available basic rate band of £33,875 can be multiplied by 10 to give £338,750 of chargeable gain that can be surrendered in this tax year, with only 20% tax applying.

This exercise can simply be repeated each year as many times as necessary, remembering that the income tax bands and personal allowances are increased each year.

Policies can also be assigned to spouses, for no consideration, allowing them to utilise their basic rate bands as well. Using bonds in this way, it is possible to release growth of over £1 million in only two separate tax years and only pay a maximum of 20% tax on the gains.

When used like this, the offshore bond and pension planning are a great combination and can really complement each other as part of a long term financial plan for clients. Following the budget, it is now difficult to see why higher earners would increase their current pension commitments with the new forestalling rules and certainly from 2011 they should seriously consider if it is worthwhile making pension contributions at all. I think the offshore bond will emerge from this as an attractive alternative, with similar tax advantages but with a much greater degree of control and flexibility.