... A guide to the suitability of offshore bonds for UK professional advisers. Summary of the Budget Measures

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1 2008 Post-Budget Update A guide to the suitability of offshore bonds for UK professional advisers The 2008 Finance Bill was published in late March, providing more detail on the proposals announced by the UK Chancellor, Alistair Darling, in his October Pre-Budget Report and March 2008 Budget The Finance Bill which received Royal Assent as the Finance Act in July 2008, enacted most of the Budget announcements, introducing a number of important changes to personal taxation As tax mitigation is a key driver for many offshore life bond investments, it is not surprising that the measures and proposals announced by the Chancellor would be seen to have some impact on the suitability of offshore bonds for UK residents and domiciles However, despite wide speculation in the media, it is clear that the offshore life bond proposition remains very relevant to UK financial advisers and their clients This guide, issued by the Association of International Life Offices, summarises some important generic facts about offshore bonds and their uses within contemporary UK financial planning following the Budget It is designed to complement the specific advice and information that financial advisers provide to their clients In 2007, UK advisers invested almost 8 billion of their clients' funds in the offshore life bonds of AILO member companies Source: Acuity Consultants Summary of the Budget Measures The relevant key measures announced in the Budget that could have an impact on the suitability of offshore life bond products as used by UK advisers are: The introduction of a new simplified 18% flat rate of capital gains tax (CGT) Married couples and civil partners being able to pass on unused inheritance tax (IHT) allowances Changes in the remittance basis of taxation for non-domiciles, including the introduction of a 30,000 charge on non-domiciles with long term residence in the UK who elect to be taxed on the remittance basis Application of the loan relationship rules to life insurance policies held by companies Impact of Changes in CGT Expected to be Minimal In his March 2008 Budget the Chancellor confirmed the CGT changes first proposed in his Pre-Budget Report, reducing the rate of CGT to a flat 18% regardless of the investor's income tax rate, while at the same time abolishing indexation allowance and taper relief from 6 April 2008 The impact of these changes on individual investors will very much depend on their circumstances Most higher rate tax-paying investors will pay less CGT on realised gains under the new regime, with rates reducing from between 24%-40% to 18% on gains that exceed the annual exemption ( 9,600 for 1

2 individuals in 2008/09) Significantly, basic rate taxpayers will also pay 18% whilst they would have paid between 12-20% under the previous regime This change has caused obvious concern among financial advisers that offshore portfolio bonds may no longer be a sound investment recommendation, as higher rate tax-payers (at the time of a chargeable event) will continue to be liable to pay 40% income tax on chargeable event gains This means that direct investment in mutual funds appears to enjoy a tax advantage via the 18% CGT rate, at least at the headline level Chargeable Events A chargeable event is a transaction that would trigger a potential UK income tax charge on a bond These events include: death of the last life insured, maturity, encashment or surrender of the policy, withdrawals in excess of the cumulative 5% a year tax deferred allowance, assignment for money or money s worth, and significant policy changes, such as changes to the lives insured However, this simple headline level comparison hides many issues Perhaps the most significant issue is that a high proportion of the investment growth in collectives held directly by UK investors creates an annual income tax liability, as investment returns are generated by interest or dividend income and not by capital growth in the underlying assets (including offshore funds, the majority of which have non-distributor status) This includes all payments from fixed-interest funds, as well as rental income from property funds This means that many investors still face an immediate annual income tax charge at their highest marginal tax rate, rather than paying CGT, so in many cases higher rate taxpayers will suffer 40% on their investment returns from collective investments rather than the 18% which is widely quoted This point is illustrated clearly by looking at the growth in the FTSE 100 While many investors would consider this to be a growth option, most of the returns from the FTSE 100 over the last 10 years has come from dividend income (which would be taxed at income tax rates that year, rather than being liable for capital gains tax on the growth ) Source: LIPPER May 2008 The income from the same assets held in an offshore bond would not be taxed annually and any tax payable would instead be deferred until a chargeable event is generated, which will often be at a time the policyholder chooses This tax deferral feature means that the investor has greater control over how much, and when, tax is paid Where the investor s assets are structured exclusively to provide capital growth, they may be better off from a tax perspective with direct equity and mutual fund holdings The reality, however, is that a significant proportion of UK clients investment goes into income-producing funds which will still benefit from being held in an offshore bond wrapper, both in terms of tax treatment and administration simplicity These benefits can be seen, for example, when advisers use offshore bonds as part of their pre or post-retirement planning for clients, investing in lower risk investments which tend to have a high income generating content Another key consideration is that an active investor switching funds within a portfolio of direct equity or unit trust investments will incur a potential CGT charge in the tax year during which the switches are made Fund switches within offshore bonds do not trigger a personal liability to CGT, providing a more tax efficient structure for active investment management When investors switch, they can offset gains against their annual CGT allowance, but bearing in mind how large the average offshore bond is, in many cases the increase in value of funds being switched will far outweigh the CGT allowance An important factor in advisers use of offshore bonds with high net worth investors has always been the 5% deferred tax withdrawal facility, which allows investors effectively to turn their existing capital into a tax-efficient income stream Nothing in the 2008 Finance Act has changed this attractive feature 2

3 Additionally, offshore bonds enable advisers to recommend financial planning strategies such as: Assignment of segments to children, grandchildren, spouses, partners and non-uk residents, who are often non-taxpayers or basic rate taxpayers Top slicing relief for those who have held their bonds for several years Time apportionment relief for those who have lived abroad for some of the time they have held the bond Using the 5% withdrawal facility to ensure investors over 65 can increase their retirement income without losing out on the benefit of the Age Allowance With sensible financial planning, the investor may be a basic rate taxpayer on encashment (ie the eventual UK tax liability on the offshore bond gains will be at 20% and not at 40% ( )), or be living abroad and outside of the UK income tax net How the CGT regime change affects individual investors will obviously depend on their circumstances, further stressing the requirement It s not all about tax! There are some very important administration and investment benefits of investing through an offshore bond wrapper rather than holding a portfolio of collective investment funds directly: Self Assessment Friendly Investors holding a portfolio of collectives directly face a complex and onerous set of tax calculations and reporting requirements every year Every sale and acquisition within the portfolio will potentially create a tax charge The administration burden on a personal investor is heavy, and trustee investors have even more accounting and administration work to do This is burdensome and time-consuming, and the costs of obtaining professional help may seriously erode the real return of the portfolio As offshore bonds are non-income producing assets, there is nothing for the investor to report on their annual self assessment form until a chargeable event occurs, eg when taking a withdrawal in excess of the 5% cumulative tax deferred withdrawal allowance At the point where the investor does need to include information on a tax return, reporting chargeable event gains from an offshore bond is simple, as the information needed to complete the self assessment form appears on the chargeable events certificate produced by the life company Investment Choice One of the major features of offshore bonds is the investment freedom that they provide to advisers and investors, enabling a range of risk profiles to be established Offshore bonds offer investment links to a wide variety of onshore and offshore fund managers, providing a much greater range of fund types and assets than is available in the UK collective investment market For example, offshore investing is an effective way for retail investors to access alternative investments such as hedge funds, property funds, derivative based investments and offshore partnership arrangements, as well as deposit accounts with attractive rates of interest An offshore bond enables investors to create a diversified portfolio of investments and hold them all in the one product, removing the need to buy and value them separately Offshore bonds can often help to deliver cost effective investments by enabling retail investors to access funds at institutional prices which, for many funds, will mean the ability to purchase at net asset value or creation prices Offshore bonds also offer funds in currencies other than sterling, which can be useful for investors looking to manage currency risk, or for those who have access to capital in other currencies Charges Offshore bonds offer very competitive initial and ongoing product charges Adding discounted fund charges to these product charges usually means 3

4 investors will benefit from total charges which are lower than the charges payable when investing directly in collective investments In summary, while this change in the CGT regime appears at first glance to damage the potential suitability of offshore life bonds for UK investors, the more considered view post-budget is that there has been no real change in the fundamental reasons why an offshore bond may be recommended to many types of client Inheritance Tax Planning Still Essential The changes to inheritance tax (IHT) announced by the Chancellor in his 2008 Budget Report and finalised in the 2008 Finance Act made it possible for spouses and civil partners to transfer their IHT nil-rate band allowances so that any part of the nil-rate band not used when the first spouse or civil partner died could be transferred to the individual's surviving spouse or civil partner for use on their death This means that a combined total of 624,000 can now be sheltered from IHT on their deaths by a married couple or civil partners This combined total will rise to 700,000 by April 2010 While this is a welcome change in tax policy, many clients of UK advisers have assets that exceed substantially this double IHT allowance Residential property alone will often use up the combined nilrate band Estimates from the Halifax in late 2007 show that there are 600,000 properties in the UK valued above 600,000 The Halifax has estimated that if the IHT nil-rate band had increased in line with house price inflation since 1995/96, it would have been at a level of 460,000 in 2007 and the combined allowance would have been 920,000 The ability to transfer any unused nil-rate band is only available to married couples and civil partners In today s society, that excludes many people from being able to take advantage of this arrangement After accepting the Chancellor's generosity at face value when he made it possible to claim a deceased spouse's or civil partner's unused nil-rate band allowance, it has become clear from HMRC s guidance notes that this isn't quite as straightforward as might have been expected The administrative burden is onerous, even for the personal representatives of the surviving partner of someone dying since the new rules were introduced HMRC requires a range of documents, such as death certificate, marriage certificate, wills, probate etc, along with detailed evidence of asset types, gifts, pensions and trusts While many of these can be obtained from public bodies if they are missing, in practice many people will have great practical difficulty in providing all the information and evidence required to enable them to claim the unused portion of the nilrate band and at a stressful time in their lives For investors who may wish to do some IHT planning in the future, structuring their assets through an offshore bond can mitigate, or avoid altogether, taxes due on transfers of wealth An existing bond can be assigned to another individual or into trust without triggering a chargeable event for income tax purposes, whereas a similar gift of collectives may give rise to an immediate CGT charge if not made to a spouse or civil partner Trust and offshore bond combinations have long been popular with financial advisers, as making a gift or transfer to trustees is a transfer of value for IHT purposes and can reduce the investor s estate The use of such a trust and offshore bond combination can also help to ease the administrative burden of settling an estate and speed up this process The nature of this change in IHT rules has not yet, and is not expected to, result in any significant impact on the popularity of offshore bonds sold in conjunction with trusts for IHT mitigation purposes, such as discounted gift trusts, with UK advisers and their clients 4

5 Offshore Bonds and Corporate Investors Legislation was introduced in the 2008 Finance Act which applies the loan relationship rules to life insurance policies held by limited companies from April 2008 This removes the opportunity for companies to allow their offshore life investments to roll up free from annual taxation, in line with the changes in the tax treatment of capital redemption bonds made in 2005 However, during its passage through the Houses, this has now been amended so that companies utilizing the historic cost accounting method can continue to defer tax on any gain This applies to unlisted companies satisfying two out of the three criteria below: annual turnover of 56m or less a balance sheet total of 28m or less an average of 50 employees or fewer These criteria would appear to make the tax deferral opportunity of a bond investment available to a wide range of companies Other companies may still wish to invest in offshore life bonds to access a range of cash funds and high interest deposits while accepting that tax on the interest will be paid annually Advisers may still consider this to be a suitable option within their financial planning recommendations for some companies Taxation of Non-Domiciles in the UK Individuals resident, but not domiciled, in the UK have for years enjoyed the remittance basis of UK taxation, only paying UK income tax or CGT when they remit overseas income or investment gains to the UK The 2008 Budget changed this picture, and since April non-doms have only been permitted to access the remittance basis if their unremitted foreign income or gains are less than 2,000 on an annual basis, or if they are prepared to sacrifice their personal allowances for income tax and annual CGT exemptions In addition, those non-doms who have been resident in the UK for more than 7 out of the past 10 years are now only able to choose the remittance basis if they pay an annual tax charge of 30,000 The annual charge is payable in addition to any UK tax due on remitted income or gains Non-doms will have the choice each year of whether to pay the charge and claim the remittance basis, or to be taxed on all their overseas earnings and capital gains Following these changes, offshore bonds will play an important role in helping advisers to manage their non-domiciled clients investments whilst minimising UK taxation If a non-dom chooses not to use the remittance basis, they can effectively be regarded as a normal UK resident and all the usual offshore bond benefits apply In addition, there is another important consideration for a non-dom in that any assets they own in the UK are subject to IHT on death Helpfully an offshore bond is not a UK-situated asset In addition to this important IHT planning aspect, a key consideration for non-dom investors choosing the remittance basis is that they have no income tax or CGT allowances available to offset any UK tax liabilities An offshore bond investment does not create any liability to UK income tax or CGT provided that no withdrawals are made in excess of the cumulative 5% per annum tax deferred allowance, and provided that no other chargeable events occur, such as the death of the last life assured, or changes made to the lives assured Non-doms can use the 5% per annum tax deferred withdrawal facility to remit an income to the UK without triggering an immediate tax charge In summary, an offshore bond can provide a core element of financial planning for all non-doms, whether using the remittance basis or not, by holding their worldwide investments in a way 5

6 that does not generate annual income or an IHT liability, or by controlling the timing and amount of any tax charge caused by cashing in part or all of their bond Offshore bonds have a number of key generic benefits that all financial advisers should consider nowadays when making recommendations to their clients: Virtually tax-free investment growth Greater control over how much, and when, tax is paid Superior investment choice from around the world Trusted global brands serving the needs of the market Highly reputable jurisdictions all with regulations to protect investors Product flexibility and choice High quality service Suitable investments for individuals, trustees, companies and pension schemes Positive Outlook It is clear that, following the 2008 Budget, the offshore life bond proposition still has a lot to offer UK financial advisers and their clients In the immediate aftermath of the Budget, offshore bonds continue to record strong sales levels, demonstrating the product s position as a valuable ingredient in the advice process With a winning combination of superb investment choice, tax deferral, IHT planning effectiveness, and favourable applications for those with an international dimension to their lives, an offshore bond remains a contract to be considered for many UK investors Further information on the way offshore bonds can be used in personal financial planning can be found in a range of AILO publications, available from our website at: wwwailoorg This guide is published by the Association of International Life Offices (AILO), an independent body whose member companies have more than 25 billion of client funds under management, held within offshore life insurance products Association of International Life Office Secretariat PO Box 1747 L-1011 Luxembourg Grand Duchy of Luxembourg Telephone Fax wwwailoorg This document has been approved for use by financial advisers only and is not to be used with retail clients This document is issued by the Association of International Life Offices (AILO) It has been prepared on behalf of the members of AILO and relies on information and technical analysis provided by third party professional advisers Whilst AILO has used its best endeavors in selecting its advisers to ensure the accuracy of the information contained in this document, AILO cannot be held responsible for any errors and omissions This document has been prepared for general information purposes only Tax legislation is complex and subject to frequent change, including the removal of specific allowances and benefits This document must not be relied on as a basis for providing best advice Published February