In November’s International Adviser, Fundsnetwork’s Paul Kennedy wrote about a “savage 60% tax trap” for offshore bonds. Just when we all thought the Finance Act 2009 had been rather positive for offshore bonds, it seemed as though a terrible abyss had opened up.
Kennedy explained how, from April, anyone earning more than £100,000 will lose personal allowance at a rate of £1 for every £2. The article highlighted that the whole of the gain from an offshore bond will count as income for this purpose, although it may be top-sliced in calculating the actual tax liability.
Kennedy also noted that the loss of allowance creates a marginal tax rate of 30% for a basic rate taxpayer and 60% for a higher rate taxpayer.
Poor advice
But would this happen much in practice? The examples used in the article look rather contrived – and are full of ill-advised behaviour.
Here’s one: “Take as an example an investor earning £12,950 who, after investing for 10 years, receives a payout with a gain of £100,000.”
Let’s examine this more closely. With an investment return, after all charges, of 6% a year, you would need to have invested around £126,500 to achieve a gain of £100,000 after 10 years. If the net return was 5% a year – perhaps more realistic in the current environment – you would need to have invested close to £160,000.
So where, you might be wondering, did the person earning just £12,950 a year get this kind of money to invest? Of course, he might have inherited it. But then you have to imagine that, throughout the 10 years of the investment, he was happy not to cash in any of it – then, all of a sudden, he wants the whole lot in one go.
Well, perhaps he was earning a lot more in the past and has now fallen on hard times. But would this person really need to cash in the entire investment? After 10 years of not touching it, he could withdraw 50% of the original amount without any immediate tax liability – thanks to the accumulated 5% tax-deferred allowance.
The other hand
Alternatively, he could cash in some of it through segment surrender. In fact, based on an investment of £126,500 that has grown at a net 6% a year, he could cash in 85% and still not lose any of his personal allowance. Thanks to top-slicing, the whole of the gain would be taxed at 20%.
He can also combine segment surrender with the 5% tax-deferred allowance – meaning, for instance, that he could cash in 85% and then withdraw 50% of the remainder. His tax bill is still only 20% on the 85% cashed in.
If he has a spouse or civil partner who is not earning close to the £100,000 trigger point, he could assign part of the bond. As long as no money changes hands, this will not give rise to any tax charge. They could then cash in the whole bond between them without either one losing any personal allowance.
So, to start with, an adviser worth his salt is hardly likely to advise this client simply to cash in the whole bond and suffer 30% tax, when there are a number of other options. But let’s go back 10 years to when the investment was made. Is this the only investment the client has?
Diversification
If so, would our savvy adviser have recommended putting the full amount into one offshore bond? Of course, it would depend on the client’s needs and wishes. But common sense would normally suggest some kind of spread.
So, if the client does suddenly need a large lump sum, he may have other investments to draw on. He can still take money out of the offshore bond, as outlined above, but could supplement it with other withdrawals that may be more tax-efficient at the time.
As Kennedy wrote: “Imagine losing 60% of a capital gain, when the same capital gain would have been taxed at only 18% or less with a collective or even zero with a pool of ISAs.
