However, while bonds, both onshore and offshore, have been used from time to time in conjunction with fairly aggressive tax-avoidance schemes (see HMRC v Mayes, for example), they are, in essence, non-contentious structures which, at their most basic level, occupy the same space as other legitimate retirement planning vehicles used by UK residents.
This article examines how offshore bonds work in conjunction with other retirement planning structures to help build up funds for retirement in the accumulation phase, and to keep taxation to a minimum level during the decumulation phase.
Inside build-up
For UK residents and expatriates, it is essential that any retirement planning structure is created in a way that achieves inside build-up in the most tax-efficient way.
During the accumulation phase, pensions, offshore bonds and ISAs are treated very similarly for tax purposes – that is, UK dividends are received net of corporation tax, with no credit reclaim or further tax to pay, and capital gains and interest are received tax free.
This creates a stable environment into which individuals can save, in the knowledge that their personal tax status is of no concern until benefits are taken, which could be many years in the future.
Complex build-up
Direct holdings in UK-authorised investment funds are more complex during the build-up phase.
Although capital gains roll up gross, UK-authorised funds are transparent from an income tax perspective, resulting in ongoing income tax liabilities, which vary from year to year, depending on how much of the return is from income, and how much from capital growth.
Tax relief
From a tax perspective, a registered pension plan is the most favourable retirement vehicle due to tax relief on the contributions.
Of course, this tax relief has now been substantially curtailed by the £50,000 annual allowance – which includes employer contributions, as well as the tax relief claimed at source on a personal pension plan.
This, coupled with the ‘disguised remuneration’ rules designed to curtail the use of employer-financed retirement plans, means that many higher earners will be seeking alternative retirement arrangements, and offshore bonds fill this gap very well.
Once invested, an offshore bond acts in the same way as a Sipp, with its open architecture structure and tax-free inside build-up.
However, on exit, the two structures are very different, yet extremely complimentary. The key features of a Sipp and offshore bond are compared in the table above.
Increased flexibility over retirement options, including the ability to operate nil drawdown and delay pension crystallisation indefinitely, means it is feasible for many high earners to become non-taxpayers – at least for a time – in retirement.
This could be the perfect opportunity to utilise segmentation to make surrenders of an offshore bond, which – coupled with tax-free return of capital and top-slicing relief – can result in very low marginal rates of income tax being paid in retirement.
It is perfectly feasible to avoid income being subject to the higher rate of tax,
at least.
Disposable income
Take the following example: Michael, 44, a married UK resident high earner, has a Sipp worth £250,000, and £100,000 pa disposable income, which he foresees will continue for the next ten years.
He wishes to retire at age 55. A high earner like Michael may be advised to maximise pension contributions to reduce his income tax exposure.
He will now be limited to a net £40,000 pa (with £10,000 reclaimed at source by the trustees to give a gross contribution of £50,000). Assuming he is an additional rate taxpayer, a further £15,000 (falling in 2013 to £12,500) can be reclaimed in his self assessment return.
What to do with the excess income? Michael could make maximum contributions to an ISA, and save £50,000 pa into an offshore bond. If this is the choice made, Michael can now put tax to the back of his mind as the investments grow over the term, leaving him and his adviser to concentrate on the investment strategy.
Based on a return of 5% pa after charges, at retirement, each ‘box’ would be worth the following. For Sipps: £40,000 pa net, £50,000 gross; value at commencement: £250,000; value after ten years: £1,067,563. Offshore bonds would be worth: £50,000 pa; value after ten years: £660,339. ISAs would be worth: £11,620 initially, assume the maximum contribution increases by 2.5% pa; value after ten years: £164,843.
Tailored strategies
At age 55, Michael has three tax-sheltered boxes in which his retirement funds are stored. He has complete control over which box he opens and in what order they are opened. This means his retirement income strategy can be tailored to his own circumstances.
The income can be switched on and off depending on his tax position in any year.
In the case of the bond, he can either use segmentation to surrender enough segments to keep his gains within the basic rate threshold (which will be expanded by top-slicing relief), or to top up other income using accumulated 5% withdrawal allowances.
He also has the freedom to assign segments to his spouse to double up on available allowances, as well as the lower and basic rate tax thresholds.
The ISA box will be tax-free, and can be used to top up other income, or this box could be decumulated first to provide a simple, tax-free income in the early years of retirement.
One strategy, therefore, may be to take the ISA fund first, then run down the bond structure, followed by crystallisation of the pension fund.
In the first two years, there is sufficient capital in the ISAs to provide a tax-free income.
In subsequent years, policy segments from the offshore bond structure are surrendered and, using a combination of tax-free return of capital, personal allowances, starting and basic rate thresholds, and top-slicing relief, the retirement ‘income’ stream incurs effective rates of tax that remain below 10%.
Crystal consequence
Another consequence of this strategy is to delay crystallisation of the pension funds, thus delaying the decision on how the pension is taken, continuing tax-free build-up, and the potential for tax-free return of the whole fund should Michael die prior to vesting.
A possible downside to this strategy is that, eventually, the funds in the bond structure are exhausted. This may then result in the need for Michael to crystallise his whole pension fund well in advance of age 75.
If death were to occur after crystallisation (assuming a drawdown pension is chosen), there will be a 55% tax charge if the pension fund is left to heirs in the form of a lump sum.
Directly held assets, on the other hand, would suffer a maximum 40% charge to inheritance tax.
If this is a concern, then using phased retirement may be an alternative strategy that smoothes the impact of tax on death by reducing the value of the pension funds in proportion to the directly held assets, while preserving the tax efficiency of the income stream.
Bond surrenders
Where £100,000 worth of pension funds are crystallised each year, this will give a £25,000 tax-free lump sum, and the drawdown funds are supplemented by bond surrenders and ISA encashment in such a way as to maximise tax efficiency.
The example is necessarily contrived to illustrate a point. Rarely is life so simple.
There may well be other sources of income that use up some or all allowances as well as the basic rate threshold.
In this case, the offshore bond is flexible enough to facilitate alternative strategies, such as assignment of segments, or drawing down the 5% withdrawal allowance.
Holding a proportion of the portfolio in collectives would also facilitate the encashment of sufficient units to utilise the CGT annual allowance, and would be complimentary to the overall structure.
Whichever strategy is employed, the key advantage is that it is possible, with the correct exit strategy, to keep income tax liabilities in retirement well below the 40% threshold, even where large income streams are needed.
