Offshore bond taxation Complete guide for high earners

If you regularly max out your pension annual allowance (which is usually £60,000), make ISA contributions of £20,000 every year, and utilise your annual capital gains tax (CGT) allowance, offshore bonds can offer a great next step to further increase tax-efficiencies. In addition, people earning over £260,000 can have their pension annual allowance reduced down to £10,000 (depending on their earning levels), so an offshore bond can offer a neat solution in this scenario.[1]

There are a number of strategies that can help reduce your effective tax rate. For instance, you may be able to offset some of the gain against your personal savings allowance (PSA), which allows you to earn up to £1,000 in interest tax free if you’re a basic rate taxpayer, £500 if you’re a higher rate taxpayer, and £0 if you’re an additional rate taxpayer.[4]

It’s also important to keep in mind that if you’re a UK resident but living abroad, different tax rules may apply depending on the country you’re in, as offshore bond gains can be taxed differently outside the UK. Taxation on offshore bonds is generally straightforward, seeking professional advice is important to ensure you’re following the most tax-efficient approach.

Offshore bonds and inheritance tax

Offshore bonds are not inherently exempt from Inheritance Tax (IHT), but they can be a valuable tool in estate planning to reduce potential IHT liabilities. Whilst the value of the offshore bond remains part of an individual’s estate, there are strategies that can help manage the IHT exposure.

One common approach is to place the offshore bond into a trust. By doing so, the bond may be removed from the individual’s estate, as the trust, rather than the individual, becomes the owner of the bond. This can lower the value of the estate and potentially reduce the IHT payable upon death.

However, it’s important to note that the effectiveness of this strategy depends on several factors, including the specific trust structure and the jurisdiction in which the trust is established. Different jurisdictions have varying tax rules that can impact how trusts are taxed and whether they provide the desired IHT benefits.

Given the complexities surrounding trusts and offshore bond taxation, it is crucial to consult with a qualified financial adviser or estate planning specialist. They can help ensure that the trust is set up correctly, complying with all legal requirements, and maximising the potential IHT advantages.

Personal Portfolio Bonds

Offshore bonds offer tax deferral benefits by allowing investors to postpone paying tax on investment gains until a chargeable event occurs, such as surrender or withdrawal. However, where a bond gives the policyholder an unusual degree of control over the underlying investments, particularly when those investments are tailored to their personal circumstances, it may fall under the Personal Portfolio Bond (PPB) rules.[5]

The PPB regime is an anti-avoidance measure designed to prevent individuals from using offshore bonds to shelter personal assets from tax. A bond is treated as a PPB if its returns are linked to “personalised” assets. For example, if the policyholder transfers shares in their own private company into the bond. This goes beyond the standard fund choices typically offered by insurers.

Where a bond is classed as a PPB, it is subject to an annual tax charge. This charge arises at the end of each insurance year and is calculated on a “deemed gain,” even if no actual withdrawals have been made. Importantly, the deemed gain is in addition to any tax charge that may arise from actual withdrawals, such as those from a part surrender. The rules ensure that tax cannot be deferred indefinitely and apply each year unless it is the final year of the policy.

For individuals using offshore bonds as part of a broader investment or succession strategy, it’s important to ensure that investment control does not unintentionally push the policy into the PPB regime. Careful planning and appropriate asset selection are key to preserving the tax efficient benefits of these structures. Speaking to a financial adviser is critical.

Top slicing relief

Top slicing relief can offer tax efficiencies when you cash in an offshore bond. Without it, the entire gain is taxed in one go, which could push you into a higher tax bracket.[6]  Instead, top slicing relief spreads the gain over the number of years you’ve held the bond, effectively calculating tax as if you had been withdrawing a portion each year. For example, if you have a £100,000 gain on a policy held for 10 years, the annual equivalent gain would be £10,000.

This can make a big difference, especially if it keeps you below higher or additional rate tax thresholds. While it won’t always remove the tax impact entirely, it can help ensure you’re not penalised for letting your investment grow over time.

It’s important to note, however, that top slicing relief is not available in all cases. For instance, with a personal portfolio bond, the usual rules for calculating chargeable gains apply, but top slicing relief does not apply to the deemed gain arising from a PPB.

What is the 5% allowance?

A key advantage of an offshore bond is that the holder can make 5% withdrawals of the original capital each year without suffering a tax charge.[7] This is a cumulative allowance, which means, if you don’t access your annual 5%, it will build up so you can draw more than 5% later. This allows you to maintain some immediate tax-deferred liquidity (if you need it), whilst your money is growing in a tax-efficient environment.

Time apportionment relief

Time Apportionment Relief (TAR) can provide tax benefits for individuals who have invested in offshore bonds but have spent part of the time living outside the UK. If you’ve been a non-resident in the UK during the period you’ve held an offshore bond, TAR allows you to reduce the amount of the profit (or gain) on the bond that is subject to UK income tax.

When you sell or cash in an offshore bond, you may make a profit, called a “chargeable gain.” Normally, if you’re a UK resident, you pay tax on this gain. However, if you’ve been living outside the UK for part of the time you’ve owned the bond, TAR allows you to reduce the tax by excluding the period when you were non-resident.

The relief works by looking at the length of time you were non-resident compared to the total time you owned the bond.[8] For example, if you held the bond for 10 years and were non-resident for 3 of those years, only 7 years of the gain would be subject to UK tax.

TAR reduces the taxable gain using the following formula:

It’s important to note that TAR is not a complete exemption from tax, it only reduces the taxable portion of the gain. Also, if the bond is transferred to another person, the new owner’s period of non-residence will determine how TAR applies, not the previous owners.

So why use an offshore bond?

There are a number of benefits to offshore bonds. The key to using an offshore bond successfully is by starting at the end. You need to ask how you are going to get the money out – what’s the exit strategy? If you’re a higher rate taxpayer, it’s a great tool in the armoury. You can invest your money to achieve capital growth and re-invest dividends without having to pay any income tax, whilst you continue to earn income over and above the top rate. However, it’s important to remember that, whilst there’s no immediate income tax to pay, there will be income tax to pay in the future. In an ideal scenario, a higher rate taxpayer pays in and a non or basic rate taxpayer draws the money out.

That might sound like an unlikely scenario, but it could be more common than you think.

An example:

James is 40 and has a goal of retiring at 60. He currently has no investments, so he’s putting a strategy in place to build wealth over the next 20 years. James earns £360,000 a year, which means he is fully tapered out of his pension and can only make contributions of £10,000 per annum.[9] He maxes out his ISA contribution of £20,000 a year and puts another £5,000 into a general investment account (GIA) every year. An offshore bond allows James to invest his money without suffering capital gains tax or any immediate income tax charge, whilst he continues to earn high levels of income. James decides to put another £25,000 a year into an offshore bond. By the time James retires at 60, assuming a net growth rate of 5% annualised, he would have just under £2 million to fund his retirement:

James would like £75,000 a year in retirement income. To achieve this, he takes £10,000 from his pension, which is within the personal allowance, so can be accessed tax free.[10] He then takes £30,000 from his ISA, £15,000 from his GIA and £20,000 from his offshore bond to cover the other £65,000 of required income. The funds taken from his ISA are also tax free.[11] The money taken from his GIA could cause a taxable event, but he will crystallise a capital gain under his annual £3,000 capital gains tax allowance, so this is also tax free.[12]

Now for the offshore bond: James has built up just over £400,000 in capital within the bond, so can access 5% of this capital (c. £20,000) free of tax from the bond every year. By the time James is 80, he’ll have used up his original capital withdrawals from the bond. At this point, though, he’ll have a range of options to maintain his full tax-free income. As he held the bond for 20 years, and because of a rule known as ‘top slicing’, he’ll likely be able to continue to access a substantial amount of money from the bond without paying tax.[13] In addition, there will likely be some surplus across his other wrappers to supplement his income from there.

In summary, James thought his options were limited because his pension annual allowance was fully tapered. With some clever planning and the use of an offshore bond, he has managed to take £75,000 a year completely free of tax throughout retirement.

This is a simplified example to demonstrate the main advantage of an offshore bond, but hopefully it provides useful insight. There are numerous other benefits of holding a bond, particularly if you are a higher rate taxpayer looking to gift money to your children over time, so they can be useful in lots of different scenarios. However, offshore bonds should form part of a broad financial strategy and it’s really something you shouldn’t consider without taking professional advice. There are pros and cons to using offshore bonds, however, if you’re a high earner and you are looking to reduce your tax position, it’s definitely worth considering.