Fundsmith Equity Fund
710.72p T Class Acc, 13 Jun 24

Invest with us

£
 
Payment type
 

An ISA (Individual Savings Account) is a savings account available to UK residents on which the return is tax-free and which need not be declared on the investor’s tax return. All income (dividends and interest) and all capital gains within the account are free of tax. For the current year, 6 April 2024 to 5 April 2025 the overall investment limit is £20,000 (excluding the British ISA which has a separate £5,000 limit).

 
Guidance

Capital Gains Tax and offshore bonds

Changes to Capital Gains Tax – can an offshore bond help?

The recent autumn statement saw changes announced to capital gains tax (CGT), specifically reductions to the annual exempt amount (AEA). The first of these changes comes into effect from 6th April 2023 and sees the AEA reduce from £12,300 to £6,000, then reduce to £3,000 one year later. These changes will impact anyone who looks to regularly harvest gains, perhaps as part of an ‘income’ strategy or perhaps as part of a bed & breakfast/bed & ISA strategy.

The reductions are broadly in line with recommendations made following a review of CGT by the now defunct Office for Tax Simplification (OTS). In November 2021, the government rejected the recommendations, but political winds change quickly. The OTS review also recommended that the rates at which CGT is charged be harmonised with income tax rates. So, where does that leave anyone who had been following a ‘tax efficiency’ plan based on a favourable CGT regime?

The recent autumn statement saw changes announced to capital gains tax (CGT).

Introducing the offshore bond

These are types of investment wrapper that can be used to hold collective investments such as open-ended investment companies (OEICs) and unit trusts. They are marketed by insurance companies and are usually only available through financial advisers. The insurance companies that issue them are found in jurisdictions such as the Isle of Man, Ireland and Gibraltar.

In recent times, the media and others have attempted to portray any form of investment that is ‘offshore’ as being some devious form of tax evasion. For the sake of absolute clarity, offshore bonds are widely used, a longstanding concept, and accepted by HMRC as investment wrappers. The reason their use is accepted is because a UK resident will eventually be subject to UK income tax if what’s known as a chargeable event occurs. Before we examine the tax position, it’s worthwhile noting some of the possible pros and cons of offshore bonds as an investment wrapper.

For the sake of absolute clarity, offshore bonds are widely used, a longstanding concept, and accepted by HMRC as investment wrapper.

Possible advantages

  • Income from the underlying investments accrues in the bond with no immediate tax charge
  • Selling one fund and buying another (within the bond) triggers no CGT, regardless of the size of any gain made
  • In a policy year (not tax year), the investor can withdraw up to 5% of their original investment with no immediate tax charge (and no need to even declare)
  • If any part of the 5% allowance is not used, it can be rolled forward to future policy years, e.g. up to 10% in year 2, 15% in year 3 and so on
  • A single bond can be split into hundreds, sometimes thousands of mini bonds (also referred to as segments) to assist with future planning
  • The bond owner can gift mini bonds (segments) to another person through processes known as legal assignment and/or legal appointment – this would not trigger any tax charge on the donor

Possible disadvantages

  • Capital gains made in bond wrappers are subject to income tax, not CGT
  • The insurance company will have charges to set up and administer the bond
  • You can usually only ‘buy’ one after taking financial advice from an adviser
  • The 5% annual withdrawal allowance is based on the original investment value, not the bond value
  • Tax legislation can change

Tax position

As neither income nor growth is taxed as it is received/ realised, offshore bonds benefit from very tax efficient growth. This tax-free accumulation is called gross roll up and means a bond is a good tax deferral vehicle. Note that tax is deferred, not necessarily avoided – if a chargeable event occurs, income tax may be due on deferred income and/or gains. The two main chargeable events would be:

  • Selling/encashment/surrender of the bond or mini bonds within it
  • Withdrawals in a policy year that exceed the 5% allowance (or accumulated allowance)

Chargeable events gains are subject to income tax, not CGT (even if the gains are all capital gains). Thus, there is potential for a bond holder to find themselves in a worse tax position if they suffered a chargeable event and paid 40% or 45% income tax on their ‘gain’ versus a comparable top rate of CGT at 20% (currently). Why then would anyone consider an offshore bond? There are many potential answers, and a short case study helps to illustrate some of these.

Chargeable events gains are subject to income tax, not CGT (even if the gains are all capital gains).

Case study

Sam is 55 years old, currently employed and is a higher rate taxpayer. Sam plans to fully retire at 65 and pays into a pension scheme, estimating this will be valued at £800,000 by 65. Sam also contributes the maximum into an ISA each year and currently has ISAs valued at £400,000. There is also an investment account valued at £250,000 (roughly half this value is capital gains). Sam recently inherited £300,000 which is sat on deposit.

Sam has been selling assets each year from the investment account to utilise the CGT exemption and used the sale proceeds to fund the ISA. Surplus income has been used to fund the pension and pay off the fixed rate mortgage which will be cleared in 3 years. Sam has two children aged 20 & 23 and one day hopes to have grandchildren. Sam wants to be able to help the children financially and also would like to be able to help grandchildren if they ever come along.

Considerations

  • the mortgage is fixed at a low interest rate. Sam is happy to pay the low rate and doesn’t want to trigger an early redemption penalty
  • Fully funding the ISA by selling down tax efficiently from investment account will be impossible once the CGT exemption reduces
  • If Sam adds to the investment account and it grows in value (which is obviously the goal), any gifts of reasonable size to the children will likely trigger a CGT charge
  • Sam has avoided holding income producing investments in the investment account in recent years due to low yields and the fact that income would be taxed at higher rates annually.

After meeting with a financial adviser, Sam decides to invest £250,000 of the cash into an offshore bond made up of 2,500 mini bonds. The rationale is as follows:

  • Due to the tax deferment benefit of the bond, Sam has no immediate concerns about the underlying investments and can therefore use income producing funds if required
  • Sam has no withdrawal needs before 65. However, Sam believes the cumulative 5% tax deferred withdrawal option offers a good way of helping the children financially in the coming years as required
  • At age 65, Sam will be able to choose which assets to draw from to provide a retirement income. This could mean Sam is a non-taxpayer for several years, even after State pension kicks in
  • As an investment bond would be liable to income tax and because Sam may be a non-taxpayer, it offers Sam the ability to make tax efficient (possibly tax-free) withdrawals from the bond
  • Sam understands that bond segments can be assigned or appointed to children and future grandchildren, giving a tax efficient way to gift
  • Sam’s financial adviser negotiated a product discount with the bond provider and the upfront charge was reduced to 1% and the annual bond charge is £650 (reviewed annually)

To demonstrate the tax position, lets assume Sam is now 65, fully retired with no taxable income. The bond is worth £425,000 and Sam made gifts of £62,500 to the children using the 5% facility. Sam also now has two grandchildren, both aged under 2.

Chargeable gain

£425,000 (current value) + £62,500 (5% withdrawals) - £250,000 (original premium) = £237,500

Sam wants to be able to help the children financially and also would like to be able to help grandchildren if they ever come along.

Top slicing relief

This relief mitigates higher rates of tax by effectively annualising any gain realised. So, if the entire £237,500 gain were realised in one go, it is divided by 10 policy years to give £23,750, aka the top slice. As Sam has no other taxable income this tax year, this top slice all falls within the basic rate band and means the highest rate of tax applicable is basic rate, i.e. 20%.

Available income tax allowances

Having no other taxable income, Sam has a personal allowance of £12,570, the savings band allowance of £5,000 and the personal savings allowance of £1,000. Sam can therefore realise £18,570 of tax-free chargeable gains this tax year.

Each bond segment has a chargeable gain of £237,500 / 2,500 = £95. Sam sells 195 segments, realising capital of £33,150 (£170 value per segment x 195) which includes tax-free gains of £18,525 (£95 x 195). Sam has no taxable income the following year so repeats this exercise. Once the State pension comes into payment, Sam continues to make segment sales but reduces the number to make continued use of unused income tax allowances. (And Sam has continued to utilise the lower CGT exemption on the existing portfolio in the previous tax years as well).

Future considerations

If Sam’s pension approaches the lifetime allowance (LTA) threshold, Sam could begin withdrawals from the pension to limit the risk of breaching the LTA. Sam could also assign/ appoint segments to the children/grandchildren to make use of their income tax allowances where appropriate.

Summary

With the upcoming changes to CGT exemptions, coupled with the concern that CGT rates may also soon change, those with investments exposed to CGT (and possibly income tax) may want to consider whether other tax wrappers offer any benefit. Offshore bonds allow for tax deferral and also offer the opportunity to plan for tax efficient encashments. The bonds offer wide investment choices including all the products offered by Fundsmith so there is no need to worry about not having access to a good investment strategy.

Offshore bonds allow for tax deferral and also offer the opportunity to plan for tax efficient encashments.