Tax advantages of offshore funds
The Prime Minister is under scrutiny this week for his investment in an offshore fund, Blairmore. There is no illegality regarding offshore funds such as Blairmore, but there is a debate over whether the system has any moral justification.
The Blairmore fund wasn’t a great performer so David Cameron was probably right to withdraw his money. It’s been in the worst 25% of performers over the last five years. But he probably could have done better with his tax planning and his investment performance.
Why use an offshore fund?
Offshore funds are very common and are widely used by investors who want to access specialist investments. They're even listed in our fund tools.
The low-tax or no-tax regimes, known as tax havens, can provide an inexpensive home for the money in the fund while the fund operates, until the investors pay tax in their home country when they take their money out.
Those against offshore funds would argue that these funds are based offshore primarily to escape paying taxes. The company that manages the fund is shielded from the higher tax burden that would be incurred in its home country.
For investors, you are required to pay tax on the money earned from the investment, just as you would if you were investing in a UK-based fund.
However, you may be able to get an advantage from the ‘reporting status’ of the fund, which relates to whether you pay income or capital gains tax on the proceeds.
UK resident investors can benefit by investing into a reporting fund as the disposal of such investments is treated as a capital gain and subject to a maximum rate of tax of 20%. This compares favourably to a disposal of an investment in a non-reporting fund, which is taxable as income and subject to a maximum rate of tax of 45%.
Where an offshore fund has held reporting fund status throughout the time you have held units in it, any gain or loss you make when disposing of the fund is treated as a capital gain or loss. However, where the fund does not have reporting fund status any gain is treated as income and therefore, if held outside an Isa or self-invested personal pension (Sipp), may be subject to income tax at the applicable marginal rate.
Setting up a fund offshore in a financial centre such as the Bahamas, the Cayman Islands or the British Virgin Islands allows it to attract investors from around the world. Supporters of offshore funds say they are set up in these countries to provide a neutral ground for global trade and investment. Investors put in their money and pay tax where they are a tax resident when they withdraw the cash.
Supporters would also argue that the offshore status of the fund allows it to perform to its full potential. A UK domiciled retail fund is subject to stricter rules about where it can invest. Offshore funds can give investors unlimited access to international markets and stock exchanges.
An offshore fund might be denominated in a different currency such as the dollar rather than pounds sterling. This might suit investors who prefer to hold their assets in another currency that they think is more stable than that of their country of residence.
Regulations only allow certain offshore funds to be promoted to UK-based retail investors. The most common legal form of these funds is a "SICAV" – an investment company which is open-ended and similar to an OEIC.
You can check the regulated status of a fund using the Financial Conduct Authority (FCA) register at fca.org.uk/register
There are big differences between offshore funds, in the investment strategies used, risks involved and the reputation of the offshore centre.
An equity fund run from Ireland by a well-known fund house with a large presence in the UK is an entirely different animal from a hedge fund that uses complex derivative strategies that is run from a tiny island that you would struggle to locate on a map of the world.
More tax advantages for investors
Offshore investment bonds are very different to the plain offshore funds. These are investment wrappers set up by life insurance companies in an offshore jurisdiction with a favourable tax regime such as the Isle of Man, Dublin or Luxembourg.
An offshore bond applies the legal and tax advantages of a life assurance policy to an investment portfolio. They are widely used by UK independent financial advisers in tax planning, particularly for clients who have already used up their annual Isa and pension allowances.
Within the wrapper of the offshore bond, you can invest in a wide range of funds covering different types of assets such as equities, fixed interest securities, property and cash deposits.
While the bond is invested you do not pay tax on it and this is known as gross roll up. This allows the investments to grow unhindered by tax, , potentially enhancing the overall return on the investment. Note that depending on the jurisdiction, withholding taxes might apply - most countries require that payers of certain amounts, especially interest, dividends, and royalties, to foreign payees withhold income tax from such payment and pay it to the government.
The offshore bond is not taxed on capital gains. Any gains are assessed to income tax in the hand of the bondholder instead of capital gains tax.
You incur income tax at your marginal rate when you take out the capital if you are a UK resident. If, for example, your marginal rate of income tax falls in the future because you have retired, then it could be cheaper to encash at that point.
You can draw down small amounts each year, up to 5% of the amount of the original capital sum, and defer the tax bill on that until the end of the contract. This 5% allowance is cumulative, so if you do not use it one year, you can carry it over to the next.
Being able to take regular amounts without upfront tax can make these useful for structuring a retirement income stream.
Over and above the 5% annual allowance you pay income tax. Offshore bonds are divided into a number of segments, often 100, each of which is regarded as a whole policy in its own right. Whether you encash a whole one or partially can make a difference to the amount of tax your ultimately pay, depending on your individual circumstances.
Other legal tax avoidance options
The UK tax system also allows large chunks of income tax to be avoided or offset using mainstream, government-endorsed schemes for investors with high salaries and high risk appetites. These include Venture Capital Trusts and Enterprise Investment Schemes.
But most of us cut our tax bill by using individual savings accounts (Isas) and pensions. We’re now in a new tax year so here’s a round up of the new allowances.