Offshore bonds - a tool for generational planning

Reports have shown that adults in their early 60s have nine times more wealth compared to those in their early 30s [1].  It is therefore unsurprising that a common aspiration among the ‘baby boomers’ is how to pass on their legacy. Although this concept is fairly simple, from a financial planning perspective it is far more complex.

One solution is to make an outright gift. Not only can this enhance wellbeing, as you get to witness your children benefiting from an early inheritance, but, depending on the size of your estate, it can also reduce inheritance tax.  Nonetheless, there are emotive factors to consider and many worry about:

• How responsible their children are, so they seek a solution which enables them to retain some control
• The longevity of their children’s relationships and how they can protect against socio-economic changes – for example, divorce [2]

We explain here how an offshore bond can have tax advantages for high earners. A trust, in conjunction with an offshore bond, can be used to help with inheritance tax planning and provide the following benefits:

• Create a protected legacy for future generations
• Enable you to retain control
• Be tax-efficient

What is a trust?

A trust is a separate legal entity whereby a person can “hold property for the benefit of other people (beneficiaries) without giving them full control over it”.[3] This will generally fall outside of their personal estate. All trusts are established by the settlor, who is the individual placing property into the trust. Those who can benefit from the trust are the nominated beneficiaries. The trustees are the named individuals who then manage the property on behalf of the beneficiaries.

There are various types of trust but, in the context of legacy planning, the discretionary trust is the most common.  This is because it can have multiple beneficiaries who are usually identified by different classes e.g., children, grandchildren.

What are the main benefits of a discretionary trust?

• The settlor can also be a trustee. This means you retain control on not only how much is paid to beneficiaries, but also when these payments are made;
• It enables you to pass wealth down to future generations, as you can name multiple classes of beneficiary, which ideally avoids inadvertently excluding loved ones, such as unborn future grandchildren;
• Your wealth should be better protected from being diluted on divorce of a beneficiary. This is because it is at the trustee’s discretion to determine how the property is paid out.  The beneficiary therefore has no legal entitlement and can claim that this should be excluded from divorce proceedings, albeit each case is reviewed on its own merits.

What are the main considerations for a trust?

The main consideration is the inheritance tax treatment once the gift has been made, as any gift made into the trust by the settlor is deemed a Chargeable Lifetime Transfer (CLT).

Although the CLT falls outside of the settlor’s estate after seven years, if the value is more than the settlor’s available nil rate band [4], there is an immediate lifetime charge of 20% on the excess.

For example:

Jane sets up a discretionary trust for her children, and places £350,000 into the trust. She has already used up her £3,000 annual gifting allowance elsewhere. Her available nil rate band is £325,000.  As a result, there is an immediate lifetime charge of £5,000 on the excess (£25,000 x 20%).

Some other points to consider:

• There are initial fees to establish a trust because you will need to involve a solicitor
• Nowadays it is a legal requirement for most trusts to be registered with HMRC [5]
• Dependent on the asset, the trustees will have to complete an annual tax return [6], which can involve accountancy fees if the trustees require assistance
• Often referred to as a periodic charge, every 10 years the trust is subject to an anniversary charge [7], whereby the value of the assets in excess of the nil rate band is subject to a tax charge of 6%. In practice, this calculation is a little more complex, which is why the use of an accountant is advised
• Lastly, distributions made to a beneficiary need to be well thought out and planned, for two main reasons:

1. 1. If the distribution is deemed to be income, the beneficiary will receive the payment with a 45% tax credit. They can use this to claim back any overpaid tax based upon their individual situation; however, the trustees will need to ensure they have held back enough within the trust to pay HMRC the tax.
   2. If the distribution is deemed capital, the trust may be subject to an exit penalty.

If the distribution is deemed a mixture of income and capital, an accountant would need to be involved prior to the distribution to ensure the split is calculated correctly and records are kept for future reporting.

How does an offshore bond fit into the picture?

An offshore bond is a single premium life assurance policy with the following features:

• They are not subject to capital gains tax so capital gains can ‘roll up’ over time without any immediate tax charge
• Chargeable gains will be taxed as income at your marginal rate when you make a withdrawal
• You can make 5% withdrawals of the original capital each year for 20 years without suffering an immediate tax charge 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% at a later date if you need to

Bonds are commonly used in trusts for a number of reasons; firstly, tax returns are much simpler, due to the fact that bonds are non-income producing.

Secondly, when it comes to making a distribution, rather than making the encashment within the trust, the trustees can choose to assign bond segments to the beneficiary.

This is tax-efficient because, instead of the tax charge being calculated on the settlors’ tax position, it is taxable at the beneficiary’s marginal rate of income tax and, due to the graduated income tax bands [8], often results in less tax.

To illustrate this, I have written some examples below.

Example One

Mary is 70 and in good health.  She has assets totalling £1,325,000, which includes £325,000 in an offshore bond. Her late husband’s spousal pension combined with her State Pension means she has more than sufficient secure income to cover her expenditure.

Her main aspiration is providing a legacy for her 5 children and grandchildren thereafter; however, she has concerns about making an outright gift to the children equally. This is because her eldest child’s marriage is turbulent, and she worries about what would happen to their share in the event of divorce. Reducing her inheritance tax liability would also be a bonus.

She decides to place the offshore bond into a newly created discretionary trust.  The transfer, although a CLT, does not give rise to an immediate tax charge because it is within her available nil rate band. After 7 years it falls outside of estate for inheritance tax, which is a saving of £130,000.

Unfortunately, Mary’s eldest child did get divorced but, because beneficiaries of a discretionary trust have no legal entitlement, it is unlikely to be included within the division of assets.  The trust has therefore protected Mary’s legacy from dilution.

Example Two

After becoming grandparents 20 years ago, Jack and Heather wanted to create a legacy which could be passed on to their grandchildren. They created a discretionary trust and placed £50,000 into an offshore bond consisting of 20 segments.

Fast forward to the present day and their first grandchild, Marty, is just about to graduate from university. They want to congratulate him by encashing one of the bond segments and gifting him the proceeds. The bond segment is now valued at £400,000 and after deducting the accrued 5% allowance, calculated on a segment proportionate basis, the chargeable gain is £17,500.

If the trust encashes the segment prior to making the distribution, the chargeable gain would be taxable on the settlors of the trust (Jack and Heather). Assuming they are both basic rate taxpayers, there is a personal tax liability of £3,500 (20% of £17,500), which is then reimbursed by the trust.

The trustees would either need to hold back the tax from the distribution – so Marty would receive £16,500 – or, if the trustees distributed the full £20,000, they would need to ensure there was sufficient cash elsewhere within the trust to fund the reimbursement.

A much simpler alternative is to assign the bond segment to Marty to encash. He has no other taxable income, so the chargeable gain is fully covered by his £12,570 personal allowance, £5,000 starting rate band, and £1,000 personal savings rate, resulting in no tax liability.  He therefore receives £20,000.

The trust set up has enabled Jack and Heather to retain control over when they pass on their legacy to their grandchildren. The use of an offshore bond has allowed them to simplify the distribution out of the trust and take advantage of the beneficiary’s unused tax allowances.

Summary

This article has been written to simplify the concept of how a trust and offshore bond can be used to pass on wealth to future generations tax-efficiently, whilst simultaneously meeting the emotive needs of retaining control and retaining wealth within the family for future generations.

In practice, trusts are a complex area of financial planning, and it is always recommended you seek independent professional advice. Even more importantly, any trust planning should be done in the context of your life goals. If planned and executed correctly, it can be an effective tool; however, trusts are not the only option, so considering all avenues, even if only to discount them, is vital to ensure suitability.

[1] Distribution of individual total wealth by characteristic in Great Britain – Office for National Statistics (ons.gov.uk)

[2] the average divorce rate in the UK is 42% – How Many Marriages end in Divorce in the UK? (harbourfamilylaw.co.uk)

[3] CII Study Text JO2

[4] Inheritance Tax nil rate band and residence nil rate band thresholds from 6 April 2021 – GOV.UK (www.gov.uk)

[5] Register a trust as a trustee – GOV.UK (www.gov.uk)

[6] Trusts and taxes: Trusts and Income Tax – GOV.UK (www.gov.uk)

[7] Trusts and Inheritance Tax – GOV.UK (www.gov.uk)

[8] Income Tax rates and Personal Allowances : Current rates and allowances – GOV.UK (www.gov.uk)