What are offshore bonds – Are they worth the risk?

Offshore bonds usually stay under the radar only to be revealed the privileged few who have maxed out their ISA and Pension allowances.

There’s is a second group, however that sometimes come across them and that’s expats.

And with good reason. Investing in offshore bonds could make a lot of sense if you live overseas. On paper they are a very tax efficient investment vehicle with a number of key advantages.

That said, they are not for everyone and do come with risks. In fact, there’s no sugar coating it, many expats and non UK residents have lost money with this type of product.

To be fair, this has mainly been a result of bad actors, or more specifically unscrupulous salesmen charging extortionate (but hidden) commissions for high risk products.

So in theory, it doesn’t have to be like that. You just need to make sure you find an honest professional offering a lower risk product with the same benefits.

As with everything in investing, but perhaps more so in this instance, doing your own due diligence is highly recommended. And perhaps it would be even better to get some professional financial advice from somebody you trust before pulling the trigger with this kind of investment.

Offshore bonds explained in six sentences

There’s no getting around it, offshore bonds aren’t the most straightforward topic. Namely because you can’t talk about them without getting bogged down with taxes and nobody likes that.

We are going to do some scratching beneath the surface here, but if you are looking for a quick summary to help you decide if its worth reading onward, then here it is:

The good

• Offshore bonds enable you to grow your wealth pretty much tax free
• It can give you a tax free income
• You have control so that you can avoid or at least minimise taxes

The bad

• Offshore bonds may not be appropriate for you
• In the past, they have been synonymous with bad actors
• They can be risky if you pick the wrong one

If that sounds like something that may be of interest then it’s probably a good idea to read on for a more in-depth view.

Who are offshore bonds suitable for?

Offshore bonds (OBs) spend most of their time under the radar.

You are most likely to hear about them through the financial press (usually after something bad has happened with them) or via a financial advisor.

They are usually recommended to two key groups:

1. Non residents and expats that live in high tax locations
2. UK residents that have exhausted their ISAs and SIPPs.

What are offshore bonds?

It’s my guess that most people reading this won’t have a clue what OBs are, so its worth starting with the basics.

An OB is a tax sheltered investment vehicle like an ISA or a SIPP but not quite as risk free and a little more complicated.

They are domiciled in places with favourable tax regimes like the Channel Islands, Luxembourg and Ireland and usually come packaged as life insurance policies, to take advantage of both legal and tax benefits.

An offshore bond is a tax wrapper for investments

Whilst sounding complicated on the surface, when you take a peep under the hood they often contain more familiar investment assets.

Typically, offshore bonds can contain a wide range of things, but the most common are stocks, bonds (fixed income), property and cash.

Not to be confused with onshore bonds aka bonds aka fixed income

Confusingly, offshore bonds can have many names.

In fact, insurance bonds, offshore investment bonds, offshore portfolio bonds, investment linked assurance schemes, international bonds and international investment bonds all pretty much describe the same thing.

And just in case you are wondering that thing isn’t traditional bonds ie the bonds part of stocks and bonds.

That’s just to say we are not talking about traditional bonds here ie fixed income securities. Traditional bonds are loans to companies or governments with interest payments for your trouble. On the other hand OBs are essentially tax wrappers dressed up as life insurance policies.

Of course these two are connected in one way because you can invest in traditional bonds within the tax wrapper of an offshore bond.

Why invest?

If you’ve got this far, you may be wondering why offshore bonds are often recommended to expats and non residents.

The key is tax.

In short, OBs can be attractive for non UK residents and expats because we don’t usually have access to other tax wrappers like SIPPs and ISAs.

(And as previously mentioned, they can also be recommended for UK residents with the luxury of having already used up their pension and ISA and tax allowances).

What are the benefits?

When it comes down to it, there are four key benefits and each of these are about reducing the taxes you pay on your investments.

1. Gross roll up
2. 5% tax free withdrawal
3. Tax deferral
4. Top slicing

And it’s worth going into these in a bit more detail:

Taxation

For most, the whole point of investing in offshore bonds is their tax benefits. In other words, the way in which they can help you to reduce the amount you pay to HMRC.

There are a few of these but the big one for most is going to be something called ‘gross roll up’.

Gross roll up

Gross roll up refers to the fact that income and gains on the underlying funds within an offshore bond are essentially tax free.

In other words offshore bonds are tax free while you are investing and growing your wealth.

Tax free 5% annual withdrawal

Another sizeable tax benefit is the 5% tax free annual withdrawal allowance.

With this, you can withdraw 5% of your premium tax free every year for 20 years.

This is a popular one. And it’s easy to see why. There aren’t many people who wouldn’t benefit from some tax free income.

And in fact, 5% is a substantial amount.

Think about it this way. A lot of pensions work based on withdrawing somewhere between 3-4% per year from your overall balance and using that amount to live on.

Of course it depends on your life expenses, but certainly, in theory, as long as you have enough money in your offshore bond you should be able to live off 5% a year. As an example:

• £2 million gives you £100K per year
• £1 million gives you £50K per year.
• £500K would give you £25K per year

It is also possible to withdraw more at less regular intervals. In simple terms if you didn’t take anything one year you could take double the next or you could take even more by waiting even longer.

Tax deferral

If or when you do get around to paying tax on your offshore bond, it will be taxed at income tax rates.

But let’s be clear, you only pay tax when you withdraw more than five percent in one year (without building up a greater amount) or you cash in your OB.

So the way the tax is set up essentially gives you a certain amount of control over when you pay it. This is called tax deferral.

And here are some examples of how you could take advantage of this.

Say you were a higher rate income tax payer, you might want to wait until you retire and drop into a lower tax band before you cash in.

Alternatively, expats and non residents or anybody with plans to do so, could wait until they moved to a low tax destination before cashing in.

Assignable assets

Due to the fact that OBs are classed as ‘assignable assets’ they can be given to somebody else without generating a taxable event.

And along the same lines, they can be passed to a trust in the same way, which can in turn help you lower an inheritance tax bill.

Top slicing relief

Another major benefit of offshore bonds is top slicing.

In short, top slicing gives you the ability to divide a monetary gain by the number of years you’ve held an offshore bond, work out the tax liability on the OB and then multiply that figure by the number of years you’ve held it to see how much tax you pay overall.

In other words, say you’ve made a gain of £12K with your offshore bond but have held it for four years. On average that’s £4K per year you’ve made. You use that figure to calculate your initial tax liability on your offshore bond and then multiply the result by four (years) to see how much you pay overall.

Seems like a long winded way of doing things but in most cases it should reduce the tax you pay overall.

What are the risks?

There are three key risks associated with this type of investment that you need to be aware of:

• Bad actors
• Underlying investments within your offshore bond are high risk
• Suitability for your current situation

So it’s worth going into each of these in a bit more detail.

Bad actors

Unfortunately, offshore bonds have had a bad press in recent years and that comes down to bad actors. More specifically, unscrupulous individuals or organisations taking advantage of unsuspecting expats, particularly British.

There are various ways they can get you, but the most common ones are charging you sky high commissions and ongoing charges, applying extortionate surrender penalties and pushing you towards high risk products.

Now depending on just how unscrupulous a person or organisation you are dealing with you could end up paying through the nose for your investments.

You hear of all kinds of crazy figures quoted but the average seems to be about 4% annually, which is to all intents and purposes insanely expensive. Let me explain.

Now to some people 4% doesn’t sound like much, but that’s because they don’t realise it comes straight off your investment returns. Moreover in the vast majority of cases investment returns are going to be single digit percentages.

Nobody knows what the future holds

Nobody knows what the future holds in terms of investment performance. However, a lot of people in the know quote expected investment returns over the very long term of somewhere between 7 and 8% for a mix of global stocks and bonds ie a typical investment portfolio.

Now think about this. That 4% fee we were talking about comes off this figure. Even if we get the higher figure of 8%, you don’t have to be a genius to see a problem here.

Subtract 4% annual charges from 8% annual returns and you are left with just 4%. You risked your own money to get 50% of the returns.

And things become worse when you see how that would pan out in real monetary value.

Say you invested £100K for 25 years which is a typical tie up period.

8% annual returns would give you £684,847.52, but with 4% per anum, you’d only end up with just over a third of that ie £266,583.63!

That dodgy salesman and firm would have cost you two thirds of your money.

Not only that but these kinds of products often have early withdrawal charges and these are likely to be extortionate with bad actors too.

This is important because it means you could get trapped. Even if you figured out you were being taken to the cleaners, you may have to pay an arm and a leg to get your money out.

In other words, at best you’d get a lot less than what you put in. At worst you’d probably get nothing.

Risky underlying investments

Another big problem people buying OBs face is that their money could be invested in risky investments.

This is more likely to be the case with the kind of person that will charge you high commissions as discussed above, but, though less likely, it could happen with a more conscientious character too, whose idea of what’s risky differs substantially from your own.

As a result it is important to know exactly what your OB’s underlying investments actually are.

This is a question that needs to be asked before you invest and any kind of opaque answer should be taken as a big red warning signal that there could be risks involved.

Suitability for your current situation

Offshore bond taxation can be beneficial for some, but it certainly isn’t appropriate for everyone.

For example, UK residents have plenty of better options such as ISAs and SIPPs and expats and non residents may not need any tax sheltering anyway.

At the end of the day, a lot of expats live in tax free or low tax destinations.

If that’s you there is probably little point investing in them anyway. These days anybody with a brokerage account can put together a very tax efficient portfolio using index funds or ETFs where you control your own money and don’t pay anybody any fees for doing so.

At the very least make sure you know the tax situation for expats in the country where you live. Lots of expats don’t! You may find you don’t pay tax on your investments or that if you do they are so low there’s no point in investing in an offshore bond anyway.

Questions you need to be asking before investing?

I think there are some simple questions you should ask before making an investment in offshore bonds.

• How do I know investing in this product is safe?
• What are the costs?
• What am I invested in?
• Are the tax benefits relevant to me where I live?

If you get clear answers that make sense and the fees don’t outweigh the tax benefits then they may just be the right choice for you.

If you get opaque answers that don’t make sense, it might be wise to give them a miss.

Should I invest?

If you are an expat who lives in a high tax area or a UK resident that has exhausted their other tax shelters (eg ISAs & SIPPs) then OBs may be worth further investigation.

Just make sure you do your due diligence, get some financial advice and don’t handover your money until you are absolutely sure what you are investing in and how much it will cost you.

Withholding tax

One final point worth being aware of relates to withholding tax. International dividends and interest payments are often taxed by governments at source before they reach your investment account.

Like many other kinds of investment, offshore bonds cannot shelter you from this.

Your provider should be able to explain what they do to limit this.

An example being, using underlying funds domiciled in countries where the tax on dividends and interest is reduced.

What are offshore bonds? – The bottom line

Offshore bonds may enable you to grow your wealth in a tax efficient manner and provide you with tax free income.

But and it’s a big BUT they aren’t suitable for everyone and they come with risks, especially for British expats.

If you are considering investing, make sure you do your homework, know who you are dealing with, understand exactly what you are investing in, be fully aware of what the charges are and recognize why this type of investment makes sense for you.

And unless you are extremely financially literate, we’d recommend getting some financial advice before you take the plunge.