"How do you make a Swiss roll?"
"Poke his eyes out."
Thankfully, tax is not quite that violent, but offshore roll-up funds to those in the know are just about as tasty as that proverbial Swiss roll.
OFFSHORE ROLL-UP FUNDS
The International Herald Tribune reported on 4 April that "there are twice as many offshore funds sold in Britain as there are home-grown funds; Ö at the last count the $647 billion in assets they held was nearly twice as much as was in British-domiciled unit trusts".
WHY GO OFFSHORE?
So why do we tend to put our money offshore? What is it about offshore funds, particularly roll-up funds, which makes them so interesting?
Ask yourself a question. If you had a choice between an investment fund on which you paid between 20% and 40% a year on any profits or one where no tax was due until it matured or was cashed in, which would you choose?
Many financial advisers recommend offshore roll-up funds just for this reason. Tax is not paid until the investment is cashed in, leaving a larger amount to invest each year.
In addition, offshore roll-up funds can also provide the following advantages:
- Be tax efficient if going abroad.
- Provide for children by maximising personal allowances.
- Provide growth without the inconvenience of tax.
- Increase investment opportunities by doing away with onshore regulation.
- Be part of a plan for tax-efficient retirement savings.
- Increase the confidentiality for investors.
- Defer tax for UK residents or UK domiciliaries.
- Increase geographic or currency diversity in an investment portfolio.
- Give the investor choice as to when income becomes taxable.
- Allow someone to use unrelieved losses under Schedule D, Case VI.
THE TECHNICALITIES
So what are the rules? Letís start with the basics. Offshore funds are collective offshore-investment vehicles. They can take the form of non-resident unit trusts or open-ended investment companies.
For UK tax purposes, offshore funds can be conveniently divided into two types, known as ëdistributorí and ëroll-upí. A distributor fund is any offshore fund that has been certified by the Revenue as having distributor status. Funds can obtain this status if they pay out at least 85% of their income as income or if income is nil or less than 1% of the average value.
With a distributor fund, all income is paid gross and is subject to income tax at your normal rate as it arises. Any capital gains on selling holdings in the fund are taxable as capital gains ó and, of course, qualify for your annual capital gains exemption of £7,100 if you havenít used it up already. From a tax viewpoint, investing in an offshore distributor fund is therefore broadly the same as investing in an onshore UK fund.
The alternative to the distributor fund is the non-distributor or ëroll-upí. A non-qualifying offshore fund is any fund that has not been certified by the Revenue as having distributor status.
With a roll-up fund, any dividends that are paid out are taxed as income when paid. However, the roll-up funds most popular with British investors are designed to roll-up all income within the fund, rather than pay out dividends. The benefit of this is that there is a deferral of tax until the investor disposes of his or her holding.
The trouble ó and for some it is quite a nuisance ó is that any profits are taxed under Case VI of Schedule D as income, at income-tax rates of up to 40%. Offshore-income gains do not give the benefit, therefore, of the annual capital gains exemption, indexation allowance or taper relief.
The good news is that, because you can decide when to sell your holding, you can select the most advantageous time, bearing in mind your personal circumstances.
Offshore funds can also invest in areas that may not be available to onshore funds, such as foreign currencies and commodities. Even where investments made by offshore funds are available domestically, restrictions offshore may be fewer or non-existent. For example, a UK unit trust may only invest up to 10% of its portfolio in countries not on the Financial Services Authorityís list of recognised stock exchanges, whereas an offshore fund might be able to invest in substantially more or be wholly unrestricted.
There are also administrative benefits to using roll-up funds. Because income is automatically reinvested, you can avoid the paperwork that would normally be involved in receiving and immediately reinvesting dividend payments.
GOING ABROAD?
An individual who is thinking that at some future point he or she will be moving abroad might want to buy units in an offshore roll-up fund ó even several years in advance of the move. Similarly, just before going abroad you could invest in units in an offshore roll-up fund. That way you can build up a fund that can be sold free of UK tax during the non-resident period. Either way, the holding should, of course, be sold prior to coming back to the UK so as to avoid the nuisance of the UK rules.
One of the additional attractions of non-qualifying offshore funds (compared to onshore UK investments) is in terms of capital gains tax. You may recall that there is a requirement for an individual to be non-resident for at least five years to avoid UK capital gains tax. This rule does not apply to roll-up funds because the offshore income gain is subject to income-tax rules, not capital gains tax. All you need to do is realise the gain during any period of non-residence and magically there is no UK tax payable.
Naturally, as with all investments, you should check out the local rules in the country you are moving to just in case they subject the roll-up fund to even worse tax rates. Places that come to mind where you should NOT live when you hold roll-up funds include the United States, where the gain would be taxed under the onerous passive Foreign Investment Company rules; and Spain where investors are taxed on money derived in tax havens as though the gains that accrue are paid out each year, even if the funds have not distributed a penny.
INVESTING FOR CHILDREN
An open question is how the rules on parental settlements apply. The UK has long had a rule that a parental settlement that generates income in excess of £100 is taxable on the parent. Conversely, for capital gains tax purposes, the childís capital gains tax allowance can be used. Some commentators reckon that the parental-settlement rules do not apply to offshore roll-up funds, and these can be used to provide adequate income to utilise a childís personal allowance. Naturally, the Revenue doesnít agree with this view!
What does seem to work is investing in roll-up funds on behalf of a child if one is prepared to leave the money untouched until the child reaches 18 years of age. At this point, redeemed gains become the childís income for tax purposes and taxable under Case VI of Schedule D. If the child has little or no other taxable income, his or her unused personal allowances can be set against the gains. What can be achieved here is, therefore, a fund that can grow in a tax-free environment and provide tax-free growth.
So beating the £100 rule is actually quite simple. All you have to do is put together a portfolio of offshore roll-up funds. Leave them alone until the child is 18 and college fees can be paid from what have effectively become tax-free savings plans.
SOME OF THE PROBLEMS
There are, of course, some disadvantages to non-qualifying funds. As mentioned above, because the gain is taxable as income, indexation and taper reliefs are not available. Rather cruelly, death causes a deemed disposal, with the gain accruing then being charged to income tax. The tax-free uplift in base cost enjoyed by other assets at death does not exist.
Similarly, bearing in mind recent stock-market performance, investors cannot claim any relief for capital losses. Talking of losses, do check out the fees charged by your fund manager. Historically these have been far higher than for equivalent onshore funds. Let the buyer beware!
So where should you go? At the last count Standard & Poors reported that there are 106 offshore fund-management companies whose products are registered for sale in Britain, including eight of the twenty largest. Funds set up and administered from the Channel Islands, the Isle of Man, Dublin and Luxembourg are the most popular with UK investors. Do bear in mind that any fund manager directly marketing in the United Kingdom must be registered with the Financial Services Authority. If in any doubt, you should check with the FSAís Central Register.
SECRECY
We have mentioned in previous ëInternational & Offshore Tax Reportsí that information exchange between the members of the European Union is now an inevitability. The Independent newspaper reported on 14 April that many customers of offshore accounts should have received a letter the week of 9 April notifying them that details of their balances and interest payments will be passed to the Inland Revenue starting from the new financial year.
It seems almost certain that the Independent has got the wrong end of the stick here. The 2000 Finance Act does indeed give the UK Government the power to exchange information with other governments. However, customers of offshore banks could include, for example, a Russian living in Moscow or a German living in Berlin. Offshore banks are somewhat unlikely to know which of their customers might be bound by British tax rules. A far more likely explanation is that non-UK-resident customers of domestic UK banks are being contacted and told that their details will be passed to the tax authorities where they live. What this does mean is that if confidentiality is on your wish list then the UK is becoming just that bit less welcoming.
IMMIGRATION ADVICE
The UK has once again tightened up its rules. While anyone can still set up in business as an accountant or tax adviser, it is now an offence to provide immigration advice unless the adviser has been registered with the Office of Immigration Services Commissioner.
This part of the Immigration and Asylum Act 1999 (Part V) came into effect in April 2001 and covers anyone who does anything as basic as just filling in an application form for a work permit through to the more complex rules for taking care of asylum seekers. If anyone should happen to ask you for immigration advice, do bear the new rules in mind!
BANANAS
Seeing that we began this month by looking at Swiss rolls, it seems only reasonable that we should finish on another food-related story.
The European Commission and the United States reached agreement on 11 April, ending the dispute over the EU banana import regime. Following this agreement, the US will suspend the retaliatory tariffs it has in place since March 1999.
Reportedly, the banana settlement has no effect on the continuing dispute over the replacement law for the US foreign sales-corporation regime, known as the US Extraterritorial Income Exclusion Legislation. The EU has threatened the United States with over $4 billion in tariff penalties over this new law. If agreement cannot be reached, the US may well re-impose sanctions once again. Check back with future ëInternational & Offshore Tax Reportsí for news on how these may affect you!
The International And Offshore Tax Report was prepared by David Treitel who is a senior US tax manager with US Tax & Financial Services in London. He can be contacted on 020 7357 8220 or by email at david@ustaxfs.co.uk.
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