01.05.2011

The benefits of offshore investment bonds, pilot discretionary trusts to avoid IHT, investing spare cash in ISAs, VCTs & EIS, pension funds  VAT court case and tax advice on succession planning.

Offshore investment bonds

Offshore investment bonds can benefit both UK residents planning to move abroad in the future and UK resident non-domiciled individuals – providing a tax-favoured way to hold overseas assets.

The offshore investment bond is designed to hold a wide range of assets although these will typically range from cash deposits to mutual funds of all types. Once inside the wrapper, these assets become sheltered from UK tax. Income or gains received on investments traded within the bond are not taxable or reportable in the UK until actually withdrawn from the bond.

In addition, subject to the nature of the original capital invested, withdrawals of up to 5% per annum of the original investment can be made with no immediate tax charge. It is therefore possible to receive a tax deferred monthly income. Note that the 5% allowance is cumulative, so an individual who has held a bond for five years and taken no withdrawals could, in year five, withdraw 25% of the original capital without any tax charge arising or HMRC notification required.

For UK residents planning to retire or move abroad in the foreseeable future, an offshore investment bond provides attractive tax deferral. Assets can be sheltered from UK tax until the move abroad is made. There are also tax deferral benefits for non-UK domiciled individuals who are UK resident. If resident in the UK for seven out of the last nine years, such individuals must either declare and pay tax on their worldwide income and gains, or agree to pay a flat £30,000 tax each year. An offshore wrapper bond enables them to legitimately shelter offshore investments and cash in a vehicle that does not need to have income declared. There is no limit to how much can be invested in the bond, so clients can save the £30,000 tax and declare worldwide assets without effectively declaring anything.

Such offshore bonds are extremely flexible, as they can hold many types of asset. Investments can be switched or managed within the bond with no tax repercussions. They can even be gifted without any UK tax charges. There is no minimum holding period required, so the bond can be surrendered at any time if necessary.

Three letter investments 

Individual savings accounts provide a tax-free shelter and future income stream. This tax year up to £10,680 can be invested into a stocks and shares ISA, or up to £5,340 of that maximum allowance can be allocated to a cash ISA.

Venture capital trusts allow UK taxpayers income tax relief at 30% on an initial investment of up to £200,000 per year. All dividend income is tax-free, as are capital gains on redemption. VCTs are held for a minimum of five years and smaller company equity risks need to be considered. More sophisticated strategies now help manage risk, so even previously sceptical investors are attracted.

Last but not least, Enterprise investment schemes provide an attractive 30% income tax relief on any investment up to £500,000 and the opportunity to carry back the full investment allowance to the previous tax year, thus allowing up to £1m to be invested. EISs need to be held for three years to retain the income tax relief and are free from capital gains tax. As an added attraction, EISs are completely free of inheritance tax after two years.

Pilot trusts give peace of mind 

One often overlooked element of family wealth planning concerns what happens to the proceeds of insurance contracts or pensions on death before retirement. For high earners, such pension fund or death-in-service payments can be substantial. However, many people simply leave them to be paid to their spouse, without considering the longer-term inheritance tax implications. Once the sums are paid to the spouse they become part of that individual’s estate, and hence subject to IHT on their subsequent death.

If the sums involved are more than the spouse is likely to need in their lifetime, a sensible plan is to set up a pilot discretionary trust. In the event of the settlor’s death, monies from any insurance contracts, death-in-service benefits or pension funds would be paid into the trust.

The funds can be retained for up to 125 years, with distributions managed by the trustees in accordance with the settlor’s letter of wishes. Clearly the spouse would be a beneficiary of the trust, but so too could children and grandchildren etc. Once within the trust, funds are protected not just from IHT on the spouse’s death, but also from assessment for long-term care funding, future relationships, and bankruptcy proceedings of any beneficiaries.

The trust sits dormant until the settlor dies and the lump sum payments are made. It may, hopefully, never be needed, but, if it is, there is much comfort to be gained from knowing that family wealth is protected.

VAT opportunity for pension funds 

An appeal concerning the charging of VAT to pension funds has been referred to the European Court of Justice (ECJ). A successful outcome for the taxpayer could result in estimated VAT savings of £100 million per year for UK pension funds.

The appeal has been brought by Wheels Common Investment Fund (WCIF) and the National Association of Pension Funds (NAPF). WCIF is a multi-employer scheme which includes a number of Ford Motor Company Limited pension funds and has assets under management of £6 billion.
 
The case concerns the VAT treatment of investment management services supplied to occupational defined benefit pension funds. Under the existing UK VAT law, such services are subject to standard rate VAT when supplied in the UK. As pension funds generally have little or no entitlement to reclaim VAT incurred on investment management services, this creates a significant VAT cost.
 
The point at issue concerns whether the UK has correctly implemented the EU VAT Directive, on which all EU Member States must base their domestic VAT law. HM Revenue & Customs (HMRC) suffered a major defeat at the ECJ in 2007 on  a similar issue in the case of HMRC v JP Morgan Fleming Claverhouse Investment Trust plc (‘JP Morgan’). In that case, JP Morgan was successful in arguing that the management of Investment Trust Companies (ITCs) was exempt from VAT. The ECJ’s judgment forced HMRC to rewrite the UK legislation, not only allowing VAT exemption for the management of ITCs, but also a range of other investment funds. However, despite industry pressure, HMRC refused to extend the exemption to the management of occupational defined benefit pension funds.
 
The ECJ’s final judgment in this latest case is unlikely to be released for 6-12 months. A defeat for HMRC would not only result in VAT savings for occupational defined benefit pension funds going forward, but would also create an opportunity for such pension funds, in conjunction with their investment managers, to submit claims to HMRC for VAT overpaid on investment management services over the past four years.

Action required
As VAT claims are ‘capped’ at four years under UK law and the outcome of this litigation may not be known for some months, many businesses are submitting ‘protective’ claims to HMRC, to prevent loss of entitlement to claim VAT which, in the months to come, will fall outside the four year capping period. Pension funds that have not already submitted a protective claim should consider doing so as soon as possible.
 
The outcome of this case is also important for investment managers providing services to occupational defined benefit pension funds. Should their services become VAT exempt, a restriction on the amount of VAT which they can reclaim on their business expenditure is likely to be suffered, as VAT cannot be reclaimed on costs relating to the making of exempt supplies. Careful consideration of the partial exemption and capital goods scheme rules will be necessary.
 

Passing on your family company 

It is never too soon for owners of family companies to begin planning how they will pass their business on to the next generation. Here are some options.
 
Succession on death
Your shares may now be standing at a considerable gain from when you acquired them, particularly if you have built up your business from nothing (though only the gain since 31 March 1982 is potentially subject to tax). On death this gain will be wiped out, so that no capital gains tax (CGT) charge arises.

On death inheritance tax (IHT) will be charged at 40% on the value of your estate to the extent that it exceeds the nil-rate band of (currently) £325,000. The nil-rate band is augmented by any part of the nil-rate band of your spouse that was not used on his or her earlier death. However, shares in an unquoted trading company will often qualify for 100% ‘business property relief’, so that their value is left out of account altogether.

Making a lifetime transfer of your shares
If you make a gift of your shares during your lifetime (or sell them for less than they are worth) to another individual there is no immediate IHT charge – but if you die within the next seven years all or part of the ‘transfer of value’ will be taken into account in calculating the IHT on death. Again, business property relief may be available in these circumstances.

On a lifetime gift, or transfer at an undervalue, CGT will arise on any gain by reference to the market value of the shares at that time. The gain may be sheltered by capital losses of the same or a previous year, or by any part of the £10,600 annual exempt amount that is not used elsewhere. In most cases the normal rate of CGT on the amount remaining in charge to tax would be 28%, but part might be taxed at 18% if your income for the year was below £42,475 (using 2011/12 figures).
 
‘Entrepreneurs’ Relief’ is available in certain cases where you have an interest of more than 5% in a trading company that you work for. Where the necessary conditions are met the tax rate becomes 10%, subject to a limit of £10 million of gains over an individual’s lifetime.
 
An alternative relief that may be available is a ‘holdover’ relief for gifts of business assets (or transfers at an undervalue), which has the effect that the gain is deferred until a subsequent disposal by the recipient. If that disposal took place on the recipient’s death the gain would be eliminated as explained above, and if it took place on a further gift by them it could again be deferred.
 
A purchase by the company of its own shares
Your circumstances may mean that you cannot simply give away your shares, but need to realise some or all of their value. If your children, or other people you wish to be your successors, already have some shares in the company but do not have the money to purchase your shares, an alternative may be a purchase of your shares by the company itself, provided it has available funds and distributable reserves. The cancellation of your holding will effectively increase the proportion of shares owned by your successors, perhaps to 100%.
 
In general a purchase of its own shares by a company gives rise to a ‘distribution’, taxable as income in the same way as a dividend. However, if certain conditions are met the amount received can instead be brought into account as disposal proceeds for capital gains purposes.  Such a gain may then be eligible for entrepreneurs’ relief, but not for the holdover relief on gifts.

Contact

Paul Renz, Head of Tax

Scott Craig. Partner VAT