Offshore structures for UK domiciled and resident individuals (or companies)
By: Simon Denton

Simple offshore structures have ceased to be effective in reducing taxes due to a raft of anti-avoidance legislation which has now been implemented by most Governments around the world. However, life insurance contracts may be used to 'decontrol' an offshore structure for tax purposes and allow an offshore structure to be most effective in deferring taxes indefinitely. Most governments treat insurance contracts very sympathetically.

Life Insurance Contracts

If the shares of an offshore company are owned by an insurance company and form part of the assets of an insurance contract then applicable attribution rules and anti avoidance laws may no longer apply. The British Inland Revenue have tried to remove some of these advantages by creating rules which attribute 15% of the initial life insurance premium as a capital gain taxable upon the owner of the insurance policy. The 15% deemed gain is then taxable in the hands of the policyholder at whatever rate of tax he is subject to. However, if the policy itself it owned by an offshore company and that company is owned by an offshore trust then the 15% charge would not apply and a tax free structure is created which can be used to indefinitely defer tax even when the beneficial owner of the structure is a UK resident and domiciled individual.

Where substantial assets are being injected into the structure then the 15% annual charge will be a real concern. If the structure is going to be used to hold a start-up company where only very low levels of capitalization are required then the premium can be kept very low so the 15% charge may not be a concern. In those instances the UK taxpayer may directly hold. The following are case studies and clearly illustrate the substantial tax savings that can be enjoyed by UK residents and domiciled individuals.

Case 1 Mr Smith wishes to set up an offshore company to trade goods between China and the US. Mr Smith is UK resident and UK domiciled. This is a start up operation but he will only buy goods when he has sold them so he is in no need of start-up investment. A year from commencement Mr Smith expects to make a profit of £1 million per year. Ordinarily Mr Smith could set up an offshore company in any reputable jurisdiction, arrange for the affairs of that company to be managed by offshore directors and that company could operate completely free from tax. However UK anti-avoidance legislation would attribute the £1 million per annum profits directly to Mr Smith thereby removing any tax advantage achieved.

Solution

As no start-up capital is required Mr Smith could invest the nominal amount of the share capital of the offshore company, say, £2,000 and put this into a life insurance contract. 15% of this initial premium is taxable as a deemed gain and this equates to £300. Presuming Mr Smith's top rate of tax is 40% then this will result in a tax bill of £120 per year. The profits of £1 million per annum can be shielded from tax until such time as they are withdrawn from the offshore company and paid to Mr Smith so effective and indefinite tax deferral is achieved. The undistributed profits of the offshore company can be reinvested into hard assets such as stocks, shares, properties or anything else deemed appropriate.

Example 2

Mr Jones is a UK domiciled and resident individual who currently has a portfolio managed on a discretionary basis by a Swiss bank in Zurich. That portfolio has historically returned 10% per annum thereby producing income of £100,000 per annum upon which Mr Jones pays tax at 40% so his annual tax bill on this income is £40,000.

Solution

Mr Jones arranges for an offshore company (OC2) to be set up which opens accounts with the Swiss bank and the £1 million portfolio is transferred into that account. The shares of that offshore company are then issued to the insurance company and held within the life insurance contract. Once this has been achieved then the £100,000 profits will now accrue to the offshore company instead of Mr Jones. Whilst this profit will not be attributed to himself, ordinarily an amount equal to 15% of the premium of £1 million would be attributed to Mr Jones resulting in a taxable profit of £150,000 per annum which is clearly worse than paying tax on the underlying profits. So to avoid the 15% annual charge on the premium, the life insurance contract is placed into the ownership of an offshore company (OC1) which in turn is owned by an offshore trust.

Tax effect

Whilst the deemed 15% tax charge on the premium may be attributed directly to an individual owner or to a trust set up by that owner and then to the owner the relevant rules do not apply to gains which are the property of a corporation so having the policy owned by an offshore company would not result in any tax charge to Mr Jones and indefinite deferral of tax is achieved. If Mr Jones or Mr Smith were to emigrate from the UK to a tax free or low tax environment before withdrawal then the withdrawal could take place subject to tax only in their new place of residence rather than at UK rates. In this way it would be possible to avoid tax completely.

Reporting

In example 1 a report must be made by the tax payer reporting the deemed 15% capital gain. In example 2, the tax payer would have no requirement to report anything until such time as distribution is received and any such distributions can be delayed indefinitely or timed to be tax efficient. Trustees based outside the UK would, similarly, not be required to report anything to the Inland Revenue in the UK.

To Proceed

The tax advantages offered by life insurance were tested in the case of R V Willoughby which went to the House of Lords. The Law Lords decided that Parliament had created a specific tax regime for life insurance contracts and therefore the taxation of these would remain as is until Parliament legislated otherwise. This would seem to mark the end of the attempts by the Inland Revenue to tax life insurance contracts until distribution of funds out of the same. Similar constructions, as reported above can, in principal, be successfully deployed for residents of Germany, Switzerland, the US and other nations.

Simon Denton
Sovereign Corporation And Fiscal Services Ltd.
Managing Director

Tel: +44 207 389 0555 Ext. 210
Fax: +44 207 930 1151
E-mail: sdenton@sovereigngroup.com
Web: www.sovereigngroup.com