Unsure About Offshores?

There is a view that investing offshore is only for the professional and the sophisticated: institutions, and high net worth individuals with long acquired or expensively employed expertise on tap. This is not necessarily the case, and I want to explore some of the ways in which this area increasingly makes sense for people with more modest resources.

Originating from the island tax havens of the Caribbean and the English Channel, the term 'Offshore' has now come to be used to signify any jurisdiction that is advantageously different from one's own domestic financial marketplace. So, landlocked Luxembourg, for example, is generically and actually an 'offshore' centre.

It has to be said that some established offshore territories do not inspire confidence, and should be avoided. The British Virgin Islands is known to be a home to high-risk hedge funds, and asset protection trusts of dubious legal standing. Places like Nauru, being virtually unregulated, are magnets for the proceeds of organised crime. However, the ones that are politically stable, and have strong regulatory regimes to protect investors, are readily identifiable. Dublin, Luxembourg, Jersey, Guernsey, the Isle of Man and Bermuda all have these attributes, as well as compelling business reasons to foster reputations as high quality financial centres.

And 'advantageously different' is the thing.

The advantages largely take two forms: a tax-free, or 'tax-lite' regime which reduces the costs on the fund - making increased performance achievable, and a less restrictive regulatory environment.

Let's take a brief look at the regulatory environment.

In the UK, regulations are tightly drawn so as to meet a government-perceived need to protect the inexperienced, the unwary, or the plain feckless consumer - a prescriptive 'widows and orphans' approach. As a result, Fund Managers are restricted as to the classes of assets in which they can invest their clients' money, and are constrained to forego potentially rewarding opportunities. Without the more extreme restrictions, offshore funds are free to access asset classes such as commodities, derivatives and hedge funds. And in this last case, many investors will have been daunted by the barriers to entry posed by high minimum investment levels, while eyeing enviously the 20-30% annual returns hedge funds have been able to pull in. It is this access to a wider range of instruments or currencies that a domestic-only investor misses.

Under the Financial Services and Markets Act 2000, offshore fund managers are restricted in what they are able to market directly to UK investors. However, section 87 of the Act makes provision for certain territories and investment funds to be 'recognised' by the Financial Services Authority (FSA). Through this recognition, the FSA has satisfied itself that the regulations governing the fund provide protection equivalent to that which applies in the UK; in effect, the regulations echo those that apply to UK Authorised funds and their managers.

The funds themselves are structured and operated much like the familiar UK collective investment vehicles, Unit Trusts and Open-Ended Investment Companies; they are subject to formal constitutions, drawn up within the regulations of the local jurisdiction. It is these FSA-Recognised funds that may be directly sold to the public in the UK, and they're what we shall focus on in this piece.

Here is a performance snapshot of some randomly-selected UK funds, and a comparison with the same Managers' offshore equivalents. The tables, from Financial Express Analytics, show standard performance, bid-to-bid, with income re-invested.

UK-Domiciled Funds

FSA-Recognised Offshore Funds

In each case here we see the offshores outperforming their UK cousins over three- and one-year periods. This is a particularly dramatic outcome with JPMF's Asia funds. It's not difficult to imagine that a fund taxed at zero, or even 5, percent is going to grow better than one with a 20% burden, and that the access to UK-prohibited instruments is perhaps having a beneficial effect, too. So what other advantages justify the bother of seeking out such an investment - and where are the downsides?

In short, they have a culture of confidentiality; assets lodged there have a degree of protection; and they widen the scope for tax planning.

While conceding the need for greater degrees of co-operation with onshore authorities, the offshore centres' tradition of protecting investors' privacy still persists. If they are implementing measures necessary to maintain a reputation for probity, on money-laundering for example, and if they are co-operative when there is evidence of criminal activity, they will actively resist any attempts at 'fishing expeditions' on the part of onshore tax authorities.

It is this confidentiality, and an asset repository one step removed from mainstream life, that can protect those who are subject to a risk of litigation: business proprietors, doctors, lawyers and people perceived to have substantial net worth. In our increasingly litigious society, it is not always the person directly causing an actionable event that gets sued. Litigants, maybe even frivolously, are likely to pursue those with loose connections to the chain of events, because they are seen as having deep pockets. And with increasing compensation levels, liability insurance may be insufficient to cover an award. If assets are less clearly identifiable or easy to recover, this can deter such actions, or at least circumscribe losses.

In terms of tax, Recognised funds are classified into one of two categories, and this determines what treatment investors' returns will receive.

The first category is a 'Qualifying', or 'Distributing' fund, which must distribute at least 85% of its income to investors. Distributions are paid gross of tax, and UK investors are left with the responsibility of declaring the income in their annual tax returns. At this stage a 'what's the point, if I'm going to have to pay tax anyway?' question arises. The point is one of cashflow: until the tax is paid, and depending on the timing and frequency of distributions, the money is better off in the investor's account than being deducted at source.

As soon as a holding is disposed of, the matter of capital gains tax (CGT) arises. If the distributing fund has achieved growth over and above the income it has paid out, then the capital gain is declarable for tax. Conversely, a capital loss may be taken into account in an investor's overall CGT computation.

The benefit here is that CGT taper relief and the individual's annual CGT allowance may be applied. And if the holding is split with a non-earning spouse, the reliefs can be doubled.

The second category, logically enough, is 'Non-Qualifying', and better known as a 'roll-up' fund. No income is distributed, the fund's gains being re-invested to augment the value of the investors' holdings. Unlike the accumulation units of UK funds, no attribution of a share in these gains is made to the individual investor, and so no liability to tax is incurred for the duration of the holding.

The interesting part comes when - if - the investment is sold and money is repatriated. The Revenue debars access to the reliefs normally available on capital gains, and classifies the return as an 'Offshore Income Gain'. Effectively, it will be subjected to income tax at the investor's highest marginal rate. Another 'what's the point?' moment, to which the answer at worst is that the exercise has enabled the investor to defer crystallisation of the tax liability until a point chosen by him or her.

But there are other mitigating measures that can be employed here. As before, holdings in the name of a non-earning spouse will lessen the liability. Further, the investor can plan the repatriation to coincide with an anticipated move into a lower tax bracket - upon retirement, say. And if the funds are not repatriated at all - witness the increasing number of people retiring abroad - the UK tax regime can be sidestepped completely.

So maybe it's time for a re-think on offshore investing. It's not the tax-sheltering vehicle it once was, but in terms of access to a wider, better-performing selection of asset classes, privacy and protection, and tax planning, there are still benefits to be had by the well-informed investor.