Tax-Efficient Investment Case Study
Mr. and Mrs. Smith seek a tax-efficient investment for their capital. They have reorganized their pension plans into one easy-to-monitor Flexible Access Drawdown (FAD) non-resident SIPP. This fits in much better with their eventual retirement in the EU country where they are now residents. FAD allows income withdrawals to vary each year according to how much is required. This avoids taking a set income from an annuity, which may be too high or too low.
The reason for not stating the specific country they live in is that many of the principles are common to many EU countries.
The next task in their financial planning is to restructure their capital investments so that they maximize opportunities and minimize taxation.
They own various assets, including £250,000 in ISAs, £200,000 in a Managed Portfolio Account (MPA), and £300,000 in cash.
Having spoken to a local tax adviser, they are concerned about the following:
- Are the ISAs still a tax-efficient investment in their new home country?
- Capital Gains Tax (CGT) on the MPA and ISAs
- Currency exposure now their home currency is Euros
- Can overall costs be reduced?
- Their UK adviser has told them that he can’t deal with them in the post-Brexit environment due to the removal of ‘passporting’ rights
- Are there any ‘local’ investment products or services that reduce annual taxation?
- Do they need to compromise investment growth in exchange for tax efficiency?
ISAs
ISAs are a highly tax-efficient investment and savings product available to UK residents. They are very popular and offer tax-free withdrawals and a shelter from Capital Gains Tax.
Mr. and Mrs. Smith’s ISAs are currently invested in a range of shares and funds.
Their tax adviser has informed them that despite being tax efficient in the UK, they no longer enjoy the same status in their new home country. In fact, they are now potentially liable to CGT and Investment Income Tax.
MPA
Mr and Mrs Smith’s MPA is invested in a range of regulated investment funds. Although performance has been acceptable, fees appear to be high, and CGT and Investment Income Tax will now apply to gains and dividends.
On closer inspection, they realise they’ve been paying 1% per annum to their adviser for service and administration. This appears rather high, bearing in mind the investment management is outsourced to the MPA provider, who is also being paid 1% p.a. Additionally, annual fund management fees are also relatively high, averaging around 1.25% p.a. They have been researching Exchange Traded Funds (ETFs) and realise they can reduce fees considerably by switching some of their funds in that direction.
The problem is that CGT will be charged when they make their next tax declaration if they switch funds. They have already paid tax on dividend payments from a few of the funds and would also like to avoid this if possible.
Cash Holdings
Mr and Mrs Smith have been living off a combination of drawing funds from their UK bank accounts and rental income from a house they own.
This is working well enough, but exchange rates are penal, and they are concerned about having too much exposure to Sterling. They aren’t especially concerned about the GBP/Euro rate in the long term but have occasionally had to send money to their new home country when rates weren’t favourable.
The solution
In many EU countries, Insurance Bonds enjoy favourable tax treatment. Examples include France, Portugal and Spain, where as long as the particular product meets compliant criteria, gains and income are tax-free or deferred, and income withdrawals are taxed at lower rates than general income.
In some countries, local banks and insurance companies offer this type of product. However, one drawback is that investment choice is limited, sometimes only to ‘guaranteed’ funds. In the low interest rate environment we have experienced for several years, bank and insurance company guarantees are very low and barely keep pace with inflation.
However, any EU country can provide compliant investment products if they meet all local requirements.
As such, Ireland and Luxembourg, which are well-developed financial services industries, have stepped into the market, and various insurance companies now offer a much more sophisticated range of tax-efficient ‘Bonds’.
So, the Smiths can invest in a Bond based in Ireland or Luxembourg and benefit from no CGT or income tax on annual investment growth and ‘gross roll-up’ internally within the issuing country.
This is fine, except that if they have to cash their ISAs and MPA in one go, CGT will be payable when they make their tax declaration.
Thankfully, Ireland and Luxembourg insurance companies have a solution to this. It is possible to transfer funds in specie. This means the funds aren’t cashed in but transferred to the new location. Certain conditions must be met in some cases, but the principle is the same. Funds aren’t sold, so they can be transferred without being liable to CGT.
France and Portugal, for example, can accept any in specie transfer. To be compliant in Spain, the funds must be ‘UCITS’ (Undertakings for Collective Investments in Transferable Securities). If they were to live in Spain, the general tactic would be to move everything that is UCITS registered, then gradually sell the other funds in such a way as to use up annual CGT allowances. Either way, once in the Bond, their portfolios can be managed without the need to pay CGT or Investment Income Tax.
Similarly, and subject to local conditions, income can usually be withdrawn so that a large part is considered return of capital and the rest taxable under income tax rules. So, some tax will need to be paid, but it will be minimised.
Fund choice
Ireland and Luxembourg Insurance Bonds are sophisticated investment platforms that use ‘open architecture’ to manage transactions. Open architecture means a wide range of funds are available, and management is all conducted online.
This means the Smiths can access funds from the entire global market and in multiple currencies. Fund choice includes almost all ETFs available, so they can restructure their investments into lower-cost alternatives that have performed better than their existing holdings that have underperformed and retain those that haven’t.
Their new portfolio can be spread among a range of currencies, which more accurately reflects their currency of daily use and protects them from exchange rate fluctuations.
Cash Holdings
A straightforward solution exists that will reduce their forex costs. A number of specialist currency exchange companies offer much improved rates. In most cases, savings of 2-3% can be achieved. The Smiths don’t want to send all their UK cash to their EU account but see sense in making one large transfer when exchange rates are high.
EU regulated advice
The Smiths now have an EU MiFID-regulated adviser who can take care of administration and investment management.
In addition to using an adviser accountable to an EU regulator, they can reduce overall costs as they now don’t need the services of an MPA manager or their UK adviser. Fees need to be paid to the EU adviser; however, as this company works mainly online and visits clients in person, they don’t need to charge for layers of additional charges created by expensive operational costs. In fact, depending on fund selections and the level of work required, the total cost of advice, investment platform, and funds could be less than 1% p.a.
Actions
After discussing the general strategy with their adviser, they decide to set the plan in place.
- Transfer ISA and MPA holdings into a compliant Bond either in specie and/or by selling underperforming funds if CGT is an issue
- Add £100k to their compliant Bond from their UK cash account
- Restructure their portfolio into a combination of ETFs and ‘Active’ funds, retaining those which have performed well
- Change their currency exposure to 20% Sterling, 50% Euros and 30% US$
- Register for a currency exchange specialist and transfer £100k to their EU bank account, retaining £100k in the UK
- Prepare for future income requirements using Flexible Access Drawdown and withdrawals from their Bond. They have complete flexibility and can ensure they don’t withdraw an amount which would take them into a higher tax band
Summary of tax-efficient investment strategy
Moving country involves much more than just upping sticks and going. Changing financial planning strategy to maximise investment opportunities and minimise taxation is also necessary.
The Smiths achieve this by investing in a locally compliant insurance Bond based in Ireland and managing their income streams more tax effectively.
They hold sufficient cash, which, along with their rental income and consultancy work, enables them to meet their pre-retirement living costs. When they decide to fully retire, they can draw on their Bond, state pensions, and non-resident SIPP.
Managed correctly, they won’t run out of income in their lifetime, and their capital reserves should be preserved long enough for them to pass their wealth onto their children.
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