Are Offshore Savings Accounts Safe?

British savers have substantial sums on deposit in offshore savings accounts. But just how secure are these non-UK accounts?

If you're a frequent Fool reader, then you'll know that British banks and building societies have been battling hard to win savers' money. Indeed, we savers are enjoying some of the highest interest rates since at least 2001. This is largely thanks to the Bank of England's base rate being raised five times in a year, plus the knock-on effects of a global credit crunch which has left financial firms desperate for more cash.

As well as the onshore savings-rate battle, offshore banks are also desperately keen to raise money from British savers. Indeed, the offshore rate war has produced some headline-grabbing deals, as shown in the table below:

Offshore savings accounts: rates over 6.50%

Source: Moneyfacts

As you can see, you can earn a mighty 6.55% a year before tax on £5,000 or more at Scarborough Channel Islands, and the same rate on £25,000+ at Kaupthing Singer & Friedlander (Isle of Man). According to Fool partner Moneyfacts, no onshore account pays such a high rate without imposing various restrictions. (We've ignored special-purpose savings vehicles for children or house purchase.)

Around three million UK residents have offshore accounts, with total deposits of £180 billion. But why bother to squirrel your nuts offshore? Why not simply keep your money here in the UK?

It's important to note that it is illegal to hide offshore interest earnings from HM Revenue & Customs. However, some offshore accounts allow you to 'defer' interest indefinitely, until such time as you decide to bring back your money into the UK. In other words, no interest is earned until you repatriate your money, at which point you declare this interest to HMRC and pay any  tax due.

The big advantage from a tax perspective is that an offshore account allows you to `defer' your savings interest. Thus, you can leave interest to roll up offshore in a deferment account where the interest is only paid when you request. Then you only pay tax when you bring the interest back to the UK.

So, if you pay 40% tax now but expect to pay 20% tax when you retire, then you can repatriate your interest after your personal tax rate has fallen. Then again, HM Revenue & Customs is clamping down on overseas tax evasion, and has enlisted the help of offshore regulators, so do tread carefully!

Nevertheless, although the interest rates on these accounts may be attractive, just how secure are the institutions which provide them? Minimum balances for offshore accounts are often £25,000 or more. Thus, a lot could be at risk if, like Northern Rock, an offshore bank got into difficulty. However, the big difference between offshore and onshore saving is the depositor protection on offer.

In the UK, the Financial Services Compensation Scheme (FSCS) has been upgraded in response to the Northern Rock crisis. Today, the first £35,000 of your savings with any single institution is covered in full by the FSCS. So, if a bank was unable to honour its promise to return your money in full, then any shortfall on the first £35,000 would be met by the FSCS.

However, when you head offshore, such as to Guernsey, Jersey or the Isle of Man, you get nothing like the protection which you enjoy in the UK. Indeed, there is no depositor protection whatsoever in Guernsey and Jersey! In the Isle of Man, your money is covered by a scheme under the Banking Business (Compensation of Depositors) Regulation 1991. However, this protection is limited, as only three-quarters (75%) of the first £20,000 of savings with an institution is covered, so the maximum payout is £15,000.

So, given that many offshore savers are wealthy individuals who often maintain very high savings balances, it pays to check the financial strength of institutions outside of the UK. Before handing over your money, ask what depositor protection applies, what an offshore bank's credit rating is, and whether an offshore subsidiary is guaranteed by a UK-based parent. Otherwise, in the (relatively unlikely) event that a non-UK bank comes a cropper, your savings could be in danger!

More: Find ace accounts in our savings centre | What's A Guarantee Worth? | Parents: Make 10% A Year!

Editor's postscript: Kaupthing Singer and Friedlander (Isle of Man) is anxious to point out that its deposits are guaranteed by its corporate parent, Kaupthing Bank.