Budget 2009: Asset Management - Mazars - United Kingdom

Tax Elected Funds (“TEFs”)

HM Treasury consulted in July 2008 for an elective regime for AIFs that would move the point of taxation from the fund to its investors, who will effectively be taxed (or not) on a similar basis as if they had received the underlying income directly.

The aim of TEFs is mainly to ensure that tax exempt and overseas investors do not suffer a trapped and unreclaimable tax charge on their income and also to simplify the pricing of the funds (combined with simplified voucher requirements).

Draft regulations have now been published to govern those Tax Elected Funds (“TEFs”), to be laid before the House of Commons in July and come into force on 1 September 2009. From that date, promoters will be able to start the formalities to launch new TEFs and convert their existing funds to TEFs, subject to obtaining unitholder approval and any necessary regulatory approval for alterations required by the rules to the scheme literature. It will also be possible to set up TEF and non-TEF sub-funds in the same umbrella fund.

An application for TEF treatment must be made at least 42 days before the establishment of a new fund. The conversion of existing funds/sub-funds will only require 28 days notice before the beginning of the first accounting period to which it will apply.

It will be possible to elect for a fund to be a TEF in one year and an ordinary fund in another year. In the latter case, notice of non-TEF treatment should be given to HMRC before the end of the accounting period and it will cease to be a TEF from the end of that period. As a result, TEF treatment will in effect be revocable, but not retrospectively.

In order to qualify as a TEF, a fund must meet the following conditions:-

A TEF will upstream all UK dividends and returns from REITs or PAIFs as dividends and all other income as interest, payable net or gross according to the same criteria as interest distributions by ordinary AIFs.

TEF treatment may not suit all AIFs. This depends on investor profile, investment strategies (they are not ideal vehicles for property investment), the tax position for overseas dividends (see dividend exemption), and how present systems are coping for existing funds. A TEF and non-TEF version of the same product may sometimes be advisable. The position must be reviewed on a case by case basis.

Chargeable gains and tax-transparent offshore funds

Certain offshore funds are structured as purely contractual arrangements, like Fonds Communs de Placement. Although their underlying portfolios are managed on a pooled basis, they are tax transparent for the purpose of tax on chargeable gains as well as tax on income.

Whereas it is relatively simple for UK investors to identify income by reference to statements sent by the fund manager, it is a major disincentive for those investors to calculate chargeable gains at the level of the underlying investment portfolio.

It is now proposed that for investors subject to Capital Gains Tax, investments made on after 1 December 2009 in such funds will be treated as chargeable assets in their own right rather than on a look-through basis, in the same way as if they were acquiring shares in a company or units in a unit trust. The new rules will however not apply to partnerships, as these will fall outside the offshore funds legislation.

This means that they will acquire a single base cost and will be taxed only on realisation, aligning their CGT treatment with that of opaque funds.

For pre-1 December 2009 investment in such funds, existing acquisition costs relating to the assets held will be carried forward to count as the acquisition cost of units or rights in the fund. It will therefore still be necessary for investors to ensure that they have clear records of these costs. Any additional rights acquired in the same fund after 1 December 2009 will be treated as having a single acquisition cost, within the new, simpler regime.

There will be transitional rules with respect to existing investment in such funds.

With effect from 22 April 2009, investors will also be able to elect for the new treatment to apply retrospectively, all the way back to 2003-2004. Once made, such an election would be irrevocable.

Although this tax treatment is intended to extend to companies, the commencement date for the new regime to apply to these has not yet been fixed, and will be introduced by secondary legislation.

Offshore funds legislation

The 2008 Budget saw the launch of a proposed new regime for offshore funds, for which draft regulations were published in May that year, with a view to replacing the existing regime. Following extensive consultation and draft legislation, the new regime will now have effect from 1 December 2009, with transitional rules for existing fund and grandfathering provisions relating to the definition, so that investors in existing arrangements will not see their investment reclassified as offshore funds.

The reform is on two fronts:-

1. A change in the definition of offshore funds, to “delink” them from the definition of a collective investment scheme in s235 FSMA 2000 and abolish the “7 year rules” which took collective investment schemes outside the scope of the legislation if an investor could not reasonably expect to realise an amount approximate to Net Asset Value within 7 years of investing, based on the arrangement being a mutual fund rather than a collective investment scheme. The new definition is published in the Finance Bill.
2. A reform of the existing regime for qualifying funds, replacing “distributor fund” status with a “reporting fund” status and allowing qualifying funds to invest in non-qualifying funds without a limit, as long as they follow certain rules to report fund returns. This will be introduced by regulations.

The new definition, and its exclusions are shown in the respective tables:-

It is intended that regulations will provide that, subject to conditions, arrangements within the definition of an offshore fund that are tax transparent for income purposes but not tax transparent for chargeable gains tax purposes will be excluded from the charge to tax as an offshore income gain. We will report on the regulations when they are published.

The rights of current investors in a mutual fund which currently does not meet the definition of an offshore fund (e.g. because it meets the 7 year rule) but becomes an offshore fund as defined from 1 December 2009 will be grandfathered.

This means that only investors acquiring interests in that fund as from that date will be affected by the new rules, and existing investors will continue to be outside the scope of the offshore funds legislation, although regulations may be brought in to allow them to elect to be treated as falling under the new regime.

Sub-funds of umbrella funds, as well as different classes of interest in a fund or sub-fund, are treated as separate arrangements.

It is therefore possible to have an umbrella fund where some of the sub-funds will be mutual funds and others will not be. It is also possible, in the same fund or sub-fund to have different rights, some of which will be treated as rights in a mutual fund while others will be excluded by virtue of falling within some of the conditions in Table 2. Apart from the flexibility that this separation affords, it may also facilitate identification for people making investments in the same fund or sub-fund before or after 1 December 2009.

Investment Trust Companies invested in interest-bearing assets

A more tax-transparent regime to prevent tax leakage arising on interest received by an investment trust was consulted on in July, and legislation will be introduced by regulation to take effect as from 1 September 2009

This will move the point of taxation form the investment trust to the investor.

SDRT Schedule 19

The Government has announced that it will not proceed with any reform of the legislation applicable to SDRT for authorised investment funds, despite extensive representations made by the industry on the subject.

The specified transaction list: Investment - management exemption

The March 2008 Budget announced a revamp of the method whereby transactions will be recognised as “investment transactions.” This aims to provide more certainty to the UK managers of offshore funds and make the UK more competitive for global investment management.

A set of regulations came into force on 12 May setting out a list of specified actions, which can be updated with time to accommodate new types of investment transaction if appropriate.

The white list: Distinction between trading and investment

In December 2008, the Government published a discussion paper entitled “Trading and Investment for Authorised Investment Funds” setting out a “white list” of investment transactions which would not be categorised as trading.

The white list will be brought in under new legislation, now published in draft, which will be part of the main Authorised Investment Fund regulations as from 1 September 2009.

The Government has also agreed to extend the white list to equivalent offshore funds, as from 1 December 2008, which will provide more certainty, both for qualifying fund marketing in the UK and for those managed by UK managers.

Both UK and offshore funds will have to be “diversely owned” i.e. they must meet the “genuine diversity of ownership” condition to qualify for the white list.

It should be noted that the rules will not give the opportunity to “financial traders” such as banks, insurance companies or any other business which would otherwise deal in the instruments on the list directly in the course of a trade to shelter profits from tax by routing them through authorised investment funds or equivalent offshore funds. To prevent this, the draft rules provides that where those fund investments do not form part of the financial trader’s stock in trade or are not otherwise fair valued, the trader must nonetheless bring into account any distributions from or fluctuations (realised or unrealised) on those funds as part of its trading profit or loss for tax purposes.

The up to date published white list is for the moment the same as the latest published list of investment transaction which is intended to apply for the purpose of the Investment Management Exemption. It can therefore for the moment be looked up in the same section as the IME list.

It should not therefore be overlooked that two different sets of regulations will apply for each purpose and in theory, there is a potential for them to diverge although there are no obvious practical reasons for their doing so.

Once both sets of rules are in place, as long as they are the same, their overall effect for offshore funds should eventually be as follows:-

1. If a fund effecting those transactions is diversely owned, the transaction on the list should not be treated as a trading transaction and it should not be necessary for it to qualify for the conditions required for the IME

2. If the fund is not diversely owned, those transactions will qualify as investment transactions and it will be possible, subject to meeting other conditions, to obtain the IME.

The specified transactions and white list

This is the specified transactions list now in force for the IME. Under separate sets of regulations, the same trasaction will also constitute the “white list” of non-trading transactions for AIFs as from 1 September and offshore funds as from 1 December.

Charity Authorised Investment Funds

The Government will consult, in conjunction with the Charity Commission and the Financial Services Authority on ways to bring the regulation of charity pooled investment funds more fully under the FSA’s regime whilst preserving their existing tax reliefs.

A new single diversity of ownership condition for QIS, PAIFs, TEFs and the White List 

Eligibility for PAIF status is currently subject to a diversity of ownership conditions, and so is the availability of AIF treatment for QIS as from 1 January, the idea being that wide market prevents tax avoidance vehicles for select groups of investors from using tax favoured treatments intended for bona fide investment funds. At present there are slight variances between the QIS and PAIF rules. As from 1 September, a single set of conditions will apply to the eligibility of all the above.

It should be noted that Condition C is met even if at a point in the accounting period the fund has no capacity to receive additional investments unless

(a) the capacity of the fund to receive investments is fixed by the fund documents (or otherwise) and

(b) a predetermined number of specific persons or specific groups of connected persons make investments in the fund which collectively exhausts all, or substantially all, of that capacity.

The diversity of ownership condition will therefore not be breached by virtue of the fund becoming closed to new investment either temporarily or permanently, as long as this is not due to the fund being de facto a close ended fund in the first place. This allows for situations where commercial practice dictates a hard close or soft-close of certain funds having reached a certain size or refocusing investment strategies, or necessary closes due to market conditions.

If clearance is given for the diversity of ownership condition, clearance for TEF treatment will require only 14 days notice instead of the 28 or 42 days notice applicable to existing and future funds respectively.

Taxation of foreign profits: Dividend distributions paid to AIFs

AIFs, regardless of their size, will, as from 1 July, no longer be taxed on overseas dividends.

Like ordinary companies, they will be able to elect for the exemption not to apply in certain cases. The latter option could be useful in respect of dividends receivable from territories which would otherwise not grant relief from withholding tax under double tax treaties with the UK if the dividends were exempt. The election is very flexible, as it is available on a dividend by dividend basis, and may be made at any time until the second anniversary of the end of the accounting period in which the distribution is received.