Funds Investing in Non-Reporting Offshore Funds - Mazars - United Kingdom
Funds Investing in Non-Reporting Offshore Funds
In 2008, the Financial Services Authority (“FSA”) issued a consultation paper proposing greater investment freedom for UK fund managers by allowing non-UCITS Retail Schemes (“NURSs”) or Qualified Investor Schemes (“QISs”) to invest up to 100% of their assets in unregulated retail schemes instead of the existing 20%. This development will bring the possibility of retail “funds of hedge funds” or private equity funds of funds. These rules are now in force.
Whether the structure will be useful now depends on what further amendments will be necessary to the FSA regulations against the background of the Alternative Investment Fund Managers’ Directive. Tax considerations will however have to be factored into any planning for new products made possible by the new FSA regulations.
Rationale for new tax rules
From a tax perspective, unregulated investment schemes are likely to include non-reporting offshore funds. Should this be the case, a fund taking advantage of the new flexibility may be subject to large offshore income gains on realisation of its investments in the scheme. Since those gains would form part of the capital of the fund they would not be distributable and this would result in tax being trapped in the fund.
The new tax rules
In preparation of the new regime, HMRC have released new legislation taking effect from 6 March 2010 which gives separate tax treatment to a new class of fund, namely Funds Investing in Non-Reporting Offshore Funds (“FINROFs”).
FINROFs will not suffer a tax charge on income from investment in non-reporting offshore funds. Instead, UK resident investors in FINROFs (excluding long term funds of life insurance companies, as these are excluded from the effects of the offshore funds legislation anyway) will be charged to income tax on any gain realised on disposal of the units. This will put them in broadly the same position as if they had invested directly in offshore funds.
There appears to be no attraction in this treatment for UK individual taxpayers who could be taxed at the higher rates of 40% or 50% compared with an effective rate of 34.4% resulting from the combination of the 20% rate payable by the AIF and the 18% CGT rate payable on disposal (with proceeds reduced by the tax).
When is a fund treated as a FINROF?
Under the new legislation, an Authorised Investment Fund (“AIF”) will automatically be treated as a FINROF if more than 20% of its gross asset value is invested in non-reporting offshore funds.
Funds which do not meet the definition of a FINROF may elect to be within the new regime (“Elective FINROF”) at least 3 months before the date on which it is intended to be treated as such. This may be attractive where the AIF’s main investors are e.g. life insurance companies, exempt investors like pension schemes or charities, or overseas investors.
Investors may elect, in their tax return for the year in which the fund became a FINROF, to be treated as having disposed of and immediately acquired the units for their market value at the time when it became a FINROF. This would allow them to realise capital gains, taking advantage of the lower rate/Annual Exempt Amount/indexation allowance.
Once an AIF has been a FINROF for at least one accounting period, it can opt out of the regime if it does not hold or stops holding more than 20% of its gross assets in non-reporting funds. Again, investors may elect for their units to be deemed disposed of and immediately reacquired at market value.
Where an AIF inadvertently enters the FINROF regime, it will be treated as never having done so on the condition that it reverts back as soon as possible and makes sufficient disclosure to HMRC.
Is it only relevant for fund managers taking advantage of the new FSA regulations?
Despite the regulatory context in which the tax regulations were introduced, they have a wider application.
Since the regulations took effect as from 6 March, they may be relevant even before fund managers have a chance to restructure under the new FSA rules. For instance, a fund may be invested at more than 20% in regulated schemes (e.g. UCITS or recognised overseas schemes) which do not have reporting fund status. Such a fund would therefore be compliant within existing rules but it would still fall within the definition of a FINROF.
It is also important to make sure that a FINROF is not accidentally created where it is not required and that where it is created, the compliance rules are met in a timely fashion.
Compliance requirements of being a FINROF
If at any stage the AIF becomes a FINROF, the legal owner of its assets is obliged to inform HMRC and the participants of the situation within 3 months or it becoming a FINROF, and to inform participants when exiting the regime. The breach of any of these three requirements could lead to a penalty up to £3,000.
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