The UK's offshore fund tax rules are changing. Subject to the outcome of a final consultation, with effect from 1 October 2009, offshore funds will be able to elect for ‘reporting fund' status.
This article explains the proposed changes to the existing ‘distributing fund' regime and identifies the key issues which offshore funds and their managers should be considering at this time. This will be of major importance in enabling UK resident investors in offshore funds to obtain favourable capital tax gains treatment for their investment in such offshore funds. It should provide for a less burdensome certification process and greater certainty for funds and their investors.
Current Distributing Funds regime
Under the existing regime, unless an offshore fund is certified by HM Revenue & Customs ("HMRC") as a distributing fund, UK investors will be subject to income tax rather than capital gains tax ("CGT") on any gain arising from the disposal of their interests in the fund. Since the current highest marginal rate of income tax of 40% is significantly higher than the flat CGT rate of 18%, obtaining distributing fund status is of crucial importance to most UK individual investors. This importance will increase further in future if the Government's plan to increase the highest marginal income tax rate to 45% with effect from 6 April 2011 is implemented. Distributing fund status is also particularly attractive to UK investment trusts and authorised investment funds, who are exempt from capital gains but not income.
In order to achieve distributing fund status a fund must physically distribute at least 85% of its income (but not generally gains on the sale of investments unless those gains are trading profits). Furthermore a distributing fund may not at any time in an accounting period have more than 5% of its assets invested in other offshore funds that are not themselves certified as distributing funds or capable of being so certified. The fund must make an application to HMRC for distributing fund status each year, and approval is granted retrospectively by HMRC.
New Definition of "Offshore Funds"
The Government proposes to change the definition of "offshore fund" for tax purposes so that the tax definition of offshore fund will be detached from the regulatory definition of ‘collective investment scheme' and will instead follow a "characteristics" based test.
It is intended that the new definition will apply from 1 October 2009 (in tandem with the reporting fund rules), subject to transitional rules. Broadly, from 1 October 2009, "offshore fund" for UK tax purposes will encompass any non-UK tax resident company, trust or other vehicle where the participants do not have day to day control of the management of the property, and a reasonable investor would expect to be able to realise any investment based entirely or almost entirely by reference to the net asset value of the property or an index of any description.
The change in definition should not impact upon offshore vehicles within the current definition of "offshore fund" except in unusual circumstances. However the new definition may bring some offshore vehicles currently outside the scope of the offshore fund rules (such as certain closed-ended vehicles) within scope, and there is currently some uncertainty about the scope of the new rules. The Treasury has provided initial guidance on how the change in definition will apply to certain arrangements. Arrangements which are transparent for income and capital gains purposes will remain outside the scope of the new definition, as will certain capital only arrangements (which do not or would not give rise to income at a fund or individual investor level) and property investment vehicles such as REITs (though not Property Authorised Investment Funds, "PAIFs"). On the other hand, certain fixed capital companies which track net asset value, some unit trust arrangements and exchange traded funds may be caught by the new definition.
Investors in existing offshore arrangements may be affected by the change in definition, particularly where the change results in the vehicle being brought into the offshore funds regime. To prevent existing investors in such funds being disadvantaged by the change in definition, the Government intends to implement grandfathering provisions so that investments made in such funds prior to 1 October 2009 will remain outside the offshore funds rules. Investments made after 1 October 2009 will be subject to new rules. Investors should be aware that different tranches of investment in the same fund may therefore be treated differently for tax purposes depending upon the date of investment.
Offshore funds and their managers will thus need to carefully consider how the change in definition may affect them.
New Reporting Fund Regime
The proposed changes to the offshore fund rules will replace "distributing fund" status with "reporting fund" status. Ultimately the new rules will achieve the same objective as the old, namely to determine the circumstances in which investors in offshore funds can benefit from CGT treatment.
Although some areas of uncertainty still remain (which it is hoped will be dealt with before the legislation is finalised) it is envisaged that the changes will provide for a less burdensome certification process and greater certainty for certain funds and their investors. This should make reporting funds status more accessible to funds which have previously been unable to satisfy the distributing fund requirements and accordingly increase their attractiveness to UK investors. The key changes from the distributing fund rules are as follows:• instead of having to distribute income, funds will be required to report 100% of the income attributable to their investors (with a 10% margin for genuine error). There will no longer be a need to physically distribute income but rather there may be deemed distributions or a combination of physical and deemed distributions. A UK investor in a reporting fund will be taxable on its share of income in the reporting fund whether or not it is actually distributed;
• reporting funds will be required to prepare accounts in accordance with international accounting standards or UK or other acceptable generally accepted accounting practice. Reportable income will then be determined based on the "total recognised income and expense for the period" or its equivalent, adjusted for capital items and certain special classes of income. The capital items to be adjusted are primarily to reflect net gains and losses realised on investments, as determined using the most recent Statement of Recognised Practice relating to authorised investment funds issued by the Investment Management Association. However, the new rules have done nothing to prevent offshore funds from being treated as trading in their underlying investments, and funds will thus have to continue to determine if they are carrying out a trade in their underlying investments for UK tax purposes and, if so, any gains arising will be reportable income. This compares unfavourably with the position for UK authorised investment funds, in particular in light of the recent proposal to legislate a ‘white list' of investments for such funds which would provide certainty and always ensure capital treatment;
• the investment restrictions currently applying to distributing funds will be abolished. This will make it easier for funds of funds to achieve certification as reporting funds. Where a reporting fund invests in other reporting funds it will receive information from those funds to enable it to calculate its own reportable income. Where a reporting fund invests in non-reporting funds (or reporting bond funds) it will either treat that fund as though it was a "notional reporting fund" (if sufficient information is available to make a calculation of its reportable income) or fair value its investment (if sufficient information is not available) which will mean it will record any gain or loss in value over the year as income or loss as appropriate. As a practical matter, however, it may prove administratively complex for some funds of funds to determine their reportable income where they are invested in a wide variety of reporting and non-reporting funds;
• managers of offshore funds will be able to obtain forward looking certification of a fund as a reporting fund which will continue to apply until the fund chooses to leave or is removed from the regime. This is unlike the current distributing fund regime where certification must be sought annually and retrospectively which can cause uncertainty for investors;
• breaches of the rules will not necessarily cause the fund to lose reporting fund status, and it is only where there is a serious breach, or persistent breaches, that this will be the case. This is unlike the current distributing fund rules where a simple breach can lead to loss of distributing fund status;
• there will be transitional provisions, to allow existing distributing funds to become reporting funds, and for investors to continue to receive capital gains tax treatment;
• where a fund moves from being a non-distributing or non-reporting fund to a reporting fund, investors will be able to make an elective deemed disposal of their interest in the old fund. Whilst this may crystallise an income tax charge at the time of the deemed disposal the investor will then become entitled to CGT treatment on an eventual disposal of their interest in the reporting fund.
Offshore funds and investment managers should consider the applicability of the new offshore fund definition and reporting fund proposals to their arrangements. In particular, attention should be given to the benefits of seeking reporting fund status and the necessary conditions and procedures.
David Gubbay is a tax partner in the London office of international law firm, Dechert LLP.
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