after many aborted attempts, changes to the offshore funds regime, which penalises multi-tiered funds, appear to be back on the agenda
The current offshore funds regime was introduced in 1984 to cut back on offshore investors avoiding income tax charges. In the 23 years since there have been several commercial changes in the offshore funds industry, which means the net effect is multi-tiered funds, such as funds of funds, are penalised.
The problem stems with the tax status of funds. Put simply, certain offshore funds do not qualify for capital gains tax (CGT) taper relief.
This was not a result of the Government actively penalising the funds, but a by-product of its aim back in the mid-1980s to stop investors using offshore funds to reduce their tax burden by converting income into capital gains.
Prior to the introduction of the offshore funds regime, investors could avoid income tax by rolling a fund's income back into the fund rather than paying it out to investors. What we are left with now, however, is the simple fact that the offshore funds regime has become antiquated and has ended up impeding fair competition.
The industry has been campaigning for change for some time and it looked like there would be some progress in 2002 when the Government set up a consultation on the offshore funds industry. The results were unanimous in favour of change.
There was some hope in the 2003 pre-Budget report, when the Government said it was taking forward work to replace the offshore funds tax regime with new rules intended to be included in the Finance Bill 2004.
The new rules, the Government said, would ensure UK resident investors would be charged the same tax on an offshore fund as that of an investor in an equivalent UK fund. But since then there has been silence, until now.
The silence was broken with the publication of the pre-Budget report 2006 in December. In a small easy-to-miss statement, the Treasury announced it would be holding a consultation on the offshore funds regime and multi-tiered funds.
The immediate response was one of welcome. John Riches, deputy chairman of the Society of Trust and Estate Practitioners (Step) says he hopes the consultation would lead to the entire tax system for offshore funds to be overhauled.
Step has been campaigning against the "archaic" offshore funds rules for years and has called for a level playing field between these funds and onshore, regulated vehicles.
Riches says: "If you hold direct equity investments in a regulated fund, then you qualify for ordinary capital gains treatment. However, under the alternative regime for offshore funds brought in in the 1980s, any gains are charged to income tax and not CGT. If a fund does not meet a complicated set of criteria in terms of distribution, it falls within this offshore funds regime and you cannot earn CGT taper relief."
He says that the same situation applies to multi-tiered funds such as funds of funds because, in order to have returns treated under CGT, all of the funds within the fund of funds umbrella need to meet a strict disabling set of criteria on distribution.
Riches adds: "We hope this consultation will end up providing a safe harbour so that multi-tiered and offshore funds can qualify for CGT treatment without having to comply with onerous, unnecessary criteria."
Change is clearly overdue, but what are the prospects of the Government acting in the best interests of the financial services industry? Quite high, it seems.
Back in 2002, the Revenue's consultation document admitted "many of the providers of offshore funds... play a valued role in our economy". The aim of the consultation was to achieve simplification, but also to allow the fund management industry to promote funds without undue compliance burdens.
So what has been holding things up? The industry wants simplification and so, it seems, does the Government. It would make life easier for consumers, too. There is also another issue, according to the Investment Management Association (IMA). The IMA says the existing offshore funds regime is counter to EU law. It says the rules need to be simplified to bring them into line with EU law and has been campaigning hard to get things changed.
The situation may even be contributing to the UK losing fund management business to European rivals, such as Luxembourg and Ireland, in the IMA's view.
As more complex products - such as property funds, hedge funds and Ucits - become popular, the fund managers of these products are choosing to domicile in Luxembourg and Ireland rather than the UK.
According to a report - Taxation and the Competitiveness of UK Funds - published by KPMG in October 2006, the UK is losing out because of perceived and actual tax differences. The IMA-commissioned report has some damning things to say about the UK tax authorities.
The report says: "Investment managers view the UK tax authorities more as an obstacle to, rather than a supporter of, industry development and growth. By contrast, in other fund centres, tax and regulatory authorities are often considered more supportive of the industry, in particular facilitating new developments and innovations. This in turn enables those centres to attract new funds with the related employment and overall economic benefits."
That makes it pretty clear. The Government needs to act positively and quickly to end the inequality of the differing tax treatments created by the offshore tax regime.
Any more delays and it may not just be a question of a few specialist funds suffering, but the whole UK fund management industry could be sent into decline.
The indications are that the consultation period will start in January. Will it lead to the right result? That depends. Hopes were high back in 2002 when the Government set up its last consultation. Nothing has changed since then.
It seems the necessary simplifications to the regime got lost in the sheer weight of Government work. But now it is back on the agenda, the industry is pushing to make sure that this time the changes do happen. It may not be wise to hold your breath while waiting, however.
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