New UK Investment Trust Company Tax Regime - Final Regulations

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1 Tax and investment funds e-bulletin Tax and investment funds e-bulletin 10 November 2011 New UK Investment Trust Company Tax Regime - Final Regulations The Investment Trust (Approved Company) (Tax) Regulations 2011 (the Regulations) have been published. Once the Regulations have been approved by Parliament the process of the modernisation of the investment trust company (ITC) tax regime will have been completed. Corresponding changes are to be made to the Companies Act 2006 provisions relating to investment companies. The Regulations confirm that the new regime will take effect for accounting periods beginning on or after 1 January As with the publication of the draft regulations in May of this year, it is pleasing to note that the Government has taken on board comments received from the industry. ITCs are exempt from UK corporation tax on their chargeable gains, but generally pay tax on income. The conditions for approval as an ITC under the new tax regime remain as summarised in our previous bulletin on the draft regulations (available here). A reminder of the conditions under the new regime can be found below. The new regime should make the ITC vehicle significantly more attractive for certain investment strategies. Conditions for approval as an ITC under new tax regime from 1 January The business of the company must consist of investing its funds in shares, land or other assets with the aim of spreading investment risk and giving members of the company the benefit of the results of the management of its funds (Condition A) The shares making up the company's ordinary share capital must be admitted to trading on a "regulated market" (Condition B) The company must not be a venture capital trust or a REIT (Condition C) The company must not be a "close company" at any time during any accounting period (close company condition) The company must not retain more than 15% of its income (regardless of source) for any accounting period (in other words, it must distribute at least 85% of its income for the period) (income distribution condition) Contacts Tax Bradley Phillips Ben Roberts Senior associate Investment funds Nigel Farr Scott Cochrane Thiha Tun Tim West Related links Herbert Smith website More Herbert Smith tax publications Herbert Smith news Changes in the final Regulations A number of changes have made it into the Regulations. Deemed satisfaction of "spread of risk" and "trading on a regulated market" conditions winding up The regulation which provides that an ITC in the process of being wound-up will still satisfy the ITC conditions (provided no "new investments" are made) has been amended in a number of helpful ways, following input from interested parties (including Herbert Smith): The ITC will now be deemed to meet both the "spread of risk" (Condition Page 1

2 Tax and investment funds e-bulletin A) and the "trading on a regulated market" conditions (Condition B) during the "realisation period" The "realisation period" now lasts from the commencement of the winding up to completion of the winding up (rather than a maximum period of 1 year from commencement of the winding up) (provided that HMRC are satisfied such period is not being "unreasonably prolonged") Excluded from the definition of "new investments" (which would defeat the 'deemed' satisfaction of Conditions A and B) are both the placing on deposit of proceeds of disposal of the ITC's assets, and the investment of such proceeds in gilts Breach of the "eligibility conditions" The draft regulations did not appear to set out the consequences of a breach of Conditions A to C. In the final Regulations it is made clear that breach of one of these conditions will result in the company losing ITC status for the accounting period in which the breach occurs and (unless a fresh application for ITC approval is made) all subsequent periods. Disposal by an ITC of interest in non-reporting offshore fund As an ITC is generally subject to tax on income, it would be subject to tax on a disposal of an interest in a "non-reporting" offshore fund (an NRF) (as any gain on such a disposal would be re-characterised as an "offshore income gain" under the UK's offshore funds rules). If the following conditions are met throughout the period of ownership, a disposal on or after 1 January 2012 by an ITC of an interest in an NRF will not give rise to a (taxable) offshore income gain: The ITC must have access to the accounts of the NRF The ITC must have had sufficient information about the NRF to enable the ITC to prepare reportable income computations for the NRF (had it been a reporting fund) The ITC has prepared such reportable income computations Any excess of the ITC's share of the reportable income of the NRF over the ITC's share of the distributions made by the NRF is included in the amount available for distribution by the ITC for each accounting period of the ITC during the period it has owned the interest in the NRF The Regulations also provide that an ITC which has an interest in an indextracking NRF is not charged to tax under the UK offshore fund rules. It will be required that throughout the period of ownership of the NRF, the ITC's investment policy is to replicate the performance of a "qualifying index" and the investment in the NRF is in line with such investment policy. Broadly, a "qualifying index" is an index based solely on the value of securities listed on a recognised stock exchange or admitted to trading on a regulated market. Comment Since the ITC consultation was launched in July 2010, it has been clear that the new ITC tax regime would on the whole be a welcome development for the industry. The Government has listened to the views of the industry so that initial concerns with the new regime have been addressed. The new conditions for approval and new "white list" of non-trading transactions provide greater flexibility in terms of the investment strategies that can be operated through an ITC. In addition, the new administrative regime for seeking approval as an ITC is largely welcome. We look forward to publication of HMRC guidance on the new regime. The Regulations can be found here To subscribe or unsubscribe To enquire about further publications or to unsubscribe from this e-bulletin, please us, or visit the Herbert Smith website here. The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication. Page 2

3 Tax and investment funds e-bulletin Herbert Smith LLP, Gleiss Lutz and Stibbe are three independent firms which have a formal alliance. Herbert Smith LLP 2011 Page 3

4 Tax and investment funds e-bulletin 25 May 2011 New UK Investment Trust Company Tax Regime Draft Regulations Published The draft investment trust company (ITC) regulations (the Regulations) have been published. They provide further detail as to how the new UK ITC tax regime will look. The Regulations indicate that the Government has listened and responded positively to industry feedback on the original proposals. Importantly, the Regulations do not contain any nasty surprises and the Government has not sought to change the close company and income retention tests as some had initially feared. Going forward, ITCs may well prove to be a popular and flexible investment structure. On the key issues of conditions for approval and the new "white list" of non-trading transactions for an ITC, the Regulations are largely as expected. The Regulations are described as being 'near final', although there is still an opportunity to make comments which are due by 24 June The Regulations will take effect for accounting periods commencing on or after a date still to be confirmed. It is expected that this will either be late in 2011 or early Background ITCs are exempt from UK corporation tax on their chargeable gains, but generally pay tax on income. The recently introduced 'streaming regime' has made ITCs more competitive, by allowing interest income to pass through an ITC free of UK tax in the hands of the ITC. In July 2010, the Government commenced public consultation to further enhance the attraction of using an ITC structure and subsequently published a Summary of Responses to the consultation which indicated it was listening to industry feedback. The Government's proposals were largely welcomed as it was clear that they would allow for a wider range of investment strategies to be operated through an ITC as well as remove some of the administrative burdens encountered when seeking approval as an ITC. With the publication of both draft Finance Bill (No.3) clauses and now the Regulations, it is possible to understand with greater certainty how the new regime will look. Links to our previous e-bulletins can be found here, here and here. The conditions for approval Contacts Tax Bradley Phillips Ben Roberts Senior associate Investment funds Nigel Farr Scott Cochrane Thiha Tun Tim West Related links Herbert Smith website Herbert Smith Investment funds homepage Herbert Smith tax homepage Herbert Smith publications Herbert Smith news The Finance Bill (No.3) (Royal Assent for which is expected some time in July) introduces the three principal conditions for ITC status under the new regime (referred to in the Regulations as the "eligibility conditions"). They are as follows: the business of the ITC must consist of investing its funds in shares, land or other assets with the aim of spreading investment risk; the shares making up the ITC's ordinary share capital must be admitted Page 1

5 to trading on a regulated market; and the company must not be a venture capital trust or a UK REIT. The Regulations add two further (but anticipated) requirements that must be satisfied in respect of each accounting period of the company for which ITC status is sought. They are: that the ITC must not be a "close company" at any time during the accounting period; and that the ITC must not retain more than 15% of its income (regardless of source) for any accounting period (in other words, it must distribute at least 85% of its income for the period). The income retention test will not apply if it would require a distribution of less than 30,000 (the current rules specify a 10,000 de minimis). Close company test The Regulations do not provide a definition for "close company". It is therefore assumed that the term takes the general definition for UK corporation tax purposes, broadly that the company is controlled by 5 or fewer participators (and therefore retains the meaning it currently has under the existing regime). This is welcomed, as the original proposals for modernisation of the ITC regime had indicated that the current 'exception' to the close company rules where at least 35% of voting shares are held in public hands would be removed (although in December 2010 the Government confirmed that any changes to the close company test would be limited to ensuring that "very small" groups of investors cannot take advantage of the rules). Other conditions What is surprising is that the Regulations do not prohibit an ITC from distributing its capital profits. The current ITC regime contains a requirement that an ITC's memorandum or articles of association must prohibit the distribution as a dividend of surpluses arising from the realisation of investments. Under the original modernisation proposals announced in July 2010, this requirement was to be updated to a simple prohibition of distributing "capital profits". In December's Summary of Responses, the Government confirmed that this requirement would not remove the ability of ITCs to effect share buy backs or redemptions, and at the same time acknowledged that certain respondents (including ourselves) had queried the need for this prohibition at all. The removal of the prohibition is a further welcome development. Conditions for approval as an ITC under new regime: The business of the ITC must consist of investing its funds in shares, land or other assets with the aim of spreading investment risk ("Condition A" of eligibility conditions) The shares making up the ITC's ordinary share capital must be admitted to trading on a regulated market ("Condition B" of eligibility conditions) The company must not be a venture capital trust or a UK REIT ("Condition C" of eligibility conditions) The ITC must not be a close company at any time in the accounting period The ITC must not retain more than 15% of its income for any accounting period Application process Under the new regime, an application for approval as an ITC must be made in writing to HMRC, to be received within 90 days after the end of the first accounting period of the company for which ITC status is sought (AP1). HMRC will respond within 28 days of receipt of the application, either rejecting or accepting the application, or requesting further information before a decision is made. If the application is accepted, the applicant will be treated as an ITC for AP1 and for each subsequent accounting period (subject to serious breaches, on which see below). An appeal may be made to the tribunal within 42 days of rejection by HMRC. The application must: Page 2

6 specify the start of AP1; contain a statement that the applicant meets (or is expected to meet) the eligibility conditions and also those additional requirements introduced by the Regulation for AP1; contain an undertaking that the applicant will meet the conditions / requirements for AP1 and for subsequent accounting periods; enclose a copy of the applicant's current published investment strategy; and provide evidence to show that the applicant's ordinary shares are admitted to trading on a regulated market. Applications can be made in advance of the start of AP1, by specifying a provisional start date with confirmation of the actual start date as soon as reasonably practicable afterwards. Applications can also be made prior to admission of the applicant's ordinary shares to trading on a regulated market, provided the application explains how admission will have taken place by the start of AP1. In this case, a copy of the applicant's prospectus may be enclosed rather than the published investment strategy. Evidence of admission to trading will be required within 60 days of admission. Deemed satisfaction of "Regulated Market" condition The Regulations provide for two situations in which the ITC's ordinary shares will be deemed to be admitted to trading on a regulated market: If on the date of application for ITC approval, the applicant has either (i) commenced procedures for admission to a regulated market, or (ii) given a commitment in its prospectus to commence procedures for admission to a regulated market. In this case, the regulated market condition will be deemed to be met for a period of 60 days from the date of application. If an ITC which has previously satisfied the eligibility conditions is being wound up, then provided it makes no new investments during the period starting when the winding up commences, and ending after 1 year or, if earlier, when the winding up is completed (the "realisation period"), the regulated market condition will be deemed to be met for the realisation period. Breaches of conditions The Regulations set out the consequences of a breach of the requirements which must continue to be met once approval of ITC status has been granted under the new regime. Breach of the eligibility conditions (Conditions A, B and C) does not appear to be dealt with, though it is not clear whether this is intentional or not. A breach is classified as either a "minor" or a "serious" breach. A minor breach is one for which there is a reasonable excuse, which is inadvertent and corrected as soon as reasonably practicable. If a minor breach is notified to HMRC as soon as possible and is corrected by the ITC as soon as reasonably practicable without HMRC intervention, it is not regarded as a breach. However any breach of the close company condition will be a "serious" breach, regardless of whether reasonably excusable, inadvertent or corrected without delay. A minor breach will not result in the loss of ITC status. However: three separate minor breaches within a 10-year period, in respect of the same requirement, or four separate minor breaches within a 10-year period in respect of different requirements will see the third or fourth breach (as appropriate) classified as a serious breach. The consequences of a "serious" breach, if HMRC give written notice to the ITC of such breach, are that the ITC will lose ITC status for the accounting period in which the serious breach occurs and (unless a fresh application for ITC approval is made) all subsequent accounting periods. "White List" of non-trading transactions Page 3

7 The Regulations introduce the 'white listed' transactions, profits from which will be treated as investment transactions and therefore within the chargeable gains exemption for ITCs. Any transactions not within the white list should not taint the 'white listed' transactions. As expected, no further additions have been made to the white list (summarised below) and accordingly it mirrors that introduced in 2009 for AIFs. ITC "white list" transactions: stocks and shares "relevant contracts" (options, futures, contracts for differences) which result in an ITC becoming party to a loan relationship (or a related transaction) units in a collective investment scheme securities of any other description consisting in the buying or selling of foreign currency carbon emission trading products Impact on existing ITCs The Regulations contain no transitional, or 'grandfathering' provisions. As it now appears that no existing ITC would be adversely affected by the new regime, there would seem to be no need for grandfathering rules. Comment As mentioned above, the Regulations contain no adverse surprises. As promised in the December 2010 Summary of Responses, the Government has been true to its word and accordingly there will be no change to the close company test and the income retention requirement will remain 15% of the income of the ITC. The removal of the prohibition on distributing capital profits gives even greater flexibility for ITC structures. As a result, it remains our view that the proposed new ITC regime should serve to significantly increase the attraction of the ITC for certain investment strategies. Draft guidance on the new regime will hopefully provide further clarity on how the new regime might work in practice and we look forward to its publication in due course. In the meantime we would encourage interested clients to make further comment on the Regulations by 24 June Please contact us if you would like assistance in making comments to HMRC. The draft regulations can be found here. To subscribe or unsubscribe To enquire about further publications or to unsubscribe from this e-bulletin, please us, or visit the Herbert Smith website here. The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication. Herbert Smith LLP, Gleiss Lutz and Stibbe are three independent firms which have a formal alliance. Herbert Smith LLP 2011 Page 4