Offshore funds. Important tax changes a summary. March 2010

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1 Important tax changes a summary March

2 Important tax changes - a summary Why should I read this briefing? This briefing summarises fundamental changes to the taxation of both offshore funds and investors in offshore funds. All of these changes are already in force, with effect from 1 December 2009 or for accounting periods beginning on or after 1 December The changes mean that the status of funds (existing and new), their location and how they return profits to investors should be reassessed. Background The offshore funds rules are designed to prevent UK tax residents rolling up investment income in an offshore fund, without suffering UK tax on income, and then selling an interest in the fund, giving rise to tax on capital gains (which, for individuals, is currently and has in recent history been at a much lower rate than income tax). Broadly, the rules charge such gains as income where an investor disposes of an interest in an offshore fund that does not meet one of a series of exemptions. The most important exemption has been where the fund is a distributing fund (broadly, a fund that distributes at least 85% of its UK-equivalent profits). Individuals are (and until recently companies were) taxed on the distributions received from a distributing fund, so that the mischief above was materially avoided. The offshore funds rules and the rules on the taxation of investors in offshore funds have been reformed. Certain changes were made in Finance Act The Offshore Funds (Tax) Regulations 2009 (the Regulations ) were made on 12 November 2009 and came into effect on 1 December HMRC have issued draft guidance on the Regulations. The key changes include: a new tax definition of an offshore fund ; a new system of taxation of foreign dividends; a new concept of a reporting fund to replace that of a distributing fund; and a new approach to capital gains for contractual transparent funds. This briefing summarises each of these in turn and explains why they matter and what further action should be considered. New Definition of offshore fund Mutual Fund An offshore fund will no longer have to be a collective investment scheme within the FSMA 2000 definition. Instead there will be a characteristics-based test, so that each of the following will be offshore funds: a. a mutual fund constituted by a body corporate resident outside the UK; or b. a mutual fund under which property is held on trust for participants by trustees resident outside the UK; or c. a mutual fund constituted by other arrangements that create rights in the nature of co-ownership where the persons managing the property are resident outside the UK and the arrangements take effect under a non- UK law (but excluding any trade or business carried on in partnership). A mutual fund will comprise arrangements with respect to property, including money: a. whose purpose or effect is to enable participants to participate in the acquisition, holding, management or disposal of property, or to receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of the profits or income; b. whose participants do not have day to day control of the management of the property; and 2

3 c. where a reasonable investor participating in the arrangements would expect to be able under the terms of the arrangements to realise an investment in the arrangements on a basis calculated entirely or almost entirely by reference to the net asset value of the property that is subject to the arrangements or to an index of any description 1. This characteristics-based approach is intended to stop funds that economically behave like offshore funds, but which did not formerly meet the technical FSMA 2000 definition of a collective investment scheme, avoiding the offshore funds rules. Removal of the Seven Year Rule The seven year rule in the old definition of material interest (in an offshore fund) 2 has been removed. Instead there will be an interest in an offshore fund if a reasonable investor would expect to be able, under the terms of the arrangements, to realise an investment in the arrangements on a basis calculated entirely or almost entirely by reference to: a. the net asset value of the property that is the subject of the arrangements; or b. an index of any description. Under transitional rules, a UK investor with an existing investment that is not a material interest in an offshore fund under the old legislation (e.g. because of the seven year rule) will not have an interest in an offshore fund under the new legislation. However investors acquiring a similar interest in an offshore fund on or after 1 December 2009, when the new definition will take effect, will be subject to the new legislation. Does any of this matter? Closed ended funds can now more easily fall within the offshore fund rules. In many cases they were not within the offshore fund rules under the old legislation either because they were not collective investment schemes under the FSMA definition (and so they were not offshore funds) or because there was no realistic possibility of realising the value of the investment during the period of seven years from the making of the investment (so that there was no material interest in an offshore fund). A provision that the fund would be liquidated after eight years with no earlier return to investors could prevent a fund falling within the old offshore fund rules on either of the above grounds, but an interest in such a fund could be an interest in an offshore fund under the new rules. Taxation of Distributions Finance Act 2009 has fundamentally changed the taxation of foreign dividends. Individual investors can now obtain a deemed tax credit on all foreign company dividends from offshore funds, so that their tax treatment will mirror that for the receipt of UK company dividends. The deemed tax credit gives an effective rate of tax at 25% on distributions for higher rate taxpayers and (from 6 April 2010) 36.1% for additional rate taxpayers (rather than 32.5% and 42.5%, respectively, without the credit). This change applies to actual dividends and to reported income (see Reporting Fund Status below) received by UK tax resident individuals from offshore funds on or after 1 July 2009 provided that: the offshore fund is, broadly speaking, corporate in form; and the offshore fund is not a bond fund (i.e. not more than 60% of the value of the offshore funds investments are not in bond-like instruments). Corporate investors will obtain an exemption from tax in respect of distributions from the offshore fund provided that certain detailed conditions are satisfied 3. Again, the offshore fund must be in corporate form and not be a bond fund. This exemption produces the tension that 1 There are exceptions where a reasonable investor would expect to be able to realise an investment only in the event of a winding up, dissolution or termination of arrangements, subject to restrictive further conditions. 2 An investor had a material interest in an offshore fund if it could be reasonably expected that the investor would be able to realise the value of his interest within seven years from the date of his acquisition of that interest. 3 If any investors are small companies, it should be noted that the exemption from corporation tax on distributions will not apply if, broadly speaking, the offshore fund is resident in a jurisdiction having double tax treaty with the UK containing no non-discrimination article (this includes many tax haven jurisdictions). 3

4 Important tax changes - a summary corporate investors would want their profits in the form of distributions which are exempt, rather than as capital gains which are taxable at 28% for corporate investors paying corporation tax at the mainstream rate, whereas individual investors might prefer capital gains, which are taxable at the lower capital gains tax rate. Distributions from an offshore fund which is a bond fund are treated for tax purposes as interest receipts, rather than as distributions. Does any of this matter? There is a clear attractiveness in an offshore reporting fund with UK tax resident investors being a corporate entity (or otherwise structured such that reported income is for tax purposes a distribution from a company) so that corporate investors can obtain tax exemption for distributions. If the offshore fund has a material amount of UK corporate investors (both small and large) and is not a bond fund, it may be preferable for the offshore fund to be in corporate form and to consider restructuring so as to provide, if possible, the maximum return to corporate investors by way of distributions (which are generally exempt) rather than by way of redemptions (which can be taxable). In this connection, the following questions should be considered for all existing and new offshore funds where there are material UK tax resident investors: a. Who are the important UK investors in the offshore fund and can they obtain the deemed tax credit (where they are individuals) or the exemption (where they are companies)? b. Should the offshore fund be established in, or convert to, corporate form (where it is not in corporate form already)? c. If there are investors that are small companies, should the offshore fund relocate to ensure that distributions received by them will be exempt from corporation tax (see footnote 3 on previous page)? d. Should the offshore fund restructure the manner in which profits are returned to investors (e.g. corporate investors obtain all profits by way of distribution)? Reporting Fund Status Reporting fund status will replace distributing fund status for accounting periods beginning on or after 1 December A reporting fund need not actually make distributions, but will have to report its reportable income, and investors will be taxed on (a) dividends actually received; and (b) the difference between the amount actually received and the reported amount. Under transitional rules, offshore funds can continue the old distributor status for a straddle period plus one extra period (provided that the extra period does not end after 31 May 2012). Accumulating funds will be capable of being reporting funds. For the purposes of calculating reported income, any profits covered by the new white list will not constitute trading profits. The benefit of the white list will only be available where the fund is a reporting fund and: is a UCITS fund or is FSA-recognised within the meaning of Sections 264, 270 or 272 FSMA 2000; and can satisfy a genuine diversity of ownership condition (which broadly mirrors that for Authorised Investment Funds and in respect of which HMRC can give clearance). An offshore fund can apply to HMRC for reporting fund status for accounting periods beginning on or after 1 December The application must be received by HMRC before the expiry of a period of three months beginning with the first day of the first period of account for which it is proposed that the offshore fund will be a reporting fund. The application must contain specified information and be accompanied by the fund prospectus or proposed fund prospectus. 4

5 A reporting fund has the following key ongoing duties: a. to prepare accounts in accordance with IAS or in accordance with the GAAP specified in the application; b. to provide a calculation of reportable income; c. to prepare statement of the excess of the amount of the reported income per unit of interest in the offshore fund for the reporting period over the amount actually distributed per unit of interest for the reporting period; and d. to provide reports to participants and information to HMRC. Does any of this matter? It will be critically important to UK investors in offshore funds whether the fund is a reporting fund. A number of advantages and disadvantages will need to be weighed up. Advantages a. If a UK resident individual investor invests in a reporting fund, his rate of income tax on actual or deemed distributions will be an effective rate of tax at 25% (for higher rate taxpayers) or 36.1% (for additional rate taxpayers from 6 April 2010) where the offshore fund is, broadly speaking, in corporate in form and not a bond fund. A corporate investor can obtain an exemption for the distribution provided that the detailed conditions are met. If the fund is a non-reporting fund, it is likely that the fund will roll-up the income and that income will be converted into an offshore income gain taxed at 40% (for higher rate taxpayers) or 50% (for additional rate taxpayers from 6 April 2010) or 28% for a corporate investor paying corporation tax at the mainstream rate. b. There will be an advance clearance procedure to allow funds to gain access to reporting fund status. This will give more certainty to investors compared to the current rules for distributing funds where approval is only given retrospectively. There is also more convenience to the fund since reporting fund status is applied for once whereas distributing fund approval is applied for and obtained separately for each and every period of account in which it is required. c. There is also greater certainty for investors in terms of HMRC taking a flexible view of when conditions are breached. The intention is that, where a breach is minor and remedied without undue delay, no adverse consequences will arise. Disadvantages a. The reported amount should, broadly, be all income profits (although a margin of error of up to 10% of income profits is permitted in certain limited circumstances). This is less favourable than the current 85% test for distributing fund status that it replaces. b. Investors electing for capital gains treatment if the offshore fund converts from a non-distributing fund to a reporting fund will be chargeable on the crystallised offshore income gain at that time as the price for obtaining the lower rate of capital gains tax on disposal proceeds of shares in the offshore fund. c. Reporting requirements may be burdensome. d. Many hedge funds that are offshore funds will be trading. If they have to report all their trading profits as reportable income there will be less incentive for them to be reporting funds. All profits covered by the white list will not be trading profits, which should cover many transactions and instruments effected by hedge funds, but to benefit from the white list it will be necessary for the hedge fund to be a reporting fund, to satisfy the genuine diversity of ownership condition and to be a UCITS fund or to be FSA-recognised as described above, which may well not be the case for many hedge funds. Extra care is therefore needed. Any existing or new fund should decide whether to become a reporting fund. The following questions should be considered (in addition to those on page 4): 5

6 Important tax changes - a summary a. Is the offshore fund trading, and if so: (i) do the transactions/instruments entered into by the offshore fund fall within the white list? (ii) does the offshore fund satisfy the genuine diversity of ownership condition? (iii) if not, what changes would be needed and are they viable, and should HMRC advance clearance be sought? b. What will the reported income look like and will profits from the transactions/instruments be treated as capital items in the offshore funds account? c. When will income be reported (the deemed distribution is treated as made when the report is issued to investors, provided that it is issued within six months of the end of the reporting period, so it may be advantageous to delay issuing such report until the latest possible time)? d. Will it be best for an existing distributing fund to apply for reporting fund status as soon as possible, or to defer application and retain distributing fund status for as long as possible under the transitional rules (and with that in mind will a change to the accounting period of the fund be beneficial)? e. What should investors be told (including any decision changing the status of the fund, the tax effect and the consequent tax decisions that they will need to make)? Transparent funds Offshore arrangements (e.g. Baker style offshore unit trusts) which are transparent for income purposes but not for capital gains purposes are included in the definition of offshore funds, but interests in such unit trusts will generally (but not always 4 ) be exempt from the offshore income charge. The Finance Act 2009 provides that individual investors in contractual transparent funds such as FCPs (but excluding partnerships) can elect for the fund to be treated like a company for capital gains tax purposes. We would be pleased to discuss in more detail any of the issues summarised above and to help advise on any reassessment of existing fund structures or on the optimum structure for a new fund. 4 For example, if a transparent fund holds an investment in a non-transparent non-reporting fund that represents at any time more than 5% by value of such fund s assets, then the offshore funds rules imposing a charge to tax on income can arise on disposal of interests. 6

7 Contacts Nicholas Noble Partner t: +44 (0) e: Andrew Prowse Senior Associate t: +44 (0) e: 7

8 Important tax changes - a summary This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. Copyright Field Fisher Waterhouse LLP All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Law Society. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word partner to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications. 8