HMRC Consultation Modernising the taxation of corporate debt and derivative contracts

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1 2 September 2013 Andy Stewardson HM Revenue and Customs Room 3C/ Parliament Street London SW1A 2BQ Be Dear Andy HMRC Consultation Modernising the taxation of corporate debt and derivative contracts IMA represents the asset management industry operating in the UK. Our members include independent fund managers, the investment arms of retail banks, life insurers and investment banks, and the managers of occupational pension schemes. They are responsible for the management of around 4.5 trillion of assets, which are invested on behalf of clients globally. These include authorised investment funds, institutional funds (e.g. pensions and life funds), private client accounts and a wide range of pooled investment vehicles. Our response is focussed primarily on the proposals contained in chapter 13 on bond funds and the corporate streaming rules. The consultation document states that both the loan relationships rules on bond funds and the corporate streaming rules are anti-avoidance legislation designed to prevent corporates from benefitting from the lower rate of corporate tax paid by UK funds. In fact both of these rules serve a wider purpose, which is to ensure that corporates are treated in the same way if they hold debt instruments through a fund than if they hold it directly. We agree that the current rules are complex and difficult to operate in areas and acknowledge that in the past the rules have been exploited. We also acknowledge the significant benefits of simplification in the proposals, but we are concerned that the wider purpose of the existing rules is disregarded. Our members have highlighted the risk that by creating differences between the tax outcome of investing through funds and investing directly, large institutional investors (such as life companies) will prefer to hold assets directly, rather than through funds, thereby foregoing wider benefits of collective investment. 65 Kings way London W C2B 6TD Tel: +44(0) Fax: +44(0) w w w. i n v e s t m e n t u k. o r g Investment Management Association is a company limited by guarantee registered in England and Wales. Registered number Registered office as above.

2 In particular, in the hands of life company investors, the repeal of the corporate streaming rules could create a distorting tax cost at the level of the fund. Such a tax cost would not arise had the life company made an investment directly, or in an offshore fund. This could reduce the competitiveness of UK funds and could lead to the UK losing ground as a fund domicile a risk highlighted in the Government s Investment Management Strategy report. Life company investment in UK funds represents a significant proportion of total investment in funds. Our figures show that about 30% of gross sales of UK funds were to life companies last year. We therefore urge HMRC to consider carefully with the industry what measures might be introduced to address these concerns. Our responses to the questions in the consultation document are in the appendix. We address only the questions in chapter 13. If you require any further information, please do not hesitate to contact us. Yours sincerely, Jorge Morley-Smith Director, Tax Cc. Rosalind Moss, Head of Fund Taxation, HM Treasury Jonathan Rushforth, Head of Asset Management and Investments, HM Treasury John Buckeridge, HMRC Collective Investment Schemes, CTIAA 2

3 Appendix 1: IMA responses to consultation questions in chapter 13 Q13.1 Overall, would you support the proposed reform of the bond fund rules in Chapter 3 of Part 6 CTA 2009, and why? No. The bond fund rules ensure that corporate investors in debt instruments are treated in the same way if they are invested through a UK fund, or invested directly in the underlying assets. We agree that in many cases corporate investors are treated in similar ways irrespective of the bond fund rules. There are however two significant departures from this: the ability to get relief for losses in holding assets, and the tax treatment of life companies holding authorised funds under section 212 TCGA (the annual deemed disposal). Achieving equivalence of tax treatment for investors is a cornerstone of the taxation of funds. Whilst necessarily there are areas where this is difficult to achieve, the overwhelming response of IMA members is that the equivalence in treatment for corporate investors that is afforded by the bond fund rules is critical in deciding whether to invest through funds or directly. A departure from this principle would be detrimental to the competitiveness of UK funds. We agree that the current rules are difficult to operate and monitor at times. Therefore we favour a simplification of the bond fund rules. There are two parts of the current rules that we believe could be simplified. The requirement to monitor a fund s assets daily is a particularly burden. Not only in terms of administrative cost of the daily monitoring of assets, but also in terms of the risk of inadvertent and unintended breaches of the 60% test. We favour re-examining this requirement, with a view to possibly bringing into line with the test a fund needs to meet in order to pay an interest distribution (the same test but applied at all times during the accounting period of the fund). Aligning these two conditions would be a significant simplification. In particular, the bond fund test currently applies by reference to the accounting period of the investor, which means that in practice a fund does not know whether a particular distribution is treated as interest in the hands of an investor. The ability to apply both tests by reference to the accounting period of the fund means that it will be easier to provide investors with accurate information about how a particular distribution should be treated. Secondly, whether a particular instrument is a qualifying asset is sometimes difficult to determine (although in most cases this remains reasonably straightforward). We would welcome a re-examination of this condition with a view to a possibly simplification. We note that any changes in regards to what is meant by a qualifying asset are likely to be informed by the outcome of other parts of this consultation. Q13.2 How significant are the risks mentioned in paragraph and how could they be mitigated? Our view is that it is exceptional for corporate investors to seek to make changes to investments in order to achieve marginal advantages in tax, such as those highlighted in 3

4 Therefore while it is right to identify these risks, we do not believe they are significant. Q13.3 Would the proposed reform of the bond fund rules involve other risks to the Exchequer or to taxpayers? If so, how could they be mitigated? As we have mentioned, a departure from the principle that an investor should achieve the same result for tax purposes if they invest through a fund or if they invest directly in the underlying assets could undermine confidence in the tax regime for UK funds. Q13.4 Do you think the anti-avoidance rules proposed in paragraphs to are necessary and appropriate? Is there a better approach to preventing exploitation of bond funds for tax purposes? Various provisions related to the taxation of funds make use of the genuine diversity of ownership ( GDO ) condition in Part 1A of SI 2006/964, designed to deny tax advantages in situations where a fund is not diversely held. The GDO condition was developed in consultation with the funds industry and is effective and well understood. In particular it was developed to ensure that provisions continued to apply in situations where investors either inadvertently or for reasons outside their control found themselves holding significant or controlling interests in funds, or where a significant interest was required for commercial purposes (such as the seeding of a new fund). We support the continued use of the GDO condition for targeted anti-avoidance in the area of funds, and would also support a purpose test so that only tax-motivated transactions were caught. We believe that mechanical tests that look at the percentage ownership of funds are not effective. This is because the percentage interest in a fund of any particular investor varies constantly due to the open-ended nature of funds. Therefore such tests require continuous monitoring and investors can find themselves breaching thresholds without knowing, or for reasons outside their control. Moreover the intermediated nature of fund distribution means that it is difficult and often impossible to tell who the investors in a fund are at any one point, or the percentage ownership in a fund of any particular investor and its associates. Q13.5 Overall, would you support replacement of the current rules in Part 6 of CTA 2009 as they apply to holdings in offshore funds with rules similar to those in section 378A ITTOIA? No. For the reasons outlined above, we believe that the current regime works well, insofar as the treatment of corporate investors in funds is concerned. Subject to simplification of the existing qualifying investments test, we do not support the repeal of the bond fund rules, and therefore their replacement with an equivalent provision to s378a. 4

5 Q13.6 Would the introduction of such rules lead to serious practical difficulties for taxpayers or HMRC? If so, how might they be mitigated? Perhaps the biggest practical problem in relation to the operation of the bond fund rules and section 378A ITTOIA to offshore funds is the extent to which UK corporate and individual investors respectively have information about whether the offshore fund has met or not the qualifying investments test. One way in which the current rules could be simplified is by addressing this problem, and we urge HMRC to consult with the working group established to look at these rules with a view of finding an adequate solution. As we note above, a possible change that could improve the position would be to align the qualifying investment test in Part 6 CTA 2009 with the qualifying investment test in Part 3 SI 2006/964 for the purpose of paying interest distributions. In particular the use of the fund s accounting period as the reference for determining whether a return on a fund should be regarded as a loan relationship in the hands of a corporate investor. For individuals, we believe that HMRC should explore the possibility of modifying the offshore reporting funds rules in SI 2009/3001 so that investors can get better information on the nature of their return. Indeed the offshore reporting funds regime could be explored as a possible alternative to the current bond fund rules, or indeed the corporate streaming rules. We have not considered whether this is feasible, but we look forward to working with you as part of the working group that will examine the proposals in the consultation. Q13.7 What would you expect to be the extent of any deferral or loss of tax arising from the rolling up of interest in OFs? Holdings in offshore funds by UK companies and individuals are subject to the offshore funds rules in SI 2009/3001. These rules are designed to prevent investors in offshore funds from benefitting from roll up of income into capital in offshore funds. In some cases the offshore funds rules do allow investors to defer a tax liability. This happens where an investor in a non-reporting fund that does not distribute its income is not taxed on the annual income return of the fund until the investor disposes of their interest. However where this is the case the offshore funds rules taxes the gain as income, therefore offsetting any tax deferral benefit by applying a higher rate of tax, in most cases. Whilst the rate of tax paid by companies on income is the same as the rate they pay on gains, companies would forego the benefit of any indexation allowance. Arguably for companies there remains a deferral benefit for periods in which the value of indexation relief is low. However we would reiterate the point that it would be highly unusual for companies to seek to make changes in the types of investments held to benefit from these marginal tax advantages. Q13.8 What would be the commercial or tax effects on life companies of the proposals above in respect of bond funds? 5

6 We note above that the tax effect will be that holdings in bond funds will no longer be subject fair value treatment under the loan relationships regime, and instead holdings in bond funds will be subject to capital gains tax, and to the regime for annual deemed disposals under section 212 TCGA, even though income from dividends might continue to be taxed as interest. Commercially this will represent a departure from the principle that holdings in debt assets through funds are taxed in the same way as holding debt assets directly, and could result in a mismatch of tax treatment on various elements of the return on the same instrument. This departure from existing practice may result in life companies moving investments away from bond funds, and into debt asset directly. Q13.9 If it is anticipated that the proposals would cause particular difficulties for life companies, what are they and how might they be mitigated? Other than a simplification of the current bond fund regime, we cannot think of a suitable alternative to the proposals in the consultation document, or a way to mitigate the impact of the proposals for life companies. However we hope to be able to explore this in future meetings of the working group. Q13.10 Which of the options for the corporate streaming rules would you prefer, and why? For the same reason that we have outlined above in connection with the bond fund rules, we do not support the repeal of the corporate streaming rules. Again, these rules serve the wider purpose of aligning the tax treatment of corporate investors in funds with the tax treatment of holding assets directly. In particular life companies that invest in debt assets through a UK fund are able to reclaim a tax credit for the tax paid by a fund on the unfranked portion of the dividend received from the fund, regardless of whether the life company pays tax or is lossmaking. If, under option 1 the corporate streaming rules were repealed, a life company could get not relief for the tax suffered at the fund level. Equally if under option 2 the corporate streaming rules were retained, but without the tax credit, life companies in a loss-making position would not get relief for tax suffered at the fund level. Such a tax cost would not arise had the life company made an investment directly, or through an offshore fund. Either option therefore would put life company investors in a worse position by investing in a UK fund. This could reduce the competitiveness of UK funds and could lead to the UK losing ground as a fund domicile a risk outlined in the Government s Investment Management Strategy report and would run against the objectives set out in the Government s strategy. We agree, however, that there are complexities in how the corporate streaming rules currently work, and we favour a re-examination of the rules with a view to simplifying them. We are particularly concerned about the proposal to consider the possibility of introducing, or reintroducing rules should the existing corporate streaming be repealed and if there was in the future a divergence between the rates of tax. The IT and 6

7 business systems that support calculations such as those required by the corporate streaming regime require detailed appointment and scoping and are costly and complex to set up. The process typically takes in excess of 18 months, so the prospect of a fund administrator abandoning the system for calculating corporate streaming, only for them to have to reinstall it at a future unspecified date is deeply problematic. We therefore do not support the introduction of regulation-making power to enable any new rules to be put in place relatively easily. Q13.11 Once the main corporation tax rate and the rate applicable to AIFs are aligned, would repeal of the corporate streaming rules have any significant commercial or tax impacts, including impacts on particular sectors? Can you quantify any such impacts? See response above. In addition to the general impact on life companies, we note that Property Authorised Investment Funds (PAIFs) typically use of unit trusts as feeders so as not to be in breach of the 10% limit on corporate investors. Corporate streaming is required at the level of the feeder fund to ensure that life companies achieve equivalent tax treatment to investing directly in property and debt assets. If the corporate streaming rules are repealed PAIF structures would become unviable, and this would jeopardise current and future PAIFs in the UK. Q13.12 If you anticipate significant difficulties arising from repeal of the corporate streaming rules, how might they be addressed? Other than a simplification of the current corporate streaming rules, we cannot think of a suitable alternative to the proposals in the consultation document, or a way to mitigate the impact of the proposals. However we hope to be able to explore this further in future meetings of the working group. We note that the repeal of the corporate streaming rules will impact mostly on balanced funds (those that invest in both debt and non-debt assets, and that typically pay corporation tax because they do not meet the requirement to pay interest distribution). For such funds there exists an elective regime (Tax Elected Funds or TEF regime) whereby no tax is paid by the fund, but that income is streamed to investors so that they are taxed. Whilst this regime removes the requirement for corporate streaming, in practice very few balanced funds have made an election to be treated as TEFs. There are a number of reasons for this, including that the streaming of dividends required by the TEF regime is not supported by platforms that distribute funds to retail investors, and that the dividend streaming is complicated for individual investors. Therefore we do not think that the widespread adoption of the TEF regime by balanced funds is a viable alternative to the current corporate streaming rules. 7

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