Investment Trust Companies - The Success and Road Ahead

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1 Tax briefing February 2011 Investment Trust Companies: A modernised onshore fund vehicle on the horizon Summary and implications In December 2010, HM Treasury published a summary of the responses they received in respect of their consultation on the reform of Investment Trust Companies (ITC s). We now have a much clearer idea of what the new ITC regime may look like. Originally announced as part of the 2010 Budget, the modernisation of ITC s is intended to reassert the UK as an attractive jurisdiction for establishing a close-ended fund vehicle in the face of sustained competition from offshore jurisdictions. Investment Trust Companies An ITC is a UK resident, listed company which is exempt from UK Corporation Tax on chargeable gains. This tax exemption makes it a potentially advantageous UK vehicle for pooled investment. However, in order to qualify for treatment as an ITC, a company must meet strict requirements laid down by statute. It has been widely felt that the scope and inflexibility of these requirements has acted as a deterrent to fund managers who have instead been attracted by the more generous regulatory and tax regimes of offshore investment funds. The Government has recognised the need to make the UK a more desirable place for the establishment of funds and is seeking to modernise the regime to make it more competitive. However, this progressive approach is tempered by the need to ensure that the changes do not pose a threat to the UK s overall tax take. HM Treasury set out its proposed reforms for the ITC regime in a consultation document published in July The responses received from the industry have narrowed the outstanding issues for implementation of the new regime. The key proposed reforms are as follows: Ask a question If you have any questions please contact either: Michael Cant, Head of Tax T +44 (0) m.cant@nabarro.com Daniel Kennedy, Associate T +44 (0) d.kennedy@nabarro.com The Tax team To find out more about the team, and our capabilities click here 1

2 Definition of close-ended investment fund The Government has proposed introducing a new characteristics-based definition of a closed-ended investment fund for UK tax purposes, which broadens the scope of the companies which can qualify to be an ITC. The new definition seeks to ensure that an investment company qualifies for the beneficial tax regime as long as: Its sole object is investing and managing pooled funds in property of any description; With a view to spreading risk. The new definition has been welcomed by the majority of respondents who were attracted by the flexibility and clarity of the definition. Related item: The Changing Shape of Real Estate Funds Investors in real estate funds are motivated by the prospect of enhanced returns on their investment, often as a result of being bale to access expert management skills and new markets and sectors. In the aftermath of the financial crisis and downturn in real estate markets, investors want to reshape and strengthen the industry. New application process for the ITC regime The current ITC tax regime requires a fund to apply for confirmation from HMRC at the end of the relevant accounting period that the beneficial ITC tax rules apply. This leads to uncertainty for investors in the fund and places an administrative burden on the fund s managers. The Government now proposes introducing a onceonly approval process, meaning that the ITC will obtain advance approval from HMRC to join the new tax regime and will remain within the regime unless it opts out or is removed for breach of the conditions. This will provide investors with much greater certainty compared with the current regime where there remains the risk of the tax exemption being retrospectively withdrawn. All respondents that commented on this point favoured an up-front application process, and many requested a legislative requirement that HMRC must provide a response within a set time period (e.g. 28 days). It was suggested that there should be automatic acceptance for those ITCs already approved under the previous regime. The current application process leads to uncertainty for investors and greater administrative costs for the fund. This will be replaced by a once-only approval process Conditions for the ITC regime To qualify as an ITC, the Government has proposed that the following five conditions must be met: a) An ITC must not be a close company Respondents to the consultation unanimously agreed that the Government should include an exception to this condition for close companies quoted on a recognised stock exchange. The Government appears to have been persuaded by the representations and it is therefore likely that the current definition of close companies in section 446 of the Corporation Tax Act 2010 will be used. b) An ITC must comply with the spread of risk test The current condition provides that the ITC must not have a holding in another company which represents more than 15 per cent by value of the ITC s total investments. 2

3 The Government proposes introducing a new purposive approach to establishing whether the ITC is sufficiently spreading its investment risks. It is generally thought that the current condition is too inflexible and has been a significant factor in new funds choosing to launch offshore. The new approach would be based heavily on Chapter 15 of the FSA listing rules and would require the ITC to have a published investment policy (which it would be required to follow) relating to: Asset allocation; Risk diversification; Gearing; and Details of maximum exposure. The vast majority of respondents welcomed the new approach, although concerns were raised as to how HMRC would approve the investment policy in practice. The new approach would enable ITCs to be established as feeder funds, subject to the master funds also meeting the spread of risk test. c) The securities of an ITC must be admitted to trading on a Regulated Market Currently, an ITC must be listed on the UK Official List. It is proposed that this condition will be broadened to include all securities that are admitted to trading on a regulated market. Regulated markets are those regulated under Title III of MiFID. This amendment is largely uncontroversial and most respondents accept it as necessary to comply with EU law. d) An ITC must not distribute its capital profits The Government proposed modernising the legislative wording used to prohibit the distribution of capital profits. Respondents generally welcomed the drafting changes on the proviso that the updating would not prevent share buy backs or tender offers. The Government has confirmed that it was not its intention to prohibit share buy backs or tender offers. e) An ITC must distribute at least 90 per cent of its revenue income The Government proposed replacing the existing distribution condition that an ITC must retain not more than 15 per cent of its annual income from shares and securities with a requirement that the ITC must retain not more than 10 per cent of all of its income. Nearly all the responses recommended retaining the 15 per cent reserved income test. This was on the basis that retaining reserves helped maintain dividend levels by enabling ITC s to smooth distributions during periods of volatility in the markets. The Government has taken these comments on board and it now appears likely that an ITC will be able to retain up to 15 per cent of its total income (not just its income from shares and securities). A new purposive test is proposed to ascertain whether an ITC is taking sufficient steps to spread the risk on its investments The Government has been persuaded to allow ITC s to retain up to 15 per cent of their annual income 3

4 White list of transactions The Government has also proposed the introduction of a white-list of transactions undertaken by ITC s which will always be considered to be investment transactions for tax purposes. These transactions will benefit from the Corporation Tax exemption on chargeable gains. In addition, these transactions will never be considered to be trading transactions for tax purposes and therefore will not taint the tax treatment of any other transactions carried out by the ITC. The white-list will include transactions undertaken by the ITC involving: Stocks, shares and securities; Loan relationships; Futures, options contracts for differences, swaps, warrants; Units in collective investment scheme; Buying and selling foreign currency; and Carbon emission credits The list will not include real estate transactions. Respondents strongly welcomed this proposal, in particular the greater certainty it provides as to how transactions undertaken by the ITC will be taxed. Most respondents considered that this would remove the precipice problem ; that one trading transaction undertaken by the ITC could taint the tax treatment of all other transactions undertaken by the ITC. Respondents requested that the legislation enables the white-list to be amended in future to respond to changes in market practice, although the Government has stated that it has no intention of revising the list. The introduction of a white list was strongly welcomed due to the increased certainty over how transactions will be taxed Next Steps The Government has published draft legislation in respect of the modernisation of the ITC s which can be found on the HM Treasury or the HM Revenue & Customs websites. However, the current draft legislation is very limited in scope. The next step is for the Government to issue the draft regulations. These are currently under development with industry stakeholders and it is expected that these will be published in draft form for comment during Spring It is anticipated that the new regime for Investment Trust Companies will come into force in late 2011 or early HM Treasury website To read the draft legislation please click here HMRC website To read the draft legislation please click here 4

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