Rebirth of the investment trust?

The Government has recently published a Consultation Document which sets out proposals for modernising the tax treatment of approved Investment Trust Companies ('ITCs').  Consequential changes will also be made to UK company law governing distributions from ITCs.

ITCs are exempt from UK corporation tax on their chargeable gains, and the recently introduced 'streaming regime' made them more competitive, but nevertheless, over the past decade or so, many fund managers have chosen to launch new funds in more favourable offshore jurisdictions.  The proposals seek to enhance the UK's reputation as a competitive jurisdiction from a tax perspective.  

The Government's stated aims are to provide ITCs with certainty regarding their tax status, allow for wider investment strategies, clarify which transactions will be treated as investment transactions for tax purposes, and to reduce administrative burdens imposed on ITCs.

Key proposals include:

• A new definition of a 'closed-ended investment fund' for tax purposes

• Replacement of the conditions for eligibility under the ITC regime

• Creation of a 'white-list' of transactions which will not be taxed as trading receipts and therefore subject to UK corporation tax

• Ending the requirement for annual approval of ITC status and replacing it with an up-front application process and ongoing self-assessment

• Introduction of new, more pragmatic rules in the event of non-compliance

• A change to the company law definition of 'investment company'.

Responses to the consultation must be submitted by 19 October 2010. Final legislation is expected in the 2011 Finance Bill.

Summary of Proposals

New 'characteristics-based' definition

One of the proposals is to introduce a new 'characteristics-based' definition of a 'closed-ended investment fund' for UK corporation tax purposes.  Companies falling within this definition will be ITCs if they meet certain (revised) conditions. This will replace the conditions at section 1158 to 1162 of CTA 2010 (previously section 842 of ICTA 1988).

The proposed definition of a 'closed-ended investment fund' is 'an investment company whose sole object is investing and managing pooled funds contributed by holders of its listed securities: (i) in property of any description, and (ii) with a view to spreading risk'.

The new definition is not intended to broaden the scope of companies potentially falling within the ITC regime.

New ITC conditions

• The ITC must not be a close company.  For these purposes the 'quoted company' exception would not apply.  A close company is one that is under the control of five or fewer participators or participators that are directors.  A participator is very widely defined and will include a shareholder, those closely connected with the shareholder and others that are broadly entitled to have a share or interest in the capital or income of the company. The potential loss of the quoted company exemption should not be an issue for existing ITCs that are widely held.  However, those existing ITCs that are close companies (and which use the quoted company exception to fall within the existing rules) may, going forward, not be eligible for ITC status.

• The ITC must comply with the 'spread of risk' test. The new regime will introduce a purposive approach which aims to achieve (a) a spread of risk and (b) investment in a wide range of assets. This would end the present 'cliff edge' effect of the 15% holding rule for an ITC, which means broadly that ITCs can not hold interests in other companies (except in other ITCs) which equate to more than 15% by value of the ITCs investments. This is a welcome proposal in light of the recent concerns over EU law compliance of the ITC conditions (a link to a client bulletin on these issues from 21 April 2010 can be found here).

• The ITC's shares must be admitted to trading on a Regulated Market. This is a widening of the existing rule that requires shares to be listed on the UK Official List and traded on the London Stock Exchange. It is worth bearing in mind that AIM is not a Regulated Market and therefore companies whose shares are solely traded on AIM would not meet this condition. The Specialised Funds Market is a Regulated Market, however.

• The ITC must not distribute any capital profits.  This will replace the existing rule which merely requires that the ITC's articles prohibit the distribution of any surpluses arising from the realisation of investments as a dividend. It is expected that ITCs can still return capital by way of share buy-backs and redemptions.

•  An ITC must distribute at least 90% of its net revenue income received in an accounting period. ITCs will be allowed to retain 10% of all income as opposed (under current rules) to being allowed to retain 15% of income derived from shares and securities. 

The proposed amendments include the removal of the income test in the current rules, whereby the ITC's income must be wholly or mainly derived from shares and securities. This will allow an ITC to invest in a wider class of assets such as corporate loans and hedge funds.

Replacement of the annual approval procedure with an up-front application process

This should remove a degree of the ITC administrative burden and increase shareholder certainty as, under the current rules, shareholders have to wait until the close of an accounting period before HMRC confirms the tax status for that period.  This has relevance given that certain investors may only be entitled to invest in a company which has such status and until a first set of accounts is prepared and HMRC confirmation received, those investors may potentially be investing in a company without ITC status.

Introduction of a 'white list' of financial transactions which will be treated as investment transactions for ITCs

Mirroring measures introduced last year for AIFs, the profits from 'white listed' transactions will be treated as investment transactions and therefore within the chargeable gains exemption for ITCs.  Any trading or non 'white listed' transactions that do occur will not taint the 'white listed' transactions.  'White listed' transactions would include those involving shares and stock, loan relationships (including money deposits, loans and debt instruments), relevant contracts (including futures and options), units in collective investment schemes, and others. This should allow ITCs to pursue different investment strategies.

Rules to deal with breaches of the conditions of the regime

ITCs which repeatedly and deliberately fail to comply may be required to leave the ITC regime by way of the issue by HMRC of a termination notice.  There would be no loss of the chargeable gains tax exemption prior to the 'final breach', unlike the current rules whereby if any condition was not met in respect of a certain accounting period, ITC status would be lost for that period (and possibly subsequent periods until the breach was discovered and rectified).

Once a termination notice is issued, however, the ITC regime will cease to apply to the ITC for the accounting period prior to the accounting period in which the notice was issued. It will not be possible to re-enter the regime. ITCs committing minor and inadvertent breaches which are remedied without delay will likely not lose their ITC status.  

Proposed amendments to Companies Act 2006 regarding distributions made by ITCs

In order to bring the UK company law definition of an 'investment company' in line with the proposed new ITC tax regime, changes will be made to the Companies Act 2006, the effect of which will be to allow those qualifying ITCs to pay dividends based on investment income they receive without reference to any change in value of their investment assets in the same way that existing qualifying 'investment companies' are entitled to do.

Comment

These proposals are to be welcomed and can be seen as a continuation of efforts over recent years to remove taxation barriers to domiciling investment funds in the UK.  The introduction of a white list for ITCs and abolition of the 'holding' test in particular would be welcome developments.  The proposed revisions to the regime are being introduced at a critical time for the fund management industry:  ITCs are again starting to prove to be considered as possible investment vehicles and HMRC will be hoping that the proposals could entice offshore funds to come onshore and encourage further new launches to take place in the UK. 

Going forward

The Government is seeking comments on these proposals and we would encourage clients potentially affected by the proposals to respond to the consultation to ensure this critical opportunity for reform is fully explored. We would also be interested in hearing your views.  If you would like to let us have your thoughts or would like assistance in making a submission, please contact us.

A full copy of the consultation document can be found 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.

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© Herbert Smith LLP 2010