Investment funds tax update

The Government issued three consultation papers on 28 July 2008 on the taxation of collective investment vehicles. The proposals contained in the papers are designed to enhance the competitiveness of the UK asset management industry.

The consultation papers will propose the:

• introduction of a direct tax exemption regime for UK Authorised Investment Funds;
   
• removal of tax as a barrier to Qualified Investor Schemes by replacing the substantial holding rule; and
   
• change to the rules for Investment Trust Companies to deliver tax efficient investment into interest bearing assets.

The consultation papers follow on from announcements in Budget 2008, and may be considered against the more general background of new legislation and proposals for revised rules relating to Property Authorised Investment Funds, Real Estate Investment Trusts, offshore funds and the taxation of foreign profits. It is intended that, subject to the results of the consultation, any changes will be introduced in Finance Bill 2009.

Tax Elected Funds

Authorised Investment Funds (AIFs) (ie, UK tax resident authorised unit trusts and open-ended investment companies) are currently exempt from tax on chargeable gains but are taxed on income such as interest, overseas dividends and also offshore income gains¹. The proposal is that whilst the AIF would remain a taxable entity, defined streams of income within an AIF, which elects to be within the new tax regime, will not be taxable. An AIF which elects for this tax regime is described as a Tax Elected Fund (TEF). The effect of this direct tax exemption is to move the point of taxation from the AIF to the investors so that, broadly, an investor in a TEF will be taxed as if he owned the underlying assets directly.

The Government envisages that a TEF will not pay tax on overseas dividends and interest. As a result, a TEF will not be subject to double taxation and credit for any overseas tax paid will not be available. A TEF would need to identify its income into different streams according to its source, in the same way that Real Estate Investment Trusts (REITs) and Property Authorised Investment Funds (PAIFs) are currently required to stream their income. This will, it is recognised by Government, result in additional administration. When UK investors receive distributions from a TEF their tax treatment will depend on the nature of the assets from which the income has been generated and, of course, their tax position. In this regard it should be noted that the tax treatment of UK investors in receipt of foreign dividends remains subject to ongoing reform. It is to be assumed (though the consultation paper does not confirm) that any obligation to deduct UK withholding tax from interest distributions will remain.

The Government invites comments on how an offshore income gain could be treated in a TEF, including whether, and if so how, an annual notional income yield based on the underlying investment should be taken to arise in the TEF.

The consultation paper indicates that funds electing to be TEFs will not be permitted to invest in property (due to the opportunities provided by PAIFs) though further consideration will be given to whether it would be appropriate to allow a TEF to have a small proportion of investment in property to enable mixed fund investment strategies.

Under the proposed new tax regime, it is not clear whether a TEF will continue to enjoy access to the same double taxation treaties it benefited from prior to electing into the regime. This may depend on how the relevant treaty partner views the proposed new TEF.

It is envisaged that the election into the new regime will be irrevocable to provide certainty for funds and investors. One of the conditions that a TEF will have to comply with is a genuine diversity of ownership, which will be determined using a test similar to that applicable to the PAIF regime.

The Government intends to retain the PAIF regime and welcomes industry’s views on whether the bond fund regime should be retained. Our initial reaction is that the regime would be unnecessary in light of the proposals and it would also be logical to amend the PAIF regime so that a PAIF is treated in the same way as a TEF. The Government will also consider the impact of the proposals on the proposed elective tax regime for Funds of Alternative Investment Funds.

This is an exciting development which should enhance the competitiveness of AIFs.

Qualifying Investor Schemes

A Qualified Investor Scheme (QIS) is an AIF which is open only to “eligible” investors, typically either institutional or sophisticated investors who can be expected to understand the risks involved in a wide range of investments. As the QIS regulatory regime permits more flexible investment strategies than UCITS² or NURS³ and limits its investor base, the Government introduced anti-avoidance rules designed to prevent investors from gaining tax advantages by using a QIS which did not represent a genuine pooling of investors’ funds. This "substantial holding rule" imposes a tax charge on certain investors if their units (either alone or together with associates or connected persons) represent rights to 10% or more of the net asset value of the QIS.

The Government has recognised that the mechanical nature of this rule has acted as a barrier to the development of QISs and is proposing that it should be replaced with a “genuine diversity of ownership” rule, in much the same way as is required in the PAIF regime. The current substantial holding rule does not apply for certain categories of participants such as certain life insurance companies and pension funds. To align this with the genuine diversity of ownership condition for PAIFs, the Government intends that the proposed rule will apply to all QISs, irrespective of the type of investor.

If this new rule is adopted, then it would seem sensible to adopt the genuine diversity of ownership condition for REITs as well, rather than the close company test which is currently applied.

Investment Trust Companies

Whilst Investment Trust Companies (ITCs) which meet the conditions set out in section 842 of the Income and Corporation Taxes Act 1988 are exempt from corporation tax on chargeable gains, they do pay corporation tax on income such as interest and foreign dividends. The Association of Investment Companies’ (AIC's) report “Delivering lower costs and innovation in pooled investments” argued that the UK tax rules acted as a barrier to ITCs being established in the UK. This reflects our experience in practice. The report identified the main issue with the tax rules as being the absence of a tax-efficient method for ITCs to invest in bonds.

The Government intends to deliver tax-efficient investment for ITCs in interest bearing assets by “streaming” interest income. The Government envisages that interest income will remain taxable in the ITC but the distribution of interest will then be deductible from corporation tax when paid to shareholders as an “interest distribution”. The Government anticipates that the interest distribution will be treated as a payment of yearly interest and income tax at the lower rate will be deducted and accounted for by the ITC, unless the shareholder is entitled to receive the interest gross. Any income not distributed will remain subject to corporation tax in the ITC. Again, although the consultation paper is silent on the point, one would expect that any obligation to deduct UK withholding tax from such interest distribution will remain.

Effectively, the Government is proposing that the PAIF regime in relation to interest, and the manner in which a bond fund is taxed on interest income, operates for ITCs. Given that the Government is proposing to exempt interest received by AIFs from corporation tax, it seems strange that it is not proposing a similar regime for ITCs. Equally strange is that the proposal does not extend to the receipt of overseas dividends. If ITCs do opt into this regime, the streaming of income will, as with the AIF proposals, add additional administrative complexity to the running of ITCs.

The AIC’s report also favoured moving to a tax system that would allow tax-efficient investment in property. The Government has not closed the door on this option entirely but it is not minded to broaden the scope of the ITC regime in this way at this point. Its view is that tax-efficient investment in property for both closed and open-ended investment vehicles is already properly addressed by the introduction of PAIFs and REITs.

In conclusion, these proposals are welcome, as is the fact that Government is willing to engage with industry on the proposals. Comments on each of the consultation papers should be sent to Sue Harper at the Treasury by 22 October 2008. Her email address is sue.harper@hm-treasury.gov.uk

Copies of the consultation papers are available from HM Treasury's website:
http://www.hmtreasury.gov.uk/newsroom_and_speeches/press/2008
/press_82_08.cfm.
 

Footnotes

1. An AIF investing in a non-qualifying offshore fund pays tax as if the gain it makes on disposal of its interest in the fund is an income return, rather than a return on capital.
2. Undertakings for Collective Investment in Transferable Securities
3. Non-UCITS Retail Scheme

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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© Herbert Smith LLP 2008