Citation. Gabbai, Sarah and Stitt, Tony (2010): “An overview of the new UK regime for offshore funds.” British Tax Review 1, 1-9
The Offshore Funds (Tax) Regulations 20091 (the new offshore funds regulations), which came into force on December 1, 2009, represent the UK Government’s attempt to achieve greater tax efficiency and certainty for offshore funds. While some provisions remain ambiguous and others continue to be developed, the new regime may on the whole prove advantageous for both investors and managers. This note explains the main features of the new regime and highlights some of the possible attractions.
The new UK tax regime for offshore funds followed extensive consultation by the UK Government. The Government felt that the pre-December 1, 2009 regime was simply no longer compatible with the current marketplace and regulatory environment, both of which had changed significantly since 1984 when the offshore funds rules were first introduced. Accordingly, the Government proposed to simplify the operation of the pre-December 1, 2009 regime, provide greater certainty for investors and fund managers, modernise the regime at no extra cost to the Exchequer and, to the extent possible, achieve economic parity between investors in offshore funds and UK authorised investment funds (AIFs).2
This note looks at some key aspects of the new regime and compares it to the pre- December, 1, 2009 regime where appropriate. The bulk of the new regime is contained in the new offshore funds regulations,3 with the new definition of an offshore fund being incorporated into the Finance Act 2008 (FA 2008). While the new regime will apply to both UK corporate and individual investors, this note only looks at the position for UK resident individual investors in order to illustrate the current advantages of capital gains tax treatment as opposed to income tax treatment.
HMRC have recently announced further changes to the ‘‘grandfathering’’ provisions and transitional arrangements to facilitate the commercial operation of offshore funds, which HM Treasury are expected to implement by way of statutory instrument in due course. These changes will be covered in a separate note.
The pre-December 1, 2009 regime
Under the pre-December 1, 2009 regime, a ‘‘distributing fund’’ was one which, broadly, distributed (at least) the higher of: (a) 85 per cent of its accounts income; and (b) 85 per cent of the fund’s UK equivalent profits, as defined, to investors.4 Alternatively, an offshore fund could be certified as a ‘‘distributing fund’’ if it either had no income, or if its gross income for a period did not exceed one per cent of the average value of the fund’s gross assets during that period.5 Individual investors in distributing funds were subject to capital gains tax, currently at the rate of 18 per cent, on any gain on disposal of their investment, while investors in non-distributing funds were subject to income tax at up to 40 per cent on the gain, known as an ‘‘offshore income gain.’’
From April 22, 2009, dividends from corporate offshore funds paid to higher rate taxpayers are taxed as income (currently at 32.5 per cent) with the benefit of a tax credit equal to one-ninth of the grossed-up distribution, regardless of the size of the holding.6 If the fund is a bond fund (i.e. holding at least 60 per cent of its investments in interest-bearing securities) investors will be taxed on those dividends as interest at up to 40 per cent.7 Prior to April 22, 2009, distributions from offshore funds were taxable under section 402 of the Income Tax (Trading and Other Income) Act (ITTOIA) with no tax credit.8
When will the new regime apply?
For income tax, the new regime will apply for the tax year 2009–10 and subsequent tax years, and for all distributions made on or after December 1, 2009. For capital gains tax, the new regime will apply for all disposals made on or after December 1, 2009.9
Who will be affected by the new regime?
Investors with interests in ‘‘distributing’’ or ‘‘non-distributing’’ offshore funds who were taxable under the pre-December 1, 2009 regime are likely in most cases to be affected by the new regime. The new regime may also be relevant where an investor acquires an interest in a non-UK fund on or after December 1, 2009 that would not previously have fallen under either category, since the new definition of an offshore fund potentially encompasses a broader range of non-UK funds.
To be caught by the pre-December 1, 2009 regime, an investor had to have a material interest, as defined, in an offshore fund.10 The Government recognised that the abolition of the material interest rule could lead to investors who had a non-material interest in an offshore fund on December 1, 2009 being inadvertently caught by the new regime. To prevent this, ‘‘grandfathering’’ provisions ensure that such investors will not be caught by the new regime as long as they made their investment prior to December 1, 2009.11 Investors with a material interest in a fund that does not meet the new definition which they held on December 1, 2009, will not be caught by the new regime.
New definition of an offshore fund
The definition of an offshore fund under the pre-December 1, 2009, regime was contained in sections 756A–756C of the Income and Corporation Taxes Act 1988 and was tied to the regulatory definition of a collective investment scheme under the Financial Services and Markets Act 2000 (FSMA). One problem with this definition was that a fund which operated in the same way as a unit trust or open-ended investment company might not necessarily have met all the FSMA requirements, and if it did not it would fall outside the former tax definition. Another was that the tax consequences only applied to investors holding ‘‘material interests in offshore funds’’ (as defined), which arguably created uncertainty and inequality of treatment for investors.
Consequently, the Government decided that a new definition was needed to achieve greater certainty and to prevent investors from obtaining unintended tax advantages through investments in non-UK funds economically similar to UK authorised funds falling outside the FSMA-linked definition. Accordingly, a characteristics-based ‘‘mutual fund’’ test has been introduced, contained in the new sections 40B–40G12 FA 2008, to replace the ‘‘material interest’’ rule and the FSMA definition of collective investment scheme. The relevant characteristics include:
- Enabling investors to participate in, or receive profits arising from, the fund’s investments;
- Absence of day-to-day control on the part of the investors of the management of the investments; and
- Terms to the effect that a reasonable investor would expect to realise all or part of his investment at net asset value (NAV), or by reference to an index.
Funds with a fixed termination date that meet these characteristics are generally classed as mutual funds unless, broadly, the fund is a pure capital growth equities fund or a fund whose assets are hedged using derivatives such as total return swaps (sections 40E–40F FA 2008). While the first two characteristics are similar to that of a collective investment scheme, a key feature that separates the new definition from the old is the ability to realise an investment at NAV. This latter test has already been discussed in an earlier note in this Review in the context of an earlier draft of the provisions, which do not differ significantly from those enacted in the final version.13
In order to be classed as an offshore fund, a mutual fund must be non-UK resident for tax purposes.14 It can be constituted either as a company, a trust or a contractual arrangement creating co-ownership rights under the laws of the country in which the fund is established, such as Luxembourg Fonds Communs de Placement (FCP) or French Fonds Communs de Titrisation (FCT) or Irish Common Contractual Funds. Partnerships and LLPs do not qualify as offshore funds under the new definition.15
The Government’s earlier indication that funds such as Jersey Property Unit Trusts constituted as ‘‘Baker trusts’’ (Baker JPUTs) would be excluded from the definition of an offshore fund has not been implemented, but, instead, the new offshore funds tax regulations introduce the concept of ‘‘transparent funds’’, which are tax transparent for income but opaque for gains. Funds with these characteristics include Baker JPUTs. While transparent funds are technically capable of qualifying as offshore funds, investors in non- reporting transparent funds will generally escape income tax if they sell their investment, with few exceptions. Further details on transparent funds are discussed below.
Key features of the new regime
Under the regulations, distributing and non-distributing funds are replaced by reporting and non-reporting funds respectively. Most pre-December 1, 2009 offshore funds, and possibly other non-UK funds, will automatically be treated as non-reporting funds as of December 1, 2009 unless they apply to be treated as reporting funds. If their application is successful, they will continue to be reporting funds unless they breach certain conditions or choose to become non-reporting funds.
A reporting fund is, broadly, an offshore fund (within the new definition) that is required to send a report to investors for each reporting period in the manner prescribed by the new offshore funds regulations,16 and to submit details of its ‘‘reportable income’’ and certain other financial information to HMRC, within six months of each period end.17 ‘‘Reportable income’’ is, broadly, the total comprehensive income for the period under International Accounting Standards18 as adjusted for capital items, certain classes of income,19 and equalisation payments.20 Any ‘‘reportable income’’ actually reported to investors is taxed as the income of the investors concerned. The broad effect of this calculation is to capture all trading income within reportable income. Special rules also address the calculation of the reportable income of offshore funds of funds.
The post December 1, 2009 regime has some key advantages for managers and investors over the previous regime. First, managers need only make a single application to HMRC for an offshore fund to be treated as a reporting fund. This reduces the compliance burden for managers, in comparison with applications for treatment as a ‘‘distributing fund’’, which needed to be made in respect of each accounting period.
Secondly, the ‘‘distributing fund’’ certification procedure could create financial disadvantages for investors. This is because such certification had retrospective rather than prospective effect, which inevitably forced investors to wait for HMRC approval before they could decide whether or not to sell their investment, if they wanted certainty about the tax outcome of the sale. Since a reporting fund application needs to be submitted within three months from the start of the accounting period in which the fund wishes to be treated as a reporting fund, investors will know the fund’s status in advance of a disposal, which will give them certainty as to their tax treatment.
Thirdly, unlike distributing funds, reporting funds are not required physically to distribute income, although they may choose to do so. Reporting fund status is thus likely to be more commercially attractive for accumulation funds that no longer need to adopt reinvestment mechanics approved by HMRC, as was necessary for such funds to be ‘‘distributing funds’’,21 and hedge funds may also benefit since cash flow can be adversely impacted by cash distributions to investors until the underlying financial asset strategy is completed. The new procedure should also offer investors the flexibility of being able to choose whether to receive or reinvest any dividends.
Finally, the five per cent limit on investments in other offshore funds that was a requirement for certification as a ‘‘distributing fund’’ will no longer apply under the new regime.22 This is primarily because the five per cent restriction is incompatible with EU regulatory rules, since the UCITS III Directive23 permits funds to invest up to 20 per cent of their assets in other funds. The five per cent restriction not only severely limited the potential for multi-tiered fund of funds, but also restricted the market practice of investing surplus cash in money market funds, and monies awaiting investment in Exchange Traded Funds.
Breaches of reporting fund requirements
Failure to submit reports to investors and HMRC within the requisite period, or to produce accurate and complete reports, will generally be considered a breach of reporting fund requirements.24 The severity of the breach and its consequences will depend on the circumstances. A serious breach will lead to loss of reporting fund status. Minor breaches will not lead to a loss of reporting fund status unless there have been four minor breaches over a ten-year period.
Where there is a difference between the amount of reportable income and the amount of income actually reported to investors, reporting funds are allowed a margin of error of up to 10 per cent without being in breach. Anything above a 10 per cent difference will result in a serious breach unless the fund is able to rectify the situation as soon as reasonably possible, in which case the breach will be regarded as minor. If the difference is between 10 per cent and 15 per cent, the fund need only make an adjustment to the amount of reported income. If the difference exceeds 15 per cent, the fund must produce a supplementary report as soon as possible, but in any event not later than three months from the relevant period end, in order to avoid a serious breach.
Under the new offshore funds regulations, investors in non-distributing funds that choose to become reporting funds may elect to be treated as having sold their investment at its market value at the end of the last accounting period before it becomes a reporting fund, and as having acquired a holding in a reporting fund for the same amount.25 The gain resulting from this deemed disposal is taxable as a capital gain. The election should also be available to investors in funds that did not meet the requirements for certification as a ‘‘distributing fund’’ immediately before December 1, 2009 yet which have in the past been certified as distributing funds.26 Similar deemed disposal elections also apply to non-reporting funds converting to reporting funds and vice versa.
Failure by an investor to make a deemed disposal election will result in the fund being automatically treated (as respects the investor concerned) as a non-reporting fund. As such, any future disposal will trigger an income tax charge on a potentially substantial gain, as the gain is calculated based on the entire period of ownership.27
Existing funds that have consistently been certified as distributing funds up to December 1, 2009 need not make such an election. Instead, such a fund may apply to HMRC for continued treatment as a distributing fund in respect of an accounting period that straddles December 1, 2009. This should give the fund time to apply for reporting fund status in respect of the following period. If it becomes a reporting fund immediately after the end of the overlap period, it will be treated as a reporting fund from the day it became a distributing fund.28
Investors in distributing funds that do not wish to become reporting funds may elect to be treated as having sold an interest in the fund at NAV on the final day of the fund’s accounting period and acquired an interest in a non-reporting fund for the same amount. The resulting gain is subject to capital gains tax.29
Tax treatment for investors under the new regime
Investors will be taxed on gains from sales of investments in reporting and non-reporting funds in much the same way as distributing and non-distributing funds respectively. This means that, broadly, gains from disposals of interests in non-reporting funds will be subject to income tax under Chapter 8 of Part 5 of ITTOIA,30 while gains from disposals of such interests in reporting funds will be subject to capital gains tax.31 Gains from disposals of interests in offshore funds acquired prior to December 1, 2009 will not be subject to income tax32 under the new regime.
Under the new offshore funds regulations, physical distributions and reported income from corporate reporting funds will be taxed in a similar way to dividends from non-UK companies,33 or as interest if the fund is a bond fund.34 Distributions from other non- transparent reporting funds, which may include certain types of unit trust, are taxable either as interest income or miscellaneous income at 40 per cent (or possibly 50 per cent from April 6, 2010) depending on the composition of the fund.35
It is not clear from the new offshore funds regulations exactly how distributions from non-reporting funds holding mainly equities are to be taxed, since the Finance Act 2009 (FA 2009) changes to the tax treatment of corporate offshore fund distributions from April 22, 2009 refer to the pre-December 1, 2009 definition of offshore fund.36 It would be logical for the Government to carry these provisions over into the new regime by way of amending regulations so that they apply to non-reporting funds, although so far there has been no indication as to how they propose to address this issue, if at all.
As mentioned above, transparent funds are those which are transparent for income tax purposes but opaque for capital gains, which may include specific types of offshore unit trusts such as Baker JPUTs. A transparent fund is defined as a fund whose income is referable to each UK resident investor’s interest in proportion to his share of the fund, and which is taxable as relevant foreign income under section 830(2) of ITTOIA.37
Investors in transparent reporting funds will be taxed on distributions and reported income as miscellaneous income under Chapter 8 of Part 5 of ITTOIA. Disposals of directly held interests in transparent non-reporting funds will usually escape income tax, unless the fund holds more than five per cent of its investments by value in other non-reporting funds,38 or fails to make sufficient information available to enable investors to meet their UK tax obligations39 in respect of their share of income.40
Transparent funds of funds
Investors in a transparent non-reporting fund holding an interest in a reporting fund are each taxed on their share of reported income treated as made to the former. This share is taxed as miscellaneous income under section 830 of ITTOIA.41 Investors in a transparent non-reporting fund holding an interest in another transparent non-reporting fund are not subject to income tax, since the latter investment does not count towards the five per cent threshold.42 This could be a useful tax planning point to consider when structuring funds of funds.
Impact of ‘‘white list’’ transactions on reported income
As a precursor to the new offshore funds regulations, the Government proposed a ‘‘white list’’ of transactions that an AIF-equivalent43 reporting fund can enter into without being required to include their profits within reportable income, provided that certain conditions are met.44 These proposals, which particularly benefit certain hedge fund financial asset strategies, are now in Chapter 6 of Part 3 of the regulations and require the fund to obtain HMRC clearance to the effect that the fund has met an equivalence condition and a genuine diversity of ownership condition in order to benefit from this treatment.45 Broadly, a diversely owned AIF-equivalent reporting fund may treat profits from ‘‘white list transactions’’ as non-trading transactions. Transactions falling outside the ‘‘white list’’ may, depending on the facts, be regarded as trading transactions, which will form part of reportable income and therefore be taxable.
The ‘‘white list’’ broadly mirrors the types of transactions that qualify as investment transactions under the Investment Manager Exemption, which covers a wide range of transactions.46 This is very tax efficient for investors as it could significantly reduce their taxable reported income if not eliminate it altogether. Special anti-avoidance provisions apply to banks and other financial traders who hold interests in diversely owned AIF-equivalent reporting funds otherwise than on trading account.47
Part 2 of Schedule 22 to the FA 2009 introduced a new section 103A Taxation of Chargeable Gains Act 1992 (TCGA), which deals with certain types of contractual funds that are neither companies nor unit trusts (notably Luxembourg FCPs or French FCTs).48 Under section 103A TCGA, interests in these funds will be treated as company shares for tax purposes. This will make it much easier for investors to calculate any taxable gains when they sell their investments, since they will no longer need to look to the fund’s underlying assets for this purpose.
Investors will also be able to elect to backdate this treatment to the tax year 2003–04 and subsequent tax years up to 2009–10. Throughout those years, the fund will be treated for tax purposes as if it had been a distributing fund, so tax repayments may be due if the fund had in fact been a non-distributing fund during that time. This will be of particular benefit to fund managers that promote retail Luxembourg FCPs or French FCTs.
Non-UK domiciled investors
Non-UK domiciled remittance basis users49 investing in non-reporting funds will not be taxed on any dividends or gains unless these are remitted to the UK.50 The regulations do not spell out exactly how such investors will be treated vis-a`-vis investments in reporting funds, although one would expect dividends, gains and reported income not to be taxable unless remitted to the UK.
Conclusion and further developments
The regulations broadly follow the Government’s original intentions set out in the HM Treasury Consultation Papers and HMRC Budget Notes, with some minor gaps. The most notable gap concerns the treatment of distributions from non-reporting funds holding mainly equities, and in particular whether they will be taxed in the same way as distributions from reporting funds or according to the FA 2009 changes from April 22, 2009. Similarly, the treatment of non-UK domiciled remittance basis investors in reporting funds needs to be clarified, although it may be possible to determine the treatment by reference to the relevant provisions of the Income Tax Act 2007 together with the new offshore funds regulations.51
Drafting gaps aside, the ability under the new regime to become a reporting fund is, on balance, likely to be a highly tax-efficient option for UK resident investors in directly held offshore funds, and more commercially attractive for accumulation funds. The use of cer- tain transparent funds may also provide planning opportunities, provided that the planning does not inadvertently run into traps that could trigger income tax charges for investors.
To prepare for the upcoming changes and to minimise the risk of inadvertent non- compliance, fund managers should seek advice on the specific requirements and duties of a reporting fund before applying for reporting fund status. This will not only make them aware of the fund’s obligations, but should also give them time to develop suitable models for calculating reportable income and set up their reporting systems appropriately.
- The Offshore Funds (Tax) Regulations 2009 (SI 2009/3001). [↩]
- Authorised investment funds comprise authorised unit trusts and UK open-ended investment companies (OEICs). As regards the policy, see HM Treasury, Offshore funds: further steps (December 2008) at [1.2], available at www.hm-treasury.gov.uk/d/consult_offshorefunds_furthersteps.pdf [Accessed December 16, 2009]. [↩]
- See fn.1. [↩]
- See ICTA Sch.27 para.1(1). [↩]
- ICTA Sch.27 para.1(2). [↩]
- See ITTOIA s.397AA inserted by FA 2009 Sch.19 para.3. See Finance Act note on FA 2009 ss.39 and 40 and Sch.19 by R. Fraser  BTR 556. The rate is expected to increase from 32.5% to 42.5% with effect from April 6, 2010. [↩]
- This brings the treatment of such dividends into line with that of dividends from equivalent UKcompanies under CTA 2009 s.490 (formerly FA 1996 Sch.10 para.8), which treats investments inbond funds by corporate investors as loan relationships. [↩]
- The charge to income tax formerly arose under Case V of Sch.D. [↩]
- See the new offshore funds regulations, above fn.1, reg.1. [↩]
- ‘‘Material interest’’ was defined for this purpose in ICTA s.759. Such interests were, broadly, interests which could reasonably be expected to be sold at or near the market value of the attributable underlying assets, within seven years of acquisition. [↩]
- See the new offshore funds regulations, above fn.1, reg.30. [↩]
- Inserted by FA 2009 Sch.22 para.2. [↩]
- R. Fraser, ‘‘Release of Investment Fund Proposals’’  BTR 41. [↩]
- See FA 2008 s.40A inserted by FA 2009 Sch.22 para.2. [↩]
- FA 2008 s.40A(3) inserted by FA 2009 Sch.22 para.2. [↩]
- See the new offshore funds regulations, above fn.1, regs 90–93. Reports to investors must include, inter alia, reported income per unit and distributed income per unit. [↩]
- See the new offshore funds regulations, above fn.1, reg.106. The text suggests that only 90% (rather than all) of the fund’s income need be reported to investors because reg.110(3) declares that if reportable income is underreported by 10% or less ‘‘there is no breach’’ of the reporting funds requirements—see text under Breaches of reporting fund requirements, below. This note does not consider any other consequences, including possible future changes in the regulations, that might follow from such underreporting. See HM Treasury, Offshore funds: further steps, above fn.2, at [3.7]. [↩]
- See the new offshore funds regulations, above fn.1, reg.63(1). [↩]
- e.g. income from wholly-owned subsidiaries, and effective interest under International Accounting Standard 39. [↩]
- See generally the new offshore funds regulations, above fn.1, regs 62–72. [↩]
- See HMRC, Offshore Funds Guide at [OFSG01070], available at www.hmrc.gov.uk/manuals/ osfgmanual/OSFG01070.htm [Accessed December 18, 2009]. [↩]
- Although there is a 5% restriction in respect of sales of interests in transparent non-reporting funds. An income tax charge will be triggered on a realised gain if more than 5% of the fund’s assets consist of investments in non-reporting funds, see the new offshore funds regulations, above fn.1, reg.63(1). [↩]
- Directive 2001/07/EC amending Directive 85/611/EEC on laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities with a view to regulating management companies and simplified prospectuses (the UCITS III Directive). [↩]
- See the new offshore funds regulations, above fn.1, regs 106–115. [↩]
- See the new offshore funds regulations, above fn.1, reg.48 and Sch.1 para.5. [↩]
- See the new offshore funds regulations, above fn.1, Sch.1 para.5. [↩]
- See the new offshore funds regulations, above fn.1, Sch.1 para.2. [↩]
- See the new offshore funds regulations, above fn.1, Sch.1 paras 3 and 6. [↩]
- See the new offshore funds regulations, above fn.1, Sch.1 para.4. [↩]
- See the new offshore funds regulations, above fn.1, reg.18. [↩]
- See the new offshore funds regulations, above fn.1, reg.99. [↩]
- See the new offshore funds regulations, above fn.1, reg.30. [↩]
- See the new offshore funds regulations, above fn.1, reg.95. [↩]
- i.e. where more than 60% of the fund’s investments consist of interest-bearing securities—ITTOIA, s.378A (inserted by FA 2009 s.39(3). [↩]
- See the new offshore funds regulations, above fn.1, reg.96. [↩]
- ITTOIA, s.397AA, inserted by FA 2009, Sch.19 paras 1 and 3. [↩]
- See the new offshore funds regulations, above fn.1, reg.11. [↩]
- See the new offshore funds regulations, above fn.1, reg.29(2)(b). [↩]
- See the new offshore funds regulations, above fn.1, reg.29. [↩]
- See the new offshore funds regulations, above fn.1, reg.29(3)(c). [↩]
- See the new offshore funds regulations, above fn.1, reg.16. [↩]
- See the new offshore funds regulations, above fn.1, reg.29(4). [↩]
- A UK authorised investment fund (AIF) is usually in the form of an authorised unit trust (AUT) or a UK open-ended investment company (OEIC). [↩]
- A fund is ‘‘authorised investment fund-equivalent [AIF–equivalent]’’ for this purpose if it is recognised by the Financial Services Authority for the purposes of the Financial Services and Markets Act 2000, ss.264, 270 or 272 or it is ‘‘a fund which is an undertaking for collective investments in transferable secu- rities that is authorised by a . . . Member State in accordance with Article 4 of Council Directive 85/ 611/EEC.’’ See the new offshore funds regulations, above fn.1, reg.74, referring to reg.12. [↩]
- See the new offshore funds regulations, above fn.1, Pt 3 Ch.6 regs 73–89. [↩]
- See FA 1995 s.127. [↩]
- See the new offshore funds regulations, above fn.1, regs 102–105. [↩]
- See text under the heading ‘‘New definition of an offshore fund’’. [↩]
- It is assumed for these purposes that the individual has applied to HMRC for non-domiciled status and paid the £30,000 charge. [↩]
- See the new offshore funds regulations, above fn.1, reg.19. [↩]
- ITA s.809A. [↩]