Promoting the UK Funds Industry as "Best in Class"

The Chancellor's Budget rhetoric emphasised the UK's commitment to being a world leader in the asset management sector: the Chancellor stating that "in places like Edinburgh and London, we have a world beating asset management industry. But they are losing business to other places in Europe. We act now with a package of measures to reverse this decline".

The Chancellor emphasised the abolition of the SDRT charge on surrenders of interests in unit trusts and OEICs, and beyond this there was a package of other (generally positive) consultations and changes to improve the competitiveness of the UK funds sector. It is clear that while the Government has made significant strides in recent years in developing the UK fund industry's offering, it acknowledges that there is still work to be done.

The key points of note include:

  • Abolition of SDRT charge (in Schedule 19 Finance Act 1999) on surrenders of units in unit trusts and OEICs.
  • Helpful changes to the Investment Trust regime to make clear that ancillary trading transactions will not compromise the status of the vehicle as an investment trust company.
  • Consultation on changes to the taxation of partnerships, limited partnerships and LLPs to prevent them being as used as vehicles to disguise what HMRC considers to be employment relationships and thus avoid income tax and national insurance contribution charges.
  • Improvements to the taxation of limited partnerships to more effectively accommodate their use for private equity investments.
  • Consultations on changes to the "white list" of permitted investment transactions.
  • A proposal to remove the requirement to withhold tax on distributions by UK domiciled bond funds.
  • A proposal to abolish stamp duty on shares quoted on growth markets such as AIM.
  • Review of the unauthorised unit trust regime to prevent tax avoidance.

Whilst not announced at the Budget, we are also keeping a watching brief on whether the Government will expressly exclude ZDPs from the new disguised interest rules applying to income tax.

Here are the links to the HM Treasury and HM Revenue & Customs (HMRC) Budget websites. Helpful reference may also be made to the "UK Investment Management Strategy".

If you have any questions about the impact of these changes, please contact one of the authors.

1. UK Investment Strategy

HM Treasury believe that in order to enable the UK to compete more effectively, there needs to be a simplification and streamlining of taxes, a more responsive regulatory environment and improved marketing infrastructure in the UK and overseas. While recent developments in the funds tax regime including the Investment Management Exemption, "white list" provisions, Investment Trust reforms, PAIFs and Tax Elected Funds demonstrate the Government's continued focus in this area, the Government expressly understands that more work is required and has publicly indicated an intention to consult with the sector on these measures to reach the desired outcomes.

2. SDRT charge on the surrenders of units in unit trusts and OEICs to be repealed

Considered worthy of a comment in the Chancellor's actual speech, the Government confirmed that with effect from 1 April 2014, the current 0.5% (proxy) SDRT charge in Schedule 19 Finance Act 1999 on surrenders of units in unit trusts and OEICs will be abolished. Schedule 19 acts as a proxy for the principal SDRT charge and is charged to fund managers on surrenders of units in funds, although investors ultimately bear the cost.

The so called "Schedule 19" charge has long been viewed as unnecessarily complex and burdensome, requiring frequent tax calculations and returns to be sent to HMRC. The Government views this as a major deterrent to investment in the UK given that those who do not wish to pay the "Schedule 19" charge have the option of investing in funds domiciled offshore.

The abolition of Schedule 19 will be legislated for in Finance Bill 2014 to take effect in tax year 2014 / 2015.

Whilst this is a very positive development, it does raise a question as to whether Investment Trusts incorporated in the UK should also be exempt from stamp duties for the same reason.

3. Offshore Funds

By way of a statutory instrument that came into effect on the 20 March, the Offshore Funds (Tax) Regulations 2009 (the Regulations) have been amended to clarify that in a case where a disposal of an interest in an offshore fund would incur a charge to tax on an offshore income gain then the potential charge will not be avoided by a merger or reorganisation of the fund in which the interest is held. In other words, even where investors dispose of an interest in a reporting fund, they will suffer an offshore income gain charge where that interest was exchanged for an interest in a non-reporting fund as a result of a reorganisation through section 135 or 136 Taxation of Chargeable Gains Act 1992.

There will also be consultation in respect of two further measures which are expected to take effect by 30 June 2013:

  • Correction of a technical mismatch between the rules for calculating total reported income and the amount reported to individual investors. Where a fund operates "full equalisation" (as defined in the Regulations) and returns part of the capital cost of a new subscription to the investor in the first reporting period then the Regulations will be amended so that the capital returned can be set off against the first distribution made.
  • Ensuring that investors in reporting offshore funds are taxed on their correct and proportionate share of the income of a reporting fund. In a case where a fund calculates its reportable income for a reporting period over several "computation periods" making up the reporting period a technical change will allow excess expenses of one computation period to be set against income of another within the same reporting period. This will remove a potential distortion to the calculation of reportable income where computation periods are used.

4. Consultation on the impact of UK management of offshore non-UCITS funds

Where a UCITS fund is treated as resident in another EU Member State for tax purposes under article 5 of the "UCITS Directive" (85/611/EEC), section 363A of the Taxation (International and Other Provisions) Act 2010 (TIOPA) applies to ensure that the offshore fund and their investors will not be subject to any UK tax consequences as a result of having a UK resident management company.

The Government confirmed at the Budget that it intended to consult on measures to be included in the Finance Bill 2014 which will widen the scope of section 363A of TIOPA to provide certainty that locating fund management activities of certain offshore non-UCITS funds will not lead to a risk of that fund being deemed to be tax resident in the UK.

This is expected to be particularly attractive to managers who wish to operate offshore funds under the AIFM directive.

5. Investment Trusts

There are two proposed changes for the Investment Trust regime:

  • Condition A of the ITC Conditions (as currently drafted) broadly requires the ITC to confirm that "the business of the company consists of investing its funds in shares, land or other assets with the aim of spreading investment risk and giving members of the company the benefit of the results of the management of its funds". With effect for accounting periods commencing on or after 1 January 2012, the rules will be amended to make it clear that Condition A will still be satisfied where other ancillary activities are undertaken, provided all, or substantially all, of the business of a company is investing its funds in shares, land or other assets with the aim of spreading investment risk. In the ITC context, this will ensure that ancillary trading activities undertaken by an ITC will not compromise its ITC status.
  • Under current rules, there are certain exceptions to the "income distribution requirement" which broadly only apply where making a distribution would be contrary to a restriction imposed by law or would be within a de minimis amount. With expected effect from June 2013, a further exception to the "income distribution requirement" will be developed to apply where an ITC has accumulated realised revenue losses in excess of its income for an accounting period (so that a distribution out of capital will not be required).

6. Consultation on the use of Partnerships

The Government will consult on measures to:

  • Remove the presumption of self-employment for LLP partners to tackle the use of such vehicles to disguise employment relationships.
  • Counter the artificial allocation of profits to partners (in both LLPs and other partnerships) to achieve a tax advantage.

This measure will likely have a big impact on sectors that commonly operate through LLP structures such as asset managers but also on professional firms and is probably aimed at "salaried" or "fixed entitlement" partners in LLPs. It seems very possible that unless partners in an LLP bear the characteristics of a true partner (i.e. they genuinely share in profits and losses of the business and have the other usual risks of being a genuine partner), they may be treated as employed for tax purposes so that PAYE would apply to their partnership drawings and the LLP would be subject to employer NICs. At this stage, it is unclear what level of true profit sharing would secure self-employed status. The use of corporate members in LLPs alongside individual members is fairly commonplace and it remains to be seen if the measures will impact on these structures thereby eliminating the ability for profits to be taxed at the lower corporation tax rates. No further detail has been published on these measures.

A consultation document will be published with proposals to address both issues in the spring, with legislation to be introduced in Finance Bill 2014.

7. Disguised interest regime introduced for income tax and the impact on zero dividend preference shares (ZDPs)

The draft Finance Bill 2013 includes a new "disguised interest" regime for income tax. It will be based on the disguised interest rule for corporates contained in Corporation Tax Act 2009. In broad terms, disguised interest arises where a person receives amounts which are "economically equivalent to interest" (see below).

The rule will apply to arrangements that produce a return in relation to any amount that is disguised interest. Income tax will be charged if the return is not otherwise charged to income tax, unless the reason for this is because an exemption applies. To the extent the return would be charged to tax other than income tax, a claim may be made to HMRC for just and reasonable consequential adjustments to be made.

The rule will be potentially applicable to arrangements under which an amount of "disguised interest" is paid and to which a person becomes party on or after 6 April 2013.

An amount is "economically equivalent to interest" if:

  • It is reasonable to assume that it is a return by reference to the time value of that amount of money;
  • It is at a rate reasonably comparable to a commercial rate of interest; and
  • At the time the person becomes party to the arrangement, or (if later) when the arrangement begins to produce a return for the person, there is no practical likelihood that it will cease to be produced in accordance with the arrangement (unless the person by whom it falls to be produced is prevented, by reason of insolvency or otherwise, from producing it).

An important practical point to note in the context of the "disguised interest" rules for income tax is how they would apply to ZDPs. Herbert Smith Freehills and others have been engaged in discussions with HMRC about the issue and, in particular, have sought an express exclusion from the "disguised interest" regime for ZDPs. The Budget announcement confirms that certain types of shares will be excluded but gives no detail and HMRC has stated to us that we will have to wait and see until the Finance Bill is published on the 28th March 2013.

8. Changes to the "white list"

The Government has stated that it will consult on the possibility of expanding the published "white list" within secondary legislation governing the investment manager exemption, authorised investment funds, investment trusts and offshore reporting funds regimes. The list provides certainty that specified transactions will not be treated as trading activities for the purposes of those rules.

The list also acts to determine the types of investment transactions that may qualify for the investment manager exemption. In particular the Government is considering amendments to traded life policy investments and certain forms of carbon credit that are not currently covered.

9. Proposal to remove the requirement to withhold tax on interest distributions on UK domiciled bond funds in certain circumstances

Continuing the theme of improving the competitiveness of the UK fund sector, the Government also indicated that it would consult on a proposal to remove the requirement to withhold tax on interest distributions on UK domiciled bond funds when sold / marketed to non-UK resident investors by "reputable intermediaries". The introduction of such a proposal into the UK code would remove any UK tax leakage (as current rules, a bond fund has to deduct at 20%). On its face, the rules may seem vulnerable to abuse, however, we expect when the terms of the consultation are released that the measure may end up being very targeted in its scope.

10. Amendments to the UK transfer of assets abroad legislation

On 16 February 2011 the European Commission issued an infraction notice in which it stated that the current UK transfer of assets abroad legislation breaches the EU treaty principles of Freedom of Establishment and Freedom of Movement of Capital. After a consultation period, the amendments announced in Budget 2013 seek to address the infraction.

In particular, the proposed revisions to the rules provide an exemption for genuine commercial activities that take place overseas. In addition, transactions that do not involve commercial activities but are nevertheless genuine transactions protected by the single market will also be exempt. A further element will be added to the test to enable HMRC to examine each transaction and make an apportionment where appropriate between the part of a transaction which is genuine and the part which is not.

11. Private equity funds

Perhaps a move that may seem to be at odds with the comments above on closing down perceived income tax and NICs avoidance schemes using partnerships, the Investment Strategy document specifically provides that HM Treasury will consult on changes to the Limited Partnership Act 1907 in so far as it applies to funds, including the possibility of allowing them to elect for legal personality. This suggestion is in direct response to widespread concern in the private equity and venture capital sectors and will ensure that UK limited partnerships remain an effective and attractive vehicle for the private funds industry.

12. Tax Transparent Funds
More by way of reminder rather than a "new" Budget development, the competitiveness of the UK regime will be enhanced by the introduction (by the end of spring 2013) of two new tax transparent authorised contractual scheme vehicles which have been designed to be "best in class":

  • The limited partnership
  • Co-ownership schemes.

Both vehicles will be available to fund managers to establish in the UK and will be available for authorisation as UCITS, NURS (non-UCITS retail scheme) or QIS (qualified investor scheme).

These schemes are hoped to be attractive to managers looking to pool assets from funds across Europe, and potentially more widely. The Government expects that, in practice, either of the tax transparent authorised contractual scheme vehicles could form a "master fund" into which other UCITS funds from across Europe could combine their assets.

Further, the Government hopes that both vehicles will also be attractive to certain tax-exempt institutional investors, such as pensions, who may be able to take advantage of their transparent nature to secure more appropriate rates of foreign withholding tax than might be the case when investing in an opaque fund.

13. Real Estate Investment Trusts

As previously announced, the Finance Bill 2013 will contain provisions the effect of which is to allow a UK REIT to treat income from another UK REIT as income of its tax exempt property rental business. The Government is further considering the case for REITs being included within the definition of “institutional investor”.

14. Corporation tax rates reduced to 20% from 1 April 2015

The main corporation tax rate will be cut by an additional 1% with effect from 2015. The rates will now be as follows:

Tax year Rate
2013 / 2014 23%
2014 / 2015 21%
2015 / 2016 20%

15. Stamp duty abolished on the transfer of shares on AIM and the ISDX Growth Market

With effect from 1 April 2014, stamp duty (currently 0.5%) will be abolished on the transfer of shares in companies listed on growth markets including the AIM and the ISDX Growth Market.

16. Income tax and CGT

The 45% upper earnings rate will come into force on 6 April 2013 and will apply for earnings over £150,000.

The annual CGT exempt amount will be £10,900 for the 2013 / 2014 tax year.

17. Employee shareholders: relief from CGT on disposal and limited income tax and NICs relief on acquisition

As previously publicised, the Government plans to introduce a new form of employment status – the "employee shareholder" - with effect from 1 September 2013. The aim of the measure is to encourage employees to invest in their employers and reduce the regulatory burden on employers so as to drive growth. The main tax breaks underpinning this policy will be a CGT exemption of up to £50,000 on the disposal of those shares held by employees as part of such arrangements. As expected, the Government has also confirmed that the first £2,000 of share value allocated to an employee shareholder will be exempt from income tax and NICs – this will also come into effect from 1 September 2013.

18. General anti abuse rule (GAAR) reaffirmed

It was reaffirmed that the much publicised GAAR will come into effect (subject to limited grandfathering provisions) from the date that the Finance Act 2013 receives Royal Assent (expected to be around July 2013). The final HMRC initial guidance is keenly awaited.

19. Proposed changes to the employment intermediaries regime

As previously trailed, the Government will consult on changes to the employment intermediaries regime (with a focus on offshore intermediaries) to ensure that the correct income tax and NICs are paid by offshore employment intermediaries.

20. Government procurement proposals: tax compliance to influence award of Government contracts

Funds that manage Government investments by way of procurement tender should pay careful attention to the new procurement proposals relating to tax compliance. The essence of the proposals are to require any company (or individual) that wishes to supply the Government with goods or services to self-certify that it has not had any "occasions of non-compliance" within a defined period. The rules, which were originally proposed as a discussion document in February of this year, have been significantly watered down as part of the Budget.

In particular, suppliers will only be required to certify where an occasion of non-compliance occurs on or after 1 April 2013 and in respect of returns submitted on or after 1 October 2012. In consequence, suppliers will only have to keep track of future occasions of non-compliance.

An "'occasion of non-compliance" has also been amended. It now covers:

  • The submission of a tax return which has had to be amended as a result of HMRC successfully challenging a position adopted in that tax return under the VAT Halifax principle, or the GAAR as well as their international equivalents (but not, as previously proposed, under a targeted anti avoidance rule (TAAR));
  • The submission of a tax return which has been (or is) subsequently found to be incorrect because the supplier was involved with a scheme which was or ought to have been disclosed under the Disclosure of Tax Avoidance Schemes rules; and
  • Where there has been a conviction for tax related offences or subject to a penalty for civil fraud for evasion.

Amongst other changes the Government has also confirmed that the contract value threshold level should be set at £5 million and the "look back" period has been reduced from 10 to 6 years (this will apply from the date at which the "occasion of non-compliance" occurred – generally the date the supplier's tax return was amended).

21. Funds related measures in the pipeline: European Financial Transactions Tax (FTT)

In February 2013, the European Commission published a revised proposal for a FTT to be implemented using the enhanced cooperation procedure in the EU. The eleven participating member states are Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia (the FTT zone). These member states are due to have introduced the enacting domestic legislation by September 2013 to ensure that the legislation comes into effect by 1 January 2014 although we suspect that this date may slip.

Under current proposals, the FTT will apply broadly where:

  • There is a "financial transaction";
  • There is a "financial instrument";
  • One or more parties to the transaction is a "financial institution"; and
  • Any one of the parties to the transaction is "established" in the FTT zone or where a financial instrument is "issued" from within the FTT zone (so there is in fact no need for any party to the transaction to have a connection to FTT zone).

The extra territorial impact of the FTT as currently drafted is wide, it imposes liability on a joint and several basis and there is no indication as to whether existing transactions will be grandfathered. Whilst we expect the legislation to be amended before it comes into force, it is wise to consider how FTT may affect the transactions entered into from now. This will include the pricing of the transaction, whether documentary protection is necessary and the structure of the deal itself.

While the UK Government has rejected the idea of introducing the FTT in the UK and the tax generally does not appear to have gained widespread support in the UK, there is still uncertainty as to how it will interact with existing UK transfer taxes. Currently there would seem to be wide scope for double taxation given that the FTT can apply depending on the residence while UK transfer taxes are on an issuance basis. The fact that the Budget did not address this means that the EU FTT and the UK's response to it is still very much a case of "watch this space".

22. Funds related measures in the pipeline: FATCA

The inactivity in respect of the FTT is in stark contrast to FATCA where the UK has been at the forefront of implementation; being the first country to enter into an intergovernmental agreement (IGA) and being the first to grasp the nettle of implementing the IGA into its domestic legislation.

The first draft of this domestic legislation appeared in December and the consultation period for this was extended. The Budget confirmed that primary legislation will be introduced in the Finance Bill and that implementing Regulations are expected shortly. Very much a case of the sooner the better for the fund sector's FATCA compliance projects.

Herbert Smith Freehills has extensive corporate and tax advisory and transactional experience on all types of investment managers, investment funds and of numerous asset classes and investment strategies. We frequently advise on the tax, corporate and regulatory aspects of the establishment of many UK and offshore funds including investment trusts and other forms of closed ended vehicles, hedge funds and other open ended investment companies, including UCITS, authorised and unauthorised unit trusts, and limited partnerships.

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