Paul Hale and Martin Shah of Simmons & Simmons update readers on amendments to UK taxation rules on offshore funds.
The Finance Bill 2004 includes the expected amendments to the taxation rules for offshore funds. These are limited rather than a radical overhaul of the offshore funds regime.
In particular, the changes proposed in the 2002 Consultation Document regarding information-providing funds have not been implemented. Instead (for the time being) the present regime continues with a number of helpful amendments. However, a number of opportunities present themselves that merit consideration.
Overview of proposals
The changes simplify the rules that determine whether an offshore fund can be treated as a "distributing" fund. As a result, UK resident investors in offshore funds will, in a wider range of circumstances, be charged to tax in the same way as an investor in an equivalent UK fund.
Whilst some of the more onerous technical requirements of the test are removed, the basic principle --that investment income should be taxed as such --is retained.
The changes will benefit new investors rather than existing investors, in that interests in an existing non-distributing fund will remain subject to income tax rules on redemption, even if the fund now obtains distributing fund status. The changes apply for accounting periods of funds ending after Royal Assent to the Bill --effectively bringing most funds into the new regime for their current accounting period.
The key changes are:
* sub-funds of umbrella funds and separate share classes can now qualify for distributing fund status regardless of non-qualifying sub-funds or share classes within the same sub-fund;
* all except one of the prescribed investment restrictions are abolished, but an offshore fund cannot invest more than 5% by value of its assets in funds which would not themselves meet distributing fund requirements; and
* the requirement to distribute 85% of "UK equivalent profits" (and not merely 85% of distributable income) is simplified to follow corporation tax rules more closely. In particular, offshore funds will calculate UKEP in respect of debt instruments and related derivatives as if they were a UK-authorised unit trust. Funds in existence prior to Royal Assent will need to make an irrevocable election for this change to apply.
In addition to meeting the technical criteria, a fund must still seek annual certification from the Inland Revenue in order for it (or a sub-fund or relevant share class as the case may be) to have distributing fund status.
There is potential for offshore fund mergers, which will benefit fund managers and promoters who have previously had to operate separate UK targeted funds in order to obtain distributing fund status. As sub-funds of umbrella funds and separate share classes can now qualify for that status, it is possible to set up a single umbrella fund with a mixture of accumulating and distributing sub-funds and/or share classes, whilst preserving capital gains treatment for UK investors.
These mergers will allow greater economies of scale and a number of managers are already seriously considering them. However, it will not be possible for existing investors holding interests in currently non-qualifying funds to roll these over into interests in a newly qualifying fund without crystallising a tax charge.
It should now be possible to replicate offshore the quasi-hedge funds investing in debt securities that have been launched onshore in recent months. For such funds, the adoption of corporation tax rules in respect of debt instruments and related derivatives for the calculation of UKEP means that any dealing profits, provided these are treated as capital profits in the fund's accounts, cannot be treated as trading income.
This benefit will not generally be available for equity-based funds or funds which are significantly invested in equity-based derivatives, and these funds are unlikely to be able to follow a full distribution policy even under the new rules, if any part of their profits would be treated as trading income.
For funds of funds, particularly funds of hedge funds, the extension of distributing fund status to a wider range of offshore funds will be attractive, particularly if more "distributing" hedge funds are set up in which fund of fund managers may invest (and given that a number of such funds have obtained certification under the current rules, this seems a real possibility).
However, the operation of the rules, particularly the need to monitor and obtain information on underlying hedge fund investments for the purposes of identifying whether the 5% threshold is exceeded and calculating the resulting "excess income" adjustment to UKEP, still presents some practical difficulties which will inhibit the development of new funds.
Given these difficulties, for funds of funds, use of an offshore closed-ended corporate structure remains the only practical route to obtain certainty of tax treatment for UK investors.
Paul Hale is a partner and Martin Shah a solicitor in the Corporate Tax Group at the London office of Simmons & Simmons, the international law firm.