The UK's offshore fund tax rules are changing. Subject to the outcome of a final consultation, with effect from October 1, 2009, offshore funds will be able to elect for reporting fund status. David Gubbay of law firm Dechert explains the proposed changes to the existing distributing fund regime and identifies the key issues which offshore funds and their managers should be considering at this time.
The proposed changes to the existing distributing fund regime will be of major importance to UK-resident investors in offshore funds to enable them to obtain favourable capital tax gains treatment for their investment in such offshore funds. It should provide for a less burdensome certification process and greater certainty for funds and their investors.
Under the existing regime, unless an offshore fund is certified by HM Revenue & Customs as a distributing fund, UK investors will be subject to income tax rather than capital gains tax on any gain arising the disposal of their interests in the fund. Since the current highest marginal rate of income tax of 40 per cent is significantly higher than the flat CGT rate of 18 per cent, obtaining distributing fund status may be of crucial importance to UK individual investors.
This importance will increase further in future if the government's plan to increase the highest marginal income tax rate to 45 per cent with effect from April 6, 2011 is implemented. Distributing fund status is also particularly attractive to UK investment trusts and authorised investment funds, which are exempt from capital gains but not income.
In order to achieve distributing fund status a fund must physically distribute at least 85 per cent of its income (but not generally gains on the sale of investments unless those gains are trading profits).
Furthermore, a distributing fund may not at any time in an accounting period have more than 5 per cent of its assets invested in other offshore funds that are not themselves certified as distributing funds or capable of being so certified. The fund must make an application to HMRC for distributing fund each year, and approval is granted retrospectively.
The government proposes to change the definition of offshore fund for tax purposes so that this will be detached from the regulatory definition of 'collective investment scheme' and will instead follow a 'characteristics-based' test.
It is intended that the new definition will apply from October 1 (in tandem with the reporting fund rules), subject to transitional rules. Broadly, from then on offshore fund for UK tax purposes will encompass any non-UK tax resident company, trust or other vehicle where the participants do not have day-to-day control of the management of the property, and a reasonable investor would expect to be able to realise any investment based entirely or almost entirely by reference to the net asset value of the property or an index of any description.
The change in definition should not impact upon offshore vehicles within the current definition of offshore fund except in unusual circumstances. However the new definition may bring some offshore vehicles currently outside the scope of the offshore fund rules (such as certain closed-ended vehicles) within scope. Offshore funds and their managers will need to consider how the change in definition may affect them.
The proposed changes to the offshore fund rules will replace distributing fund status with reporting fund status. Ultimately the new rules will achieve the same objective as the old, namely to determine the circumstances in which investors in offshore funds can benefit from CGT treatment.
It is envisaged that the changes will provide for a less burdensome certification process and greater certainty for funds and their investors. This should make reporting funds status more accessible to funds that have previously been unable to satisfy the distributing fund requirements and accordingly increase their attractiveness to UK investors.
The key changes from the distributing fund rules are as follows:
Instead of having to distribute income, funds will be required to report 100 per cent of the income attributable to their investors. There will no longer be a need to physically distribute income, but rather there may be deemed distributions or a combination of physical and deemed distributions. A UK investor in a reporting fund will be taxable on its share of income in the reporting fund whether or not it is actually distributed.
The investment restrictions currently applying to distributing funds will be abolished. This will make it easier for funds of funds to achieve certification as reporting funds.
Managers of offshore funds will be able to obtain forward-looking certification of a fund as a reporting fund which will continue to apply until the fund chooses to leave or is removed from the regime. This is unlike the current distributing fund regime where certification must be sought annually and retrospectively, which can cause uncertainty for investors.
Breaches of the rules will not necessarily cause the fund to lose reporting fund status, which will be the case only where there is a serious breach, or persistent breaches. This is unlike the current distributing fund rules where a simple breach can lead to loss of distributing fund status.
There will be transitional provisions to allow existing distributing funds to become reporting funds, and for investors to continue to receive capital gains tax treatment.
Where a fund moves from being a non-distributing or non-reporting fund to a reporting fund, investors will be able to make an elective deemed disposal of their interest in the old fund. While this may crystallise an income tax charge at the time of the deemed disposal, the investor will then become entitled to CGT treatment on an eventual disposal of their interest in the reporting fund.
David Gubbay is a tax partner in the London office of international law firm Dechert