In this article we compare the different methods of investment following the abolition of exchange control in the early 1980s. We show how offshore funds "ticked all the boxes", resulting in a financially efficient product which was capable of making money for the investors and the managers. The offshore fund structure is still attractive today.
Conventional collective investment funds exist to serve one or both of two commercial purposes – to enable retail investors to gain investment exposure to a portfolio of assets which they could not acquire directly ("benefit of scale") or to enable pension or other investment funds to benefit, in relation to specialised investment areas, from expert investment advice ("benefit of expertise"). Some "offshore" arrangements, usually of an ad hoc or primitive type ("attempted offshore cloaks"), do not seek benefits of scale or of expertise, or any other commercial end, but exist solely to conceal assets or income from regulators or investors' tax authorities: such concealment is often unlawful and attempts to achieve it do not require the structures necessary for collective investment schemes, targeting benefits of scale or benefits of expertise. There has recently been confusion in the media, in relation to UK investors, between conventional collective investment funds and offshore cloaks. This confusion has led to uninformed pejorative comments.
One of the simplest possible ways of arranging collective investment is to launch a UK company which holds the portfolio of assets and in which the investors take shares. UK tax law however tends to discourage the use of such a structure for collective investment schemes by effectively duplicating the charge to capital gains taxation: the company would be charged to such tax when it switches investments and the investors would be charged again on essentially the same gain when they sell their shares. The difficulty was recognised by the Government right from the start, when capital gains tax was introduced in 1965. Since 1980 the problem has been resolved by special rules which apply to particular structures for collective investment – originally unit trusts and investment trusts, whereby unit trusts and investment trusts have been exempt from UK capital gains taxation by specific legislation.
Unfortunately, neither a unit trust nor an investment trust is commercially satisfactory for every kind of investment and for every kind of investor – overseas investors for example may find a unit trust unfamiliar. The attractions of investment trusts, whose shares must be listed on a stock exchange (itself a potential disadvantage), are often reduced by the "discount" phenomenon – an exiting investor may find he cannot realise his shares at net asset value. The solution which emerged in the 1960s was to arrange for the fund to take the form of an "offshore fund" (a non-UK resident company, formed in a jurisdiction which did not subject investment entities to tax on capital gains and whose company law was less developed and therefore less prescriptive than the UK's, such that redemption of units or shares at net asset value was feasible).
To some extent the problems have been reduced by the introduction in 1997 of the UK open-ended investment company ("OEIC") which resolves the duplicated capital gains tax problem (by exempting the OEIC from tax on gains) and the discount issue (by allowing the OEIC to redeem its shares at a price based on the value of the underlying investments). However, the OEIC structure is not always commercially appropriate, and so, alongside the offshore funds formed in the pre-1997 era which still exist, there are a number of newer funds of this type. It is important to remember that the selection of an offshore jurisdiction represents, as the UK Prime Minister pointed out recently, "standard practice", and in the case of a genuine investment fund, the choice of an offshore fund structure for an investment fund will have been made on rational business grounds, quite different from those which prompt the use of a foreign structure in the case of the "attempted offshore cloak" arrangement described above.
The attached table summarises the factors which historically have favoured, and in some cases still do favour, the use of an offshore structure for collective investment funds.