Although the new UK offshore fund tax rules took effect from 1 December 2009, in reality it was during calendar year 2010 that existing offshore vehicles and vehicles coming to launch had to grapple with the new definition of an “offshore fund” for UK tax purposes. For those offshore vehicles caught by the new definition, 2010 required consideration of the new “reporting fund” regime for the first time. This was not helped by the fact that it was only in May of 2010 that HM Revenue & Customs (HMRC) published final guidance to accompany the new regime.

In light of this, we thought it helpful to summarise the new regime.

Why are the offshore fund rules relevant?

A UK resident investor in an offshore vehicle caught by the offshore fund rules will be subject to income tax treatment on any gain realised upon disposal of their interest, unless the fund applies for and is granted approval as a “reporting fund”.

For certain types of UK investor, this will compare unfavourably with chargeable gains tax treatment. For example, UK individuals will be taxed at 40/50% rather than CGT at 18/28%.

The new definition of an “offshore fund”

From 1 December 2009, an offshore vehicle (i) that is a non-UK company, (ii) under which property is held on trust for investors (the trustees being non-UK resident), or (iii) that is constituted by other arrangements (other than a partnership) creating co-ownership rights, taking effect under non-UK law, will fall within the offshore fund rules if it is a “mutual fund”.

The key limb of the definition of a “mutual fund” is that:

  • under the terms of the arrangements of the vehicle, a reasonable investor would expect to be able to realise all or part of their investment on a basis calculated entirely, or almost entirely, by reference to
  • The net asset value (NAV) of the property, or
  • An index of any description.

Exceptions to the new definition

There are four exceptions to the new definition which are specifically legislated for, and which apply where a reasonable investor can expect to realise at NAV or by reference to an index only in the event of the winding up, dissolution or termination of the fund:

  • the arrangements are not designed to wind up, dissolve or terminate on a date stated in or determinable under the arrangements (Exception 1);
  • the arrangements are designed to wind up, dissolve or terminate on a date stated in or determinable under the arrangements, but either:
    • none of the assets are “income-producing assets” (assets which, if held directly by an individual resident in the UK, would produce income on which that individual would pay income tax) (Exception 2);
    • the investors in the arrangements are not entitled to the income from the assets, or to any benefit arising from them (Exception 3);
    • any income produced by the assets, after deductions for reasonable expenses, is required under the arrangements to be paid or credited to the investors and any individual UK-resident investor would be charged to UK income tax on such income (Exception 4)

Exceptions 2 to 4 will not be available if the arrangements are designed to produce a return for investors that equates to the return on an investment of money at interest.

It has been our experience to date that, in practice, Exception 4 is likely to be the most important of the exceptions to the new offshore fund rules for funds (or individual share classes – see below) that have a fixed or a “determinable” life. A fixed-life fund (or share class) that pays out all of its income, less reasonable expenses, and which is not designed to produce an interest-like return for investors, will be able to fall outside the scope of the new offshore fund rules without having to rely on obtaining and maintaining “reporting fund” status.

Umbrella arrangements and multiple classes of interest

Arrangements which provide for separate pooling of contributions of investors are disregarded, with each part treated as separate arrangements. The same approach will apply to an individual cell within a protected cell company.

Where there is more than one class of interest in an offshore vehicle, each class is to be treated separately. An overseas vehicle may have one share class which constitutes a “mutual fund” and another share class which does not.

Reporting fund status

UK resident investors in a “mutual fund” will still be taxed under UK CGT rules upon realisation of any gain upon disposal of their interests if the offshore vehicle is approved by HMRC as a “reporting fund”.

A reporting fund will be required to report its “reportable income” and UK investors will be subject to tax on the reported income whether or not such income is actually distributed by the fund.

To be a reporting fund, a “mutual fund” must:

  • apply to be a reporting fund within the relevant time limits;
  • prepare accounts in accordance with International Accounting Standards (“IAS”) or other GAAP (as specified in the application);
  • provide a computation of its reportable income;
  • report the reportable income to investors; and
  • provide all required information to HMRC.

“Reportable income” is, assuming IAS is to be applied, the “total comprehensive income for the period” as shown in the accounts as adjusted by certain items. Alternatively, for a vehicle not using IAS, the starting point is to take entries in the accounts that are considered to equate to “total comprehensive income for the period”, as that expression is used in IAS.

Items adjusted for include capital items, income from other “offshore funds” and effective interest.

The offshore fund rules prescribe the information that must be reported to both investors and HMRC on an annual basis.

As a result of the fact that each share class in an offshore vehicle is considered on a separate basis for the purposes of the offshore fund rules, it follows that the “reportable income” of a particular share class that constitutes a mutual fund will be the income attributable to that share class.

Expected amendments/developments

Since the introduction of the new offshore fund tax rules on 1 December 2009, HMRC have been working with the industry to identify and address any issues with the revised regime. We have already seen draft legislation to amend the Offshore Funds (Tax) Regulations to account for the effect of equalisation arrangements in the calculation of reportable income and the Government has announced that legislation will be enacted in Spring 2011 to address all issues that have been identified. We would expect any future developments in this area to address (amongst others):

  • the application of the new rules to index-tracking funds;
  • how genuine private equity funds are affected by the new regime; and
  • amendments to allow more funds to take advantage of the reporting fund regime “white list” of non-trading transactions.

HMRC have also confirmed that (contrary to indications given in its published guidance) a zero-dividend preference share class should not constitute an offshore fund under the revised rules. It remains to be seen whether the legislation and/or guidance is updated to reflect this treatment.