A compact summary of the most recent regulatory developments relevant to the UK asset management industry. This issue includes details of the FCA’s statement on the implementation period for Brexit; the requirement for firms offering cryptocurrency derivatives to be authorised by the FCA; publication of a cybersecurity penetration testing framework; the FCA’s policy statement and final rules for the asset management market; an ECON draft report on the relationships between the EU and third countries regarding financial services regulation; notice of new MiFID II and MiFIR Q&As; and taxation developments in the implementation of BEPS and separately in the treatment of “loyalty payments”.
FCA Statement on EU Withdrawal Following Brexit
The Financial Conduct Authority (FCA) has issued a statement welcoming the agreement reached on the terms of an implementation period (29 March 2019 to end December 2020) that will apply following the UK’s withdrawal from the European Union. The implementation period will permit firms and funds to continue to benefit from passporting between the UK and the EEA (European Economic Area) with obligations derived from EU law continuing to apply, meaning firms must continue with implementation plans for EU legislation that is still to come into effect before the end of December 2020.
The FCA has outlined that in light of the agreement on the terms of an implementation period and HM Government’s commitment to providing for a Temporary Permission Regime as a backstop, firms and funds currently benefitting from an EU passport need not apply for authorisation at this stage. The Temporary Permissions Regime is intended to enable relevant passporting firms and funds to undertake new business that falls within the scope of their existing permissions, enable them to continue performing their contractual rights and obligations, manage existing business and mitigate risks associated with a sudden loss of permission.
The FCA has also launched a survey to collect information from EEA firms and funds wishing to participate in the Temporary Permission Regime and is encouraging those firms and funds to complete it. The survey closes on 11 May 2018. Further details on proposals relating to the Temporary Permissions Regime are expected later this year.
The implementation period permits firms and funds to continue to benefit from passporting between the UK and EEA until the end of December 2020. The FCA has recommended that UK firms and funds passporting into the EEA should discuss with their relevant EU regulator the implications of a transitional period for their contingency planning. The FCA has also confirmed it will cooperate closely with home state regulators of EEA firms as well as the European Supervisory Authorities.
FCA Statement on the Requirement for Firms Offering Cryptocurrency Derivatives to be Authorised
Cryptocurrencies are not currently regulated by the FCA if they are not part of other regulated products or services. However, the FCA has stated that cryptocurrency derivatives are capable of being financial instruments under the Markets in Financial Instruments Directive (recast) (MiFID II) even though it does not consider cryptocurrencies to be currencies or commodities for regulatory purposes under MiFID II. The FCA has published a statement to the effect that dealing in, arranging transactions in, advising on or providing other services that amount to regulated activities in relation to derivatives that reference either cryptocurrencies or tokens issued through an initial coin offering, will require authorisation by the FCA. This includes cryptocurrency futures, contracts for differences and options.
The FCA refers firms to its general guidance on the regulatory perimeter (PERG) and encourages firms to seek expert advice if they have additional questions. Further information on cryptocurrencies is available in the feedback statement to the discussion paper on distributed ledger technology.
Publication of Cybersecurity Penetration Testing Framework
The Global Financial Markets Association (GFMA) has published a Framework for the Regulatory Use of Penetration Testing in the Financial Services Industry. It is designed to create an agreed upon approach for regulators and financial services firms to conduct effective cybersecurity penetration testing to satisfy both supervisory and firm originated requirements.
The GFMA has outlined that penetration testing serves as one of the foremost tools in enabling a robust security program for financial institutions. Such testing allows firms to evaluate their systems and the controls that protect them in order to identify and remediate vulnerabilities, thereby strengthening their infrastructure against cyber threats.
The Framework is aimed at those in the financial services industry who conduct, rely or call for the execution of penetration testing and red teaming, including regulators, firm executives, information security professionals, information technology specialists, testers, third party stakeholders and industries outside financial services. A number of jurisdictions around the world already leverage penetration testing in their regulatory regime. The goal of the GFMA proposal is not to compete with existing frameworks but rather to coordinate their development and use to ensure that financial institutions are able to safely, securely and efficiently increase their cyber resilience while complying with their supervisory requirements. The GFMA penetration testing framework is similarly aligned with the G-7’s broader recommendations on how institutions can conduct effective cybersecurity assessments, promoting safe and effective testing methods.
FCA Policy Statement and Final Rules Implementing Asset Management Market Study Remedies
The FCA has published Policy Statement (PS18/8) which sets out final rules and guidance for Authorised Fund Managers (AFMs) primarily in the areas of fund governance, movement of fund investors to better value share classes and fair treatment of dealing profits. The Policy Statement follows FCA Consultation Paper 17/18. The new rules are intended to require AFMs to focus more on their duties as agents of investors in their funds and are part of a package of measures introduced to address weaknesses identified in the asset management market study, the findings of which were published last summer.
With the exception of the non-Handbook guidance relating to share classes which is effective immediately, the above final rules and guidance will be inserted into the Collective Investment Schemes (COLL) Sourcebook and will come into force on a staggered implementation basis as further outlined in the Policy Statement.
ECON Draft Report on Relationships Between the EU and Third Countries Concerning Financial Services regulation and supervision
The European Parliament’s Committee on Economic and Monetary Affairs (ECON) has published a draft report on the relationships between the EU and third countries concerning financial services regulation and supervision. The report primarily focuses on the concept of “third country equivalence” under EU financial legislation and calls for the establishment of a clear framework for a transparent, coherent and consistent application of equivalence procedures which would introduce a standardised process for the determination of equivalence. The report also highlights the importance of the EU’s role in global standard-setting for financial regulation.
ECON will vote to finalise the draft report before it is considered by the Parliament in plenary session.
ESMA Publishes New Q&As on MiFID II and MiFIR
The European Securities and Markets Authority has published an updated version of its questions and answers (Q&As) on market structures and transparency topics under MIFID II and the Markets in Financial Instruments Regulation (MiFIR).
The updated Q&A on market structures amends the answer to a question on direct electronic access and algorithmic trading and adds a new question on multilateral and bilateral systems
BEPS Multilateral Instrument Ratified
More than 100 jurisdictions concluded negotiations on 24 November 2016 on the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the “MLI”) in order to implement the tax treaty-related BEPS recommendations (which amongst other action points include BEPS Action Point 6 (Treaty Abuse). The MLI was signed on 7 June 2017 and was structured to enter into force when ratified by at least five countries and in theory amends more than 1,200 tax treaties worldwide.
Last month, Slovenia became the fifth country to ratify the MLI. As such, the MLI will come into force on 1 July 2018 and will enter into effect for a specific tax treaty after all parties to that treaty have ratified the multilateral instrument.
In summary, BEPS Action Point 6 recommends certain changes to standard double tax treaty provisions with the intention of preventing the inappropriate granting of treaty benefits. This could have the impact of limiting the circumstances in which investment funds or intermediate vehicles established by investment funds can benefit from tax treaties. In particular, Action 6 requires the adoption of minimum standards by participating jurisdictions. This requires either the adoption of a so called principal purpose test (“PPT”) or a limitation on benefits test (“LOB”) together with an “anti-conduit” rule, or a PPT and simplified LOB.
The intention of most European jurisdictions (including the UK) is to apply the PPT to treaties once the MLI has been ratified.
No withholding Tax on “Loyalty Payments” Paid by Investment Platforms to Investors
In the case of Hargreaves Lansdown v HMRC ( UKFTT 0127 (TC)) the First-Tier Tribunal decided that “loyalty payments” or “loyalty bonuses” (a discount to a fund’s management fees) are not subject to UK income tax or subject to UK withholding tax as an “annual payment”.
In summary, the UKFTT were of the view that the loyalty payments do not constitute “pure income profit” in the hands of the investors and therefore did not constitute an “annual payment” as it is defined in case law and accordingly is not subject to UK withholding tax. At its most basic “pure income profit” is essentially income that is received without the person in receipt of that income having to do anything in return i.e. no outgoing/expense has been incurred for receipt of the income. The UKFTT accepted the argument that as investors were required to pay ongoing management costs with respect to their investment in order to qualify for the loyalty bonus, the loyalty bonus is not “pure income profit”. In addition, in any event, the UKFTT explained that the evidence made it plain that the nature and quality of a loyalty payment as described in Hargreaves Lansdown fund fact sheets is that it is not a “profit” to an investor, but a reduction of their net cost.
HMRC have two months to appeal the case. To the extent a platform provider has withheld amounts from investors pending the conclusion of the case, it would be prudent to ascertain whether the case will be appealed before paying such withheld amounts to investors.