It was announced in the Budget 2007 that the current offshore funds regime was to be changed. At the time, it was anticipated that the new legislation, including a new definition of “offshore fund”, would be contained in the Finance Act 2008. The new definition was included in the Finance Act 2009, which received Royal Assent on 21 July 2009. The new offshore funds regime is now expected to come into force on 1 December 2009. After a long wait, the draft Offshore Funds (Tax) Regulations 2009 (the New Regulations) were released on 4 September 2009.
The current offshore funds regime was introduced in 1984 with the aim of preventing UK investors from rolling up income offshore so that, when the investment is sold, the tax charge will arise under the more advantageous capital gains tax regime. The purpose of the regime will remain the same under the new legislation. However, the Government hopes that the new legislation will clarify, simplify and modernise the regime.
In October 2007, as part of the Pre-Budget Report 2007, the Government published a discussion paper setting out the proposed change of the offshore funds regime and inviting feedback from the industry on the proposed changes. This was followed by further publications in March 2008 and December 2008.
Under the current regime, UK investors who realise an investment in an offshore fund are taxed on an income tax basis unless that fund has been a “distributing fund” throughout each accounting period that the investment has been held. In order to obtain “distributor status” a fund has to apply retrospectively to HM Revenue & Customs (HMRC) within six months of the end of its accounting period for certification that it met the necessary tests throughout that period. The tests include a requirement that the fund distribute at least 85 per cent of its income for that period and that the fund itself must not invest more than 5 per cent of its assets in other offshore funds (unless that fund is itself a distributing fund).
What is an Offshore fund?
Prior to the Finance Act 2009, the definition of offshore fund was by reference to a collective investment scheme constituted by a non-UK company or a unit trust scheme where the trustees are non-UK resident. The definition was amended by the Finance Act 2007 so that it was no longer dependant upon the regulatory definition of collective investment scheme. The definition also operated so that where an investor could not reasonably expect to be able to realise all, or part, of their investment within seven years the fund would not be an offshore fund.
The new definition, included in the Finance Act 2009, states broadly that an “offshore fund” is any non-UK company, trust or other vehicle created to enable investors to participate in the acquisition, holding, management or disposal of property (or to receive the profits from such activities) where the investors do not have day-to-day control of the management of the property and a reasonable investor would expect to be able to realise all, or part, of their investment by reference to the net asset value of the property or an index of any description.
The reference to a realisation of an investment in seven years has, therefore, been removed. As a result, a number of offshore vehicles which were not previously offshore funds may fall within the new definition and be within the scope of the offshore funds legislation.
Although there is still some uncertainty about the scope of the new definition, the grandfathering provisions contained in the New Regulations provide a degree of certainty for investors who acquired their interest in the offshore vehicle prior to 1 December 2009. Disposals of such interests by such individuals will not fall within the scope of the new offshore funds regime (provided that their holding in the fund was not a material interest in an offshore fund under the old provisions).
Reporting and Non-Reporting Funds The new regime will replace the concept of distributing funds and non-distributing funds with that of reporting funds and non-reporting funds.
As with non-distributing funds, a charge to income tax will arise on any gain realised by a UK investor on the disposal of an interest in a non-reporting fund. In addition, an income tax charge will arise on any gain realised by a UK investor on the disposal of an interest in a reporting fund if that fund had previously been a non-reporting fund and the investor made no deemed disposal election (see the paragraph entitled Conversion Into a Reporting Fund or Non-Reporting Fund below).
A UK investor who disposes of an interest in a reporting fund will be subject to capital gains tax, or corporation tax on gains, on any gain realised (unless the fund had previously been a non-reporting fund). In addition, such an investor will be subject to income tax on the distributions received by the offshore fund and their share of the excess of the offshore fund’s reported income over the distributions made. As a result, a UK investor in a reporting fund will be subject to income tax on their share of the offshore fund’s income regardless of whether this is distributed or not.
Conversion into a Reporting Fund or Non-Reporting Fund
As stated above, if a UK investor disposes of an interest in a reporting fund which was previously a non-reporting fund they will be subject to an income tax charge on any gain realised despite the fund being a reporting fund at the time of disposal. As a result, the fund’s previous non-reporting fund status taints the reporting fund status.
Similarly, if a fund ceases to be a reporting fund and becomes a non-reporting fund, a UK investor would again be subject to a UK income tax charge on any gain realised on an eventual sale of the interest in the non-reporting fund regardless of its previous status as a reporting fund.
As a result, the New Regulations provide that investors may elect, at the time the fund changes its status, to be treated as having disposed of their interest in the fund at market value and acquiring a new interest in the fund. Where the fund converts from a non-reporting fund to a reporting fund, there will be a charge to income tax on any gain arising. This election can only be made if it would not result in the investor realising a taxable loss. Where the fund converts from a reporting fund, the gain is taxed as capital.
Entry into reporting fund regime
In order to become a reporting fund, the manager (or proposed manager) of the fund must apply to HMRC within three months of the first day of the period of account for which it is to be a reporting fund. The application must include:
- a statement of the first period of account for which it is proposed that the fund should be a reporting fund;
- an undertaking that no period of account will exceed 18 months;
- undertakings to comply with the requirements to provide information to investors and HMRC;
- a copy of the prospectus (or proposed prospectus); and
- a statement of whether the fund intends to prepare its accounts in accordance with international accounting standards. Where the fund does not intend to use international accounting standards further documents and information will be required.
HMRC are required to respond to an application within 28 days of receipt. If they refuse an application the manager will have a right to appeal within 42 days.
Duties of reporting funds
A reporting fund is required to prepare its accounts in accordance with international accounting standards or in accordance with the generally accepted accounting practice specified in its application to become a reporting fund. The New Regulations set out in detail how the accounts should be prepared and how the reportable income should be computed, in particular dealing with adjustments for capital items, special classes of income and equalisation arrangements. The legislation allows a ten per cent margin for error when calculating the reportable income. If a fund has no, or negative, income it will be required to make nil returns.
Reporting funds will be required to prepare and send a report to each investor who is resident in the UK (or which is a reporting fund) within six months of the end of the reporting period. The report must state the amount actually distributed to investors, the excess of the amount of the reporting income over the amount actually distributed, the dates of distributions and a statement as to whether the fund remains a reporting fund. The report can be made available to investors by post, email, website or newspaper. Where the report is not posted, investors may request that it is made available in a different format.
Reporting funds will also be required to provide various information to HMRC, including audited accounts, a computation of reportable income, a copy of the report made available to investors, the reported income of the fund and a declaration that the fund has complied with its obligations. This information must be provided within six months of the end of the period of account.
Leaving the reporting fund regime
A reporting fund may give notice to HMRC to leave the reporting fund regime on the last day of a period of account. Alternatively, a fund may be required by HMRC to leave the regime if it is in breach of its obligations and the breach is serious. It can also be required to leave the regime if it has made four minor breaches (a breach for which there is a reasonable excuse or which is inadvertent and is remedied as soon as possible) within a period of ten years beginning with the first day of the period of account in which the first minor breach occurs.
If a fund is required to leave the reporting fund regime by HMRC it will be unable to apply to rejoin the regime at a later date.
Transitional provisions for existing distributing funds
Funds currently certified as distributing funds may apply to HMRC to be treated as distributing funds for the period from 1 December 2009 until the end of their period of account current on the date of introduction of the new regime. Provided the fund is granted distributor status for this period, it may then apply to HMRC to continue to be treated as a distributing fund for the next period of account. Where such applications are made the fund will not be required to apply the new offshore funds regime until the expiry of such periods.
If a fund falls within the scope of the offshore funds regime due to the amended definition of “offshore fund” it may make an application to HMRC, by 31 May 2010, to become a reporting fund for the period of account current on 1 December 2009.
As with a conversion from a non-reporting fund to a reporting fund and vice versa, investors may make an election where a distributing fund becomes a non-reporting fund, or a non-distributing fund becomes a reporting fund, so that they are treated as making a disposal on conversion. This ensures that any inherent gain accumulated in respect of their interest whilst the fund is either a distributing fund or a reporting fund is not prejudiced by the fund being, at a certain point in time, a non-distributing fund or a non-reporting fund.
Other provisions to note in the New Regulations include the following. First, where a person disposes of his interest in a reporting fund, it is likely that the price will reflect any accumulated income which has not been distributed since the last distribution date. As the investor will be liable to income tax on that income, the New Regulations provide that an amount equal to such income can be deducted from the sale proceeds when calculating any capital gain that arises from the disposal.
Less welcome is the fact that where a loss arises on a disposal of an interest in a non-reporting fund (or in a reporting fund that was previously non-reporting), that loss cannot be set against any other income tax that is payable under the new offshore funds rules.
There are also provisions dealing with transparent funds, i.e. funds, such as most offshore unit trusts, where UK investors are treated as the beneficial owners of the underlying income and are, therefore, taxable on the income in any case. Such funds are excluded from the regime unless they hold (or have held) more than 5 per cent. of their assets in other non-reporting funds, or if they have failed to make sufficient information available to their investors.
Another welcome provision relates to the transactions of offshore funds which may amount to trading. Profits from such transactions will normally constitute reportable (and therefore taxable) income and it is often a grey area as to whether certain transactions should properly be regarded as investments (capital) or trading (income). The New Regulations provide that for certain funds transactions which fall within a list (which includes share dealing, most derivatives and currency transactions) will not be regarded as trading. The funds which can benefit from this provision (provided they meet certain other tests relating to diversity of ownership and production of documents) are UCITS funds and similar overseas schemes which are recognised by the FSA.
The New Regulations, which are still in draft format, are welcome as they provide greater certainty for the new offshore funds regime which is expected to take effect on and from 1 December 2009. Nevertheless, the definition of “offshore fund” requires further amendment to avoid the uncertainty created by the removal of the seven year requirement.
The new regime is likely to result in increased administrative costs for offshore funds who apply to become reporting funds due to the requirements to provide information to both investors and HMRC. Also, it may result in investors being taxed on amounts which they do not receive. However, existing distributing funds will be pleased that transitional provisions are to be introduced allowing them to continue, upon application to HMRC, to apply the current offshore funds regime for their current accounting period (and the following one). It seems, however, that there is no relaxation of the rule requiring an application to become a reporting fund to be made within three months of the beginning of the period of account in which the fund wishes to be a reporting fund. As a result, where the accounting period of a fund started more than three months before the 1 December 2009 it will be unable to apply to become a reporting fund and will, therefore, have to apply for distributor status in respect of the period of account current at 1 December 2009.