As part of its drive to increase the attractiveness of the UK as an asset management and investment hub, the UK Government has included in the Finance Bill revised draft legislation for a generous new regime for the taxation of UK resident holding companies owned as to 70% or more by regulated funds or qualifying institutional investors. This follows extensive, and continuing consultation and is part of the government’s wider review of the UK funds regime. The intention behind the regime is to minimise tax leakage in the QAHC. It seeks to provide investors in QAHCs with after-tax returns similar to those which they would receive if they invested in the underlying assets direct, and for the intermediate holding company (a QAHC) to pay no more tax than is proportionate to the activities it performs. It is intended that this new regime will be introduced with effect from April 2022. This article is an updated version of our earlier article published in July 2021.

The current design of the regime facilitates this by (very broadly):

  • introducing a corporation tax exemption for certain profits and gains on assets such as non-UK real estate and shares and securities in companies which are not UK-property rich;
  • allowing deductions for certain interest payments made by a QAHC to its investors that would usually be disallowed as distributions;
  • treating shareholder profits on the repurchase of shares as capital gain, if funded from capital gains arising to the QAHC’s exempt business, and exempting such repurchases from stamp taxes;
  • removing the obligation to withhold basic rate income tax from payments of interest by a QAHC; and
  • allowing investment managers not domiciled in the UK to take advantage of the remittance basis for income and gains on their holdings in a QAHC to the extent that these derive from the QAHC’s non-UK investments.

However, these tax reliefs will apply only if the QAHC is at least 70% owned by qualifying collective investment schemes or AIFs and/or by specified categories of institutional investors. It must also carry on an investment business and not undertake any significant trading activity. Details of the new tax reliefs and investor requirements are set out in more detail below.

In order for a company to qualify as a QAHC:

  1. it must be UK resident;
  2. it must meet the 70% ownership condition; these very complex provisionsare summarised below;
  3. its main activity must be the carrying on of an investment business, and any other activities must be ancillary to the investment business (such as provision of management services to portfolio companies) and not carried on to any substantial extent; guidance is still awaited as to the meaning of “substantial” for this purpose and whether it will follow the 20% test used for the substantial shareholdings exemption;
  4. its investment strategy must not involve the acquisition of shares listed or traded on a recognised stock exchange or other public market or exchange, or of interests deriving their value from such shares, except for the purpose of facilitating a change of control and de-listing;
  5. it must not be a REIT;
  6. equity securities in the company must not be listed or traded on a recognised stock exchange; and
  7. it must have made a notification of its entry into the QAHC regime.

The ownership condition

In order to qualify for the benefits of the QAHC regime, no more than 30% of the equity interests in the QAHC may be held by persons who are not Category A investors. However a new QAHC does not necessarily have to meet this threshold from the start. It is allowed a period of two years to meet this ownership condition if, at the time of joining the regime, it reasonably expects to be able to be able to satisfy it within that two year period.

Category A investors are:

  • QAHCs;
  • Qualifying funds, defined as collective investment schemes (including limited partnerships, unit trusts and open-ended investment companies) and AIFs (alternative investment funds) which either satisfy a complex genuine diversity of ownership (GDO) test or are non-close or are close only because they have a Category A investor as a direct or indirect participator; the non-closeness test for this purpose is a modified version of the test which applies in other UK tax legislation. The earlier draft legislation applied the close test only to companies so non-corporate funds would have had to rely on satisfying the GDO test in order to qualify as QAHCs. They now have the option of satisfying the alternative non-close test so a company owned by a limited partnership with a majority Category A investor may now potentially qualify as a QAHC.
  • relevant qualifying institutional investors including (in each case subject to qualifying conditions):
  • UK REITs and foreign equivalents;
  • pension schemes;
  • charities not connected to the fund managers;
  • insurance companies carrying on long term insurance business;
  • public authorities;
  • entities benefitting from sovereign immunity;
  • a company which is a collective investment vehicle for the purposes of the non-resident capital gains tax regime as a result of paragraphs (d), (e) or (f) of Sch 5AAA Taxation of Chargeable Gains Act 1992 (a non-UK resident company meeting a property income condition); and
  • intermediate companies owned as to at least 99% byCategory A investors; this is a very high threshold which will in most cases disqualify companies with management co-investment or other employee shareholders.

The rules for calculating the percentage held by investors who do not fall within these categories require close attention as they can produce aggregate percentages significantly higher than the proportions of shares or fund capital held by the relevant participators. The investors with “relevant interests” include not only partners, unit holders and holders of ordinary shares but also lenders who have made loans to the QAHC other than normal commercial loans. The calculation applies by reference to entitlement to profits, assets on winding up and voting rights and takes whichever of these is the highest in respect of each participator (in contrast to the corporation tax rules for group and consortium relief which take the lowest percentage). Where a class of shares has an enhanced or sole entitlement to benefit from specified assets, no more than 30% of that class may be owned by non-Category A investors; this is to prevent what HMRC call “side pocket” arrangements designed to obtain the benefits of the QAHC regime for non- Category A investors.

Furthermore some indirect interests are also included in the computation so it is generally necessary to trace through structures above the QAHC to identify relevant interests. However, there are exceptions to this rule. In particular, these tracing rules do not apply if the indirect interest is held through a structure which is itself a Category A investor. This means that a management team’s carried interest in a qualifying fund does not generally count towards the 30% limit for non-Category A investors in the QAHC owned by the fund, provided that the carried interest holders do not also hold relevant interests in the QAHC direct. If they hold interests direct and indirect, the current draft legislation provides that their direct and indirect interests must be aggregated (even if the indirect interest is held through a Category A investor) and that both count towards the 30% upper limit for non-Category A investors. Particular care will therefore need to be taken with co-investment and parallel fund arrangements and with carried interest and management co-investment at QAHC level.

The new tax regime

The Government is concerned that UK-based fund managers are setting up foreign holding companies beneath limited partnerships and other alternative investment funds because UK resident companies are seen as tax inefficient for this purpose. Luxembourg holding companies are especially popular for this purpose and the combined effect of Brexit and new double tax treaty shopping rules imposed by the OECD BEPS (Base Erosion and Profit Shifting) project have led to increasing numbers of partnerships being established under Luxembourg law rather than in the UK. The analysis below considers the main tax problems affecting UK holding companies and how the new regime would address them.

Taxation of profits

The problem

The UK substantial shareholdings exemption (SSE) is not as generous as the participation exemptions in Luxembourg and some other jurisdictions. In particular, while SSE is generally available to holding companies selling holdings of 10% or more in trading companies, it does not fully apply to sales of investment companies (unless 80% by value of investors are qualifying institutional investors) so is of limited benefit for real estate funds. Furthermore, although UK holding companies are generally not taxed on dividends, they pay corporation tax on other categories of income such as interest and rental income and on capital gains outside the SSE and the main rate will rise to 25% in 2023.

The solution

The QAHC regime will provide a wide corporation tax exemption for gains on disposal of:

  • overseas real estate, the income from which is taxable in an overseas jurisdiction;
  • shares in UK or non-UK companies which are not “UK-property rich”, i.e. do not derive at least 75% of their value from UK land; “shares” for this purpose includes units in unit trusts treated as shares and interests in tax transparent funds treated as assets for capital gains tax purposes, the interests of members in companies with no share capital, the interests of co-owners of shares and any derivative contract to the extent that its underlying subject matter is shares. There are norequirements as to the size of the shareholding or rate of tax paid by the entities in which shares are held(unlike the participation exemption regimes in Luxembourg and some other jurisdictions) although the UK controlled foreign companies regime may impose corporation tax liability if profits are regarded as diverted from the UK to companies controlled from the UK.

The regime also provides exemption from corporation tax on income in respect of:

  • overseas property business profits, including rental income, but only to the extent that these are taxed in a foreign jurisdiction; “taxed” for this purpose means subject to a tax equivalent to UK income or corporation tax and not exempt from tax nor taxed at a nil rate. It therefore applies even if the rate of such tax is significantly below the prevailing UK rate, whereas normal UK rules would generally impose corporation tax on the difference between the two rates; and
  • profits arising from loan relationships and derivative contracts that the QAHC is party to for the purposes of its overseas property business or other investments within the ringfence. In particular this removes liability to tax on interest and other returns on loans by the QAHC to property holding subsidiaries and portfolio companies. Where the loans or derivatives are not solely for ringfence investments, the exemption will apply only to the proportion attributable to the overseas property business.

There is no specific QAHC exemption for dividends but a QAHC would benefit from the general corporation tax exemption for most UK and foreign dividends.

UK property investment is permitted but income or gains in respect of UK property or shares in UK property-rich companies will be taxed in the usual way so a UK REIT remains, in many cases, a preferable structure for real estate investment in the UK.

Discussions are continuing on how income received by QAHCs from investment in REITs should be treated for tax purposes. REITs will be able to invest in QAHCs as Category A investors but not to hold 75% of more as that could cause the QAHC to become part of the REIT group.

The tax exempt element of the QAHC’s business will be ringfenced from its non-exempt business and a QAHC with both ringfenced and other business will notionally be treated as two separate companies for this purpose. Losses on the ringfenced business cannot be set against profits on its non-exempt business or surrendered to other group companies to set against non-exempt profits. Most capital gains tax reliefs for transfers between group companies will be disapplied if one is a QAHC, but a company which transfers shares to a QAHC in its group may be able to benefit from the substantial shareholdings exemption even if it has not held the shares for the requisite 12 months, provided that the QAHC continues to hold them for the remainder of that 12 month period. It appears, on the basis of the current draft legislation, that any capital gains or losses arising to a QAHC from non-qualifying items will be able to be reallocated to another member of the corporate group that is not a QAHC.

Restrictions on tax deductibility of interest

The problem

UK companies are subject to less generous interest deductions than those in other jurisdictions, notably those with flexible securitisation vehicle regimes and Luxembourg where practice has historically been to tax only a narrow margin of profit on loans to and by a holding company, with results-dependent interest generally deductible. In particular the UK generally treats results-dependent interest on loans as a distribution so the paying company is not allowed a tax deduction for such interest.

The solution

Interest on loans which are “relevant securities” will no longer be treated as a non-deductible distribution if the securities are entered into by the QAHC for the purposes of its ringfence business and the only reason why interest on them would otherwise be treated as a distribution is because they fall within the definition of relevant securities. These are (a) securities on which the interest or other returns represent more than a reasonable commercial return on the amount of the loan, and (b) securities issued for new consideration which are not equity notes and which meet one or more of the following conditions:

  • the amount of interest, premium or other returns depend to any extent on the results of the company’s business or any part of its business;
  • the securities are convertible (directly or indirectly) into shares in the company or they carry a right to receive shares in or securities of the company and they are neither listed on a recognised stock exchange nor issued on terms reasonably comparable with such listed securities; and
  • the securities are “stapled” to shares or otherwise connected with shares in the company, in the sense that it is necessary or advantageous for any person disposing ofthe securities to also dispose of a proportionate holding of the shares.

The UK hybrid mismatch rules will be amended to prevent them disapplying the QAHC’s tax deduction for payments which these QAHC rules now treat as deductible but which the recipient’s jurisdiction treats as dividends exempt from tax or taxed at a lower rate than ordinary income.

Furthermore, the “late paid interest” rules and deeply discounted securities rules which delay a company’s tax deduction for accruing interest and discount on some loans from participators will be disapplied for QAHCs if the loans are to fund their ringfence business, allowing interest and discount deductions on an accruals basis (rather than only on eventual payment).

The share redemption/buy-back rules

The problem

On redemption or repurchase of shares in a UK company, UK corporation tax treats payments exceeding the amount paid on subscription for the shares as distributions of income rather than capital distributions, even where what is being distributed is the profit or proceeds of sale of one or more of a holding company’s investments. As a result, what was a capital gain in the hands of the holding company becomes liable to income tax in the hands of UK resident individuals and other non-corporate shareholders. This is a major problem for individuals who hold carried interest in funds which distribute sale proceeds as they pay tax at rates up to 38.1% (rising to 39.35% from April 2022) on distributions but only 28% for gains representing carried interest and 20% on other capital gains.

Where the holding company is a non-UK company, this automatic income distribution treatment does not apply and, where the repurchase is a capital transaction in local law, the payment is treated as capital for UK tax purposes. In Luxembourg, the redemption of a whole class of shares is treated as a partial liquidation rather than a distribution, so Lux holding companies are commonly set up with multiple share classes to facilitate class redemptions after major investment sales.

The solution

Profits made by shareholders on repurchase of their shares by a QAHC will no longer automatically be treated as distributions and will be treated as capital rather than income where, broadly, these derive from capital gains realised by the QAHC on the underlying investments within the ringfence business. Unlike in Luxembourg, there will be no need to create multiple classes of shares for this purpose. However, this new capital treatment will not apply to shares held by employees of the QAHC or of a company in which the QAHC has at least a 25% interest. In contrast, individuals who hold carried interest in the fund which owns the QAHC and whose role is to manage the fund will benefit from capital treatment. There will also be a new stamp taxes exemption for such share repurchases.

To achieve greater certainty for taxpayers, the transactions in securities anti avoidance rules which can enable HMRC to impose income tax on amounts otherwise treated as capital gains, will not apply to shares and securities in a QAHC except those held by employees of the QAHC or of a company of which the QAHC owns at least 25%.

The QAHC legislation does not address the UK company law issues arising on share redemptions and repurchases which involve reduction of share capital. However, there is no requirement that a QAHC must be incorporated in the UK so companies incorporated in jurisdictions with more flexible company laws could be used as QAHCs as an alternative to UK companies, provided that they are tax resident in the UK.

UK withholding tax on interest

The problem

The UK generally imposes withholding tax on interest paid to lenders other than UK companies and banks, and on interest paid to non-UK residents in the absence of a double tax treaty, and loans are often structured as Eurobonds or discount notes to prevent this. Even where there are treaties between a lender’s jurisdictions and the UK, there are administrative costs and delays in applying for relief or reclaiming excess deductions, and additional complications can arise if an investor’s jurisdiction does not treat a lending investment partnership as transparent. Several other jurisdictions, such as Luxembourg, do not impose withholding tax on interest so can be more attractive holding company options.

The solution

There will no longer be any obligation to withhold tax on interest paid by a QAHC.

Stamp duty and stamp duty reserve tax

The problem

Many other jurisdictions do not levy transfer duties on sale of shares and securities so the UK’s stamp taxes regimes have made UK incorporated companies less attractive for use as holding companies.

The partial solution

There will be an exemption from stamp duty and SDRT on repurchases by a QAHC of its own shares and loan capital except:

  • where the repurchase takes place at a time when there is an arrangement for a sale of 90% or more of the relevant interests in the QAHC; or
  • the repurchase is connected with the issuing of new shares or securities to a person other than the original holder. Broadly this is intended to disapply the relief where the repurchase and issue are economically equivalent to the transfer of shares or loan capital.

Sales of shares in UK companies and certain loan capital will however continue to be subject to stamp duty or SDRT so QAHCs will, to this extent, still be disadvantaged in comparison to companies in some other jurisdictions unless the QAHCs are incorporated outside the UK.

Remittance basis

The problem

Some UK resident non-doms (persons not domiciled in part of the UK) can take advantage of the remittance basis of taxation of income and gains from foreign sources. If foreign investments are held through a QAHC, this would normally result in such investors’ profits from a fund being treated as coming from a UK source.

The solution

New rules will enable amounts received from a QAHC by a non-dom, who provides investment management services in connection with arrangements to which the QAHC is party, to be divided into UK and foreign proportions so that the foreign proportion can potentially benefit from the remittance basis.

Tax avoidance

The regime will include targeted anti-avoidance rules to prevent its use in circumstances not within its intended scope.

The loans to participators rules will be applied to QAHCs as if they were close companies. These impose a corporation tax change at the dividend upper rate on amounts lent to participators unless repaid within 9 months of the end of the accounting period in which the loan was made.

Joining and leaving the QAHC regime

The draft legislation includes detailed provisions for the treatment of companies joining the regime including the deemed sale and repurchase at market value of assets joining the exempt ringfence basis so that accrued gains can be taxed up to that point. Where a new QAHC holds shares which would qualify for the substantial shareholdings regime but for the 12 months qualifying period, the SSE will apply if the QAHC continues to hold the shares for the remainder of that period.

Not all breaches of the QAHC qualifying conditions will lead to disqualification from QAHC status. As mentioned above there is a two-year period of grace for a new QAHC to reach the 70% ownership condition and cure periods are generally permitted for rectification of non-deliberate breaches of the regime. If a QAHC ceases to satisfy the ownership condition, e.g. due to the withdrawal of a major investor, and does not expect to be able to rectify it, it is allowed a two year wind-down period in which assets of the ring fence business can be sold without tax on gains provided that no new investments are made, and no new monies raised, other than to protect the value of existing investments.

Conclusion

This new regime is a welcome, and largely successful, attempt to address the tax barriers to use of UK holding companies. It certainly goes a long way to level the playing field with Luxembourg holding companies and, provided that the ownership requirement can be satisfied, it is in several respects a more beneficial regime:

  • The exemption for income and gains on ringfenced investments is not subject to a minimum investment amount or shareholding percentage or holding period (provided that the assets are held as investments rather than as trading stock.
  • Tax exemptions are available for overseas real estate held by the QAHC direct as well as through holding companies.
  • The UK, unlike Luxembourg, has no withholding tax on dividends.
  • Profits on repurchase or redemption of shares can be taxed as gains and not as distributions without the need to create multiple classes of “alphabet” shares.
  • As a QAHC is UK resident, its investors will not need to worry about the complex UK offshore funds regime, nor the tax rules attributing income and gains of certain foreign companies to UK resident participators; and
  • UK companies will not be affected by new ATAD III substance requirements which will apply to Luxembourg companies and those resident in other EU member states.

The exemption from withholding tax on interest payments by QAHCs and new exclusions from distribution treatment for profit-participating loans and other “relevant securities” broadly match the advantages of Luxembourg’s treatment of debt securities.

The remaining disadvantages of UK QAHCs, apart from the need to satisfy the ownership requirements, are stamp duty on sales of shares in a QAHC and the UK’s capital maintenance rules which impose strict conditions for reductions of share capital. However, both of these can potentially be overcome by using a non-UK incorporated company resident in the UK as the QAHC instead of one incorporated in the UK.

Some of the detail of the new regime will in due course be clarified in guidance. In the meantime we continue to be involved with professional bodies in reviewing and commenting on this new regime.

The full text of the draft QAHC legislation can be found in Schedule 2 of Finance Bill 2022 here.