Alistair Darling's proposed measures on the reform of the capital gains tax regime will be significant for investors in investment funds and also those investment managers holding interests in management companies and manager LLPs or carried interests. Some welcome changes are proposed to the investment manager exemption but the suggestions in the discussion paper on the offshore funds regime, although issued under the guise of simplification and providing certainty to investors, would at first sight appear to create yet more uncertainty and contain a rather nasty sting in the tail. It would appear that any limited life offshore companies (regardless of the length of the life of the company) will be within the offshore funds regime. Asset management companies will need to study the discussion paper carefully and their input will be crucial in ensuring balanced and workable draft legislation. Guidance has also been issued on the tax treatment of financial derivatives. All these proposed changes are outlined and commented upon in further detail below.
Reform of Capital Gains Tax - Description of Proposals
All disposals made by individuals, trustees and personal representatives on or after 6 April 2008 will be subject to a single rate of capital gains tax (CGT) of 18%. Taper relief will also be abolished for disposals on or after that date. Capital gains realised by companies are not affected by the changes announced.
Whilst changes had been anticipated to the taxation of the private equity industry, the proposed changes are far more wide-reaching. This reform has the potential to impact significantly on M&A activity over the coming months.
Currently, individuals, trustees and personal representatives who make gains on the disposal of chargeable assets (including shares and property) are subject to CGT at their highest marginal rate of income tax. Tax is on net chargeable gains after deduction of allowable losses, taper relief and any other available reliefs.
The availability of taper relief currently reduces the amount of the gain chargeable to CGT. The availability of relief depends on the length of time an asset has been held and whether the asset is classified as a "business asset" or a "non-business asset" for taper relief purposes. Gains on the disposal of business assets (which include all shares in unlisted trading companies and interests in LLPs) are currently taxed at an effective rate of 10%, provided the asset has been held for at least two years. However, the minimum effective rate of tax on the disposal of non-business assets is currently 24%, achieved only after a period of 10 years.
Under the proposals, for disposals on or after 6 April 2008, taper relief will no longer be available (even if assets were held before this date). The new single rate of CGT (subject to allowable losses and any available relief) will also apply to held over gains coming into charge on or after 6 April 2008.
As part of the simplification of CGT following the proposed introduction of the 18% rate, indexation allowance will also be withdrawn. This was frozen for individuals, trustees and personal representatives at 6 April 1998 for assets held at that time and provided relief from tax on gains arising due to the effect of inflation prior to that date. Further, the share identification rules, which currently provide a complex order of identification dependent upon the dates when the shares were acquired, will be simplified. These measures will also have effect for disposals made on or after 6 April 2008.
The annual exempt amount for individuals and trustees will remain. The amount for 2007-08 is £9,200 for individuals and £4,600 for some trustees. In addition, principal private residence relief, business assets roll-over relief and business asset gift hold-over relief will continue to apply, as will CGT reliefs aimed at Enterprise Investment Schemes and Venture Capital Trusts.
Reform of Capital Gains Tax – Comment on Proposals
The result of these reforms is that the effective rate on capital disposals will change from the current range of between 10% and 40%, to a flat rate of 18% for all. Therefore there will be both winners and losers as a result of these measures.
Individual owners of private companies, who are currently considering disposing of their shares, may wish to think about bringing forward such a disposal to before 6 April 2008 if they have accumulated enough business asset taper relief to benefit from the effective 10% tax rate. Alternatively, individuals may wish to consider structures to extract capital value from their business prior to the change coming into effect.
Conversely, those holding assets that have no accrued business asset relief may choose to wait and dispose of their assets after 5 April 2008, in order to benefit from the new 18% flat rate.
The change will also affect taxpayers who had intended to defer gains until after this date – for example, where shares have been disposed of in exchange for loan notes in order to extend the taper period, thereby reducing the effective CGT rate. Whilst it will no longer be possible to use such an exchange to extend a taper relief period, an exchange of shares for loan notes is still attractive as it will still have the effect of deferring the payment of tax, and may therefore enable use of annual exemptions in later years.
There has been considerable media interest in private equity in recent months, with the perception in some quarters being that individuals involved in this sector gain an unfair advantage under the existing rules. HMRC have recognised that the CGT reforms in part seek to address this perception. However, there is concern that the changes will also result in an increased CGT charge from an effective rate of 10% to the new flat rate of 18% for entrepreneurs selling their companies or businesses (such as fund managers), employee shareholders and investors in AIM-listed and unlisted companies.
Whilst the proposed reforms will result in an increased tax bill for the private equity sector, a flat rate of 18% will be much more palatable than the change anticipated by some which was that their share of profits would be treated as income, taxable at 40%. The flat rate of 18% on capital gains will also remain a more attractive route for investors than an effective 25% on receipt of payments by way of dividend.
In a private equity context, the current uncertainty surrounding when the "clock" for taper relief starts in relation to a carried interest will need to be taken into account. It is understood that HMRC may argue that the "clock" only starts when the carried interest hurdle is reached and not when the carried interest is granted. The alternative view is that due to the nature of partnership law, partners hold the interest from day one, although they may not be entitled to share in the disposal proceeds until the carried interest hurdle is met. If HMRC's argument were to prevail, in practice this could mean that the 2 year requisite holding period for the 10% effective tax rate is not met on certain disposals. This becomes a non-point for disposals after 6 April 2008.
Investment Manager Exemption - Description of Proposals
New measures will amend the investment manager exemption (IME) to clarify and simplify the scope of the transactions to which the IME applies and ensure that the outcome, where one of the conditions for exemption is not met, is less disproportionate than under the current legislation.
A non-resident investor (a fund or an individual) who carries on a trade in the UK through a branch or agency, or (in the case of a company) through a permanent establishment, is in principle subject to UK tax on the profits of the trade. However, the IME enables non-residents trading in certain investments in the UK to appoint a UK investment manager without exposing themselves to UK taxation provided certain conditions are met, including the "independence test" and the requirement for all of the fund's trading profits to be generated through "investment transactions".
On 20 July 2007, HMRC revised its guidance on the IME in an updated version of Statement of Practice 1/01 following a period of public consultation. The revised SP amended the "independence test" in addition to clarifying what HMRC considers to be investment transactions.
Scope of Investment Transactions
The revised SP provided some clarity on a number of common investment strategies and on lending arrangements following advances in the form and structure of investment transactions. HMRC has confirmed in the revised guidance that all credit default swaps are within the IME. However, during the consultation process, the sector sought a considerable widening of what could be capable of constituting "investment transactions"; it was proposed that the definition of investment transactions be more closely aligned with the FSA Handbook definitions and as unrestrictive as possible. Revision of SP 1/01 did not provide scope for such wide-ranging changes to the type of transaction that can benefit for the IME as they are set out in the legislation. In the Pre-Budget Report it was announced that the amending provisions will be proposed in Finance Bill 2008. The aim of such provisions will be to bring the list of transactions to which the IME applies (with some exceptions) more closely into line with the list of activities regulated by the Financial Services Authority.
The legislation currently provides that where the manager enters into a transaction which is not an investment transaction as defined, ie, a non-exempt transaction, for example, the physical delivery of a commodity, the whole exemption is failed for the accounting period or year of assessment in question and the fund is taxable in the UK. Concerns were expressed during the consultation process on SP 1/01 on the lack of proportionality of this provision. Whilst HMRC agreed that a minor or inadvertent breach should not result in loss of the IME on the whole fund and one-off non-exempt transactions will not be regarded as jeopardising the IME if the profit on that transaction is charged to tax, which was reflected in the revised SP 1/01, the wider proportionality issue was a legislative issue which could not be resolved in the SP. It was announced in the Pre-Budget Report that proposals will be contained in the Finance Bill to reform this rule so that although the profits on a non-exempt transaction will be taxable, there is no knock-on effect on other transactions whereby the whole of a non-resident’s UK profits are brought into the UK tax net if the investment manager enters into a non-exempt transaction.
The new measures will have effect on and after the date that Finance Bill 2008 receives Royal Assent.
Investment Manager Exemption - Comment on Proposals
Generally the changes, combined with the changes introduced by the revised SP 1/01, are positive and will no doubt be welcome, particularly the removal of the risk under the current rules that non-exempt transactions could cause the whole exemption to be forfeited.
Offshore Funds - Description of Proposal
The offshore funds regime (in Chapter V, Part XVII of the Income and Corporation Taxes Act 1988) applies to disposals by UK resident individuals and companies of interests in certain types of fund resident for tax purposes outside the UK. Where the regime applies it operates to "convert" a capital gain on a disposal or realisation of an interest in such a fund into income for UK taxpaying investors (unless, amongst other things, the fund is certified as a “distributing fund”). In cases where the regime applies, it is not only the element of the investor's capital gain that represents income accumulated in the fund that is charged as income; such part of the investor's gain as represents capital gains accrued to the fund is also "converted" in this way. Many would say that this is a disproportionate outcome.
Since its enactment in 1984, the regime has been substantively amended by the Finance Acts of 1995 and 2004, and most recently, by the Finance Act 2007. The Government has now published a discussion paper on offshore funds, as a supplementary document to the 2007 Pre-Budget Report. The paper sets out how the Government intends to modernise the offshore funds tax regime, and invites comments on the proposals from interested parties.
The scope of the offshore funds regime became subject to uncertainty in 2007 as a result of changes announced in the 2007 Budget, in particular changes to the definition of "offshore fund". In response to concerns raised by both industry and advisers, HMRC published guidance entitled " "Definition of offshore fund: BN 29" (available on HMRC's website) in May 2007, which went some way to clarifying the applicability of the offshore funds regime following the changes that were to be introduced in the Finance Act 2007.
The discussion paper contains proposals not only for a new definition of "offshore fund", but also for an overhaul of the entire framework of the regime.
Interested parties are invited to provide comments on the paper to HMRC by 9 January 2008. Subject to responses to the paper, it is stated, the Government remains committed to introducing legislation for a modernised regime in the Finance Bill 2008 and intends to issue draft regulations in the New Year, from which it is to be deduced that much of the legislative material will be contained in secondary legislation, itself a break with tradition in this area.
Definition of "offshore fund"
The definition of "offshore fund", which is contained in section 756A ICTA 1988, is currently based on the regulatory definition of "collective investment scheme" as set out in the Financial Services and Markets Act 2000 (FSMA 2000), as modified. The discussion paper proposes that there should be a new definition for tax purposes, which should be detached from the regulatory definition, and states that the Government believes that any new offshore fund definition for tax purposes should be based on "characteristics". The paper states that an offshore fund will in future be "a company, trust or any other vehicle or arrangement" which possesses these characteristics, which are listed below:
- the company, etc. is "created" under foreign law;
- the company, etc. is not UK tax resident;
- the company, etc. is managed by a fund manager such that the investors do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or give directions;
- the investors' interests create rights in the nature of co-ownership where the investors are not taxed directly on their share of the underlying income;
- the company, etc. has the purpose of investment of the co-owners' funds with the aim of spreading investment risk; and
- the investor's interest entitles the investor to realise substantially the net asset value attributable to it .
HM Treasury say in the discussion paper that the new definition "is intended, in relation to bodies corporate, to capture the essence of an open-ended company arrangement" yet "the Government recognises that some non-UK entities which might not be regarded as 'open ended'” for the purposes of section 236 [FSMA] may fall within the proposed definition of an offshore fund." It is understood that HM Treasury are continuing to work on all aspects of the definition, and will no doubt welcome assistance from investment managers and others interested. This is to be welcomed in light of the uncertainty as to what particular type of funds the proposals are aimed at catching.
The stated aim of the new "characteristics-based" approach is to counter unintended tax advantages being obtained where an offshore arrangement is technically outside the current definition of an offshore fund but the arrangements are economically the same. It seems plain that the intention is to provide a self-contained definition within the tax legislation, so preventing regulatory legislation from having unexpected and - to HM Treasury - unwelcome consequences.
Currently, for a return to be re-characterised as an offshore income gain, the investor must be considered to hold a "material interest" in the offshore fund. This will be the case if, at the time when he acquired the interest, it could reasonably be expected that, at some time during the period of seven years beginning at the time of his acquisition, he would be able to realise the value of the interest.
However, the discussion paper proposes the abolition of the "material interest" concept. The intention of this, it is stated, is to make the taxation of interests in offshore funds easier to understand as well as increasing certainty for UK investors. If enacted, however, the new definition of offshore fund would (literally construed) appear to mean that a UK investor's interest in any non-resident investment company will be within the offshore funds regime. Many continental companies, for instance, have a limited (but very long) "life". Whether or not a company with a (say) 30 year "life" will be excluded from the regime may crucially depend on the entitlement to "realise substantially the net asset value" characteristic, the last in the list above. Close consideration will have to be given to any stated intention of an offshore to redeem its shares, in order to assess whether this characteristic will be met.
Distributing Fund Status / Reporting Fund
Broadly, under the existing offshore funds regime, even where there is a disposal of a "material interest" in an "offshore fund", the re-characterisation of capital as income will not occur for any accounting period where the company is certified by HMRC as being a "distributing fund".
The discussion paper suggests that under the new regime, an offshore fund can elect to be a “Reporting Fund”, which essentially replaces “distributing fund” status. The discussion paper states that while the proposed tax regime for a Reporting Fund is intended to be broadly similar to that currently applying to a distributing fund, there are likely to be some notable differences including:
- replacing the requirement to distribute 85% of income, as calculated in accordance with specific rules with the requirement to annually "report" to the UK investor their share of the fund’s income. The effect of this appears to be that a Reporting Fund will “report” income (determined by a new calculation of “reportable income” see below) to the UK investor, rather than having to distribute 85% of income under the current rules. The income reported can be a physical cash distribution, a deemed distribution, or a combination of the two. Therefore, UK investors will pay tax on reported income regardless of how much is physically distributed. Amounts taxed as deemed income but not actually distributed will be treated as reinvestments in the chargeable gain calculation;
- introducing a new calculation of "reportable income" as an alternative to the current UK Equivalent Profits (UKEP) calculation, if this would reduce the compliance burden;
- modernising the rules concerning compliance; and
- abolishing the 5% investment restriction test, which currently provides that a fund shall not be certified as a distributing fund in respect of any accounting period if, at any time in that period, more than 5% by value of the assets of the fund consists of interests in other offshore funds. It is stated that that the Government envisages that the removal of such a restriction will remove barriers currently inhibiting investment and reduce administrative complexities for offshore funds and their managers.
The Government’s suggestion is that an offshore fund can elect to be a Reporting Fund by applying for approval from HMRC in advance of the fund’s first period in which it wishes to be a Reporting Fund. As part of the approval process a fund will need to submit certain information, including the fund’s prospectus or proposed prospectus. This in itself might seem a welcome measure. However, the discussion paper states that, to avoid unintended tax advantages, it must be evident that the fund had a genuine commercial purpose and the main purpose or one of the main purposes of the fund is not the deferral or avoidance of UK taxation.
The paper does not discuss transitional provisions between the current offshore funds tax regime and the proposed new regime. It is stated that, subject to responses, the Government intends to address transitional issues when issuing draft legislation. Transitional provisions will necessarily add further complexity.
Offshore Funds – Comment on proposals
With the proposed introduction of a flat rate of 18% for CGT, the consequences for investors of an interest in a fund being within the offshore funds regime will be of even greater importance than it now is. Fund managers will no doubt appreciate that the discussion paper is just that, and it is to be hoped that they will use the opportunity to make representations to help create a workable scheme. We think it likely that the definition of offshore fund will need considerable development from the suggestions in the discussion paper, as may other of the suggestions, before they can form the basis for legislation.
Financial Derivatives – Description of Proposals
The Pre-Budget Report also included guidance from HMRC on the tax treatment of financial derivative transactions, in response to perceived uncertainty from the financial services industry as to how these transactions should be taxed. The guidance is to be incorporated into HMRC's Business Income Manual.
HMRC has confirmed it is of the view that, conceptually:
- there is no difference between a 'real' and a 'synthetic' financial transaction. Therefore, the entering into of a derivative contract that replicates the risks and rewards of share ownership is, in HMRC's view, the same as buying a share;
- buying a share in expectation that the price will rise is the same as shorting a share in the hope that its price will fall, as in both cases a view is being taken on the direction of the share's price movement; and
- financial derivatives that provide an exposure to part of an asset are the same as derivatives that give exposure to the whole asset
Guidance will also be issued that "multi-derivative" or "hybrid" strategies should not be unbundled. HMRC expect there to be evidence that the transactions were executed in pursuit of a clear prior strategy in cases involving such "bundling". The guidance gives three, non-exhaustive examples of such strategies. The first is where a series of derivative transactions are entered into in the expectation that the price will increase but only within a certain "band", and the most efficient way to express that single view is via a series of derivative transactions. The second example given is the writing of a put option for an asset (at a value lower than current value) and the potential acquisition of that asset. Finally an example is given whereby a sequential series of similar derivatives are entered into. HMRC concludes that the elements of each example should be viewed as a whole and not in isolation.
In HMRC's view, the financial derivative transactions referred to are not, in themselves, indicative of trading. They may constitute investment in themselves, or form part of an overall investment strategy. HMRC stresses that the guidance does not alter HMRC's view of the distinction between trading and investment in the wider context of commercial activity.