Why are Reporting Funds generally more suitable than Non-Reporting Funds for a UK resident, non-UK domiciliary?
Briefly, managers of offshore collective investment schemes can apply for their fund to have Reporting Fund status with HM Revenue & Customs (HMRC) in the UK. Any fund which does not have Reporting Fund status is by default a NonReporting Fund.
Reporting Funds are obliged to report details of their income to their UK resident investors and to HMRC, whether or not such income has actually been distributed to participators. The UK investor must then include not only the distributed income but also any reported but undistributed income on their UK tax return - unless it is foreign source, they leave it outside the UK and claim the remittance basis of taxation.
In contrast, a Non-Reporting Fund is not obliged to report details of its income and as a result the UK resident investors will only be liable to income tax on the income of the fund to the extent that it is actually distributed to them (and then subject to the remittance basis if available).
Whilst this might at first glance make NonReporting Funds more attractive, this income tax advantage is arguably overridden by the fact that any gain the UK resident investor makes on their investment in a Non-Reporting Fund will be subject to income tax (at a current top rate of 45%), whereas a gain on a Reporting Fund will be subject to capital gains tax (CGT) in the ordinary way (at a current top rate of 28%).
This is illustrated by the following examples.
Marco is a UK resident, non-UK domiciliary with £5m of clean capital to invest outside the UK. He is claiming the remittance basis of taxation.
Marco invests the £5m in an offshore collective investment scheme, eg a SICAV, which has Reporting Fund status. The offshore fund also distributes all its income on a periodic basis. Marco's banker arranges for the income distributions to be directly mandated to Marco's income account.
Marco subsequently disposes of his interest in the offshore fund for £6m, realising a capital gain of £1m. This gain will be subject to CGT at 28% if remitted to the UK.
Marco's banker therefore arranges to receive the entire proceeds of sale into his 'capital gains account' (remembering that it is not possible to segregate the gain element from the original capital invested).
When Marco (who has no completely clean capital remaining) next needs to remit funds of £500,000 to the UK, he transfers funds to the UK from the capital gains account. He leaves his income account (which has received income from the offshore fund of £250,000) untouched other than for funding his non-UK expenditure. As a result of this transfer to the UK, he is treated as remitting £500,000 of the £1m gain realised on the offshore fund, which will be subject to CGT of £140,000.
Marco invests the £5m in an offshore collective investment scheme, eg a SICAV, which has Non-Reporting Fund status. The offshore fund also accumulates and reinvests its income (rather than distributing it).
Marco subsequently disposes of his interest in the offshore fund for £6.25m, representing a capital gain of £1m and accumulated income of £250,000. The aggregate amount of the capital gain and the accumulated income will be treated as an 'offshore income gain' under special rules relating to Non-Reporting Funds, and therefore subject to income tax at 45% if remitted to the UK.
Marco's banker therefore arranges to receive the entire proceeds of sale into his 'offshore income gains account' (remembering that it is not possible to segregate the accumulated income or gain elements from the original capital invested).
When Marco (who has no completely clean capital remaining) next needs to remit funds of £500,000 to the UK, he transfers funds to the UK from the offshore income gains account. As a result of this transfer, he is treated as first remitting £500,000 of the £1.25m offshore income gain realised on the offshore fund, which will be subject to income tax totalling £225,000.
As illustrated, Marco would have been much better off in scenario 1, ie if the offshore fund had Reporting Status and had distributed all its income.
It is worth noting that Reporting Funds which do not distribute all their income can also be tax inefficient for UK resident nonUK domiciliaries because upon a sale of their units in the fund they will not be able to segregate the income which has accumulated within the fund from their original capital invested or any capital gain they make on disposal of the fund and so the proceeds will be tainted.
A particular trap also applies to NonReporting Funds if they are still held by the individual on death, as illustrated below:
Marco dies owning a Reporting Status Fund which he acquired for £5m and is now worth £6m. The investment benefits from an uplift in base cost for CGT purposes upon his death and so his heirs inherit it as if the base cost was £6m. If they dispose of it before it increases in value, there will be no CGT to pay on this investment.
Marco dies owning a Non-Reporting Status Fund which he acquired for £5m and is now worth £6m. Marco is deemed to have disposed of the fund immediately before his death, triggering the offshore income gain of £1m, taxable at 45%, giving rise to an income tax liability of £450,000 (unless the remittance basis of taxation is claimed by Marco's executors in respect of the tax year of death).
In either scenario, if Marco is deemed domiciled for inheritance tax purposes by the date of his death, the value of the fund will also be subject to inheritance tax at 40% (unless the spouse exemption applies).
However, in Scenario 2 the income tax liability on the deemed disposal would be deductible from the value of his estate, thereby reducing but not eliminating the tax disadvantage of this scenario.