As announced at Spring Budget 2020, the government is pursuing a review of the UK funds regime. HM Treasury opened a consultation (document found here), which seeks to gather evidence and explore the attractiveness of the UK as a location for the intermediate entities through which alternative funds hold fund assets. Please see below some of the key points that DLA Piper submitted to HM Treasury in response to the consultation questions, in support for the case of reform to the UK alternative funds industry.
The role that Asset Holding Companies (AHCs) perform within alternative fund structures
There are typically a large number (and varied categories) of investors in a Fund Limited Partnership (Fund LP). Many investors, in particular institutional investors, charities and sovereign wealth funds, investing in a Fund LP, which is generally transparent for tax purposes, are generally reluctant to suffer any tax liabilities and / or filing obligations as an investor, and would instead prefer to accept a lower rate of return on their investment, should tax be imposed.
For example, when the Fund disposes of shares in a property holding or operating company (InvestCo), AHC as the shareholder of InvestCo could be subject to tax liabilities payment and / or filing obligations imposed by the jurisdiction in which InvestCo is resident (e.g. if InvestCo is a “real estate rich” company). By contrast, without an AHC in a Fund structure, as Fund LP would be tax transparent for the vast majority of investors, the underlying investment jurisdiction may impose tax payment liabilities and / or filing obligations which would be borne by each of the investors.
AHCs also provide certainty, as investors only need to consider the tax rules of the jurisdiction in which AHC is tax resident (e.g. Luxembourg), as opposed to the many InvestCo jurisdictions that could impose a tax payment and / or filing obligations (instead, AHC as shareholder of the InvestCos would be subject to any such obligation).
Furthermore, and absent an AHC in a Fund structure, each of the investors would be required to file a double tax treaty claim (DTT Claim) in order to mitigate withholding tax liabilities imposed on receipt of interest and dividends. This would impose a disproportionate compliance burden on the investors, as compared to a single DTT Claim being made by the AHC. This can be particularly relevant for credit Funds where loans are often made through an AHC entity, as opposed through the Fund LP direct.
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Third party financing
The existence of the AHC assists with third party financing, as lenders usually require a single point of enforcement, as close to the underlying assets as possible. The AHC may also provide vertical and horizontal flexibility (allowing for stacking of companies and separate portfolio clusters, such that lenders can come in at different levels), senior and mezzanine debt (very common in private equity structures) and also in the fund finance context, across different elements of the portfolio, or including some assets and excluding others, depending on the commercial arrangements.
In addition, investors may have preferences for levered and unlevered investment sleeves, which AHCs can facilitate by enabling segregation and avoiding cross-collateralisation. This is also helpful from the lender perspective in terms of portfolio segregation - to the extent one of the portfolios has no third party financing, lenders are likely to be more comfortable lending into a “clean structure” (notwithstanding that a parallel portfolio has third party financing).
By contrast, if the Fund LP, acting through its general partner, held all the assets direct (or through a number of InvestCos), this may not suit all the investors in the structure, and financing would be more difficult, and more costly to obtain.
The existence of AHC provides flexibility for the Fund to hold portfolio clusters under the AHC, which provides greater flexibility on partial exits, partial refinancing and for liquidity rebalancing / restructuring purposes (including being able to separate illiquid assets for specialist investor / financing arrangements, allowing the main fund portfolio to revitalise for on-going investment purposes).
The case for reform: challenges that the UK tax rules create for choosing the UK as the jurisdiction for the AHC
Withholding tax on interest
The consultation document rightly identifies that withholding tax on corporate interest can adversely impact the UK as a destination of choice for the AHC. We agree. Investors use debt financing in order to receive a fixed return on their investment (as well as a capital gain on exit / upside equity return). As such, the Fund LP will usually make an interest bearing loan to the AHC, and AHC will in turn onlend down to the InvestCo entities. AHC will therefore pay interest to the Fund LP on the shareholder loan.
Many European jurisdictions (including Luxembourg) provide for domestic exemptions on withholding tax on interest, without the requirement to make a DTT Claim. By contrast, other than with respect to a number of limited domestic exemptions (which are usually not applicable to shareholder debt in investment fund structures), interest payments made by a UK tax resident AHC to Fund LP will require investors to suffer withholding tax at 20%, or to make a DTT Claim in order for the AHC to pay gross. This is often costly and time consuming, and as mentioned above, many investors are very reluctant to have any tax filing obligations.
There are a number of approaches that the UK government could take in order to limit the administrative burden:
- Exempt all holding companies from withholding tax on interest, if the recipient is not in a tax haven / EU blacklist (provided that the lender also imposes withholding tax on interest payments to tax havens and EU blacklisted countries). The UK does not withhold tax on dividends, so that would make the UK very straightforward for investors.
- Exempt an AHC in a widely held investment fund structure from paying interest without withholding. This would be a more specific exemption.
- Exempt certain categories of investors from withholding tax - similar to the approach taken for the Qualifying Institutional Investors under the SSE test.
The consultation document refers to limitations of the UK’s participation exemption, the substantial shareholding exemption (SSE), as it applies to real estate and private equity funds, and consideration is given to extending its remit. We agree that it is important to exclude disposals of UK property rich companies from an expanded SSE test, in order to protect the UK tax base. In addition to real estate and private equity funds, credit funds may also need to rely on a participation exemption, for example where the Fund (through the AHC) takes an equity slice in the borrower, typically shares or warrants. We understand that a number of other jurisdictions have more comprehensive and simpler participation exemptions, for example in Luxembourg, which allows an AHC holding more than 10% of the shares in an InvestCo for more than 12 months, to dispose of the shares in InvestCo without realising a capital gain in Luxembourg.
Two approaches are outlined in the consultation document, either expanding the Qualifying Institutional Investors (QII) rules, or creating a more comprehensive participation exemption. Although both approaches would be helpful to the investment funds industry, the downside with the QII test (at least in its current form), is that it does not provide a level playing field for investors, it requires Fund managers to diligence and categorise each investor, and (as QIIs are increasingly asking for this in the Fund LPA), it requires the Fund manager to pass on the benefit of the higher returns to the QIIs, which can be time intensive to implement. Expanding the participation exemption is much simpler and would eliminate in many cases the issue of deciding whether the investee company is carrying on a trading or investment business. We favour this second, simpler approach.
The consultation document explains that credit funds incorporate AHCs in jurisdictions that ensure taxation on a simple financing margin, whereas the UK corporate tax rules can impose barriers on such arrangements. Ireland’s ‘section 110’ vehicle and Luxembourg’s securitisation vehicle, are seen as destinations of choice for structured finance and securitisation arrangements. Although the UK has its own securitisation regime which limits tax to a ‘margin’, in order to fall within this regime there are a number of onerous conditions that the consultation document identifies, for example the GBP10 million issue threshold and the permitted activities and financial asset requirements of the securitisation vehicle.
In addition, we note that there is also a requirement for the issued notes to be part of a "capital market arrangement", which in practice requires the securitisation SPV to issue secured notes that are rated, traded or listed – we understand that this is not required for the Ireland’s ‘section 110’ vehicle and Luxembourg’s securitisation vehicle. The UK government should look to amend some of the more onerous requirements in the securitisation regime. Alternatively, having a safe harbour margin for interest for the AHC would give confidence to the parties and would also avoid costly and burdensome transfer pricing documentation and benchmarking and would provide a simple and tested workable solution.
The consultation document recognises that UK tax rules treat the repurchase of share capital as an income distribution for UK participators in the fund including carried interest holders. The tax rules in s.1000(1)(B) CTA 2010 state that a purchase of shares is a distribution out of the assets of the company, except so much of it as represents a return of capital. S.1033 ibid and onwards, sets out rules where share buybacks are not distributions for tax purposes, and a number of onerous conditions must be met, one of which is that the buyback is made wholly or mainly for the purpose of benefiting a trade carried on by it or by its 75% subsidiary. HMRC Guidance (Statement of Practice 2 (1982)) provides examples of the so called ‘trade benefit test’, which applies for example to remove a disgruntled shareholder. This would be unlikely to be applicable in a Funds context. S.1033 ibid also requires that the share buyback is not made for tax avoidance purposes.
Investors in a Fund will often prefer to receive capital as opposed to income, as returns of capital generally provide lower rates of tax as compared to returns of income (e.g. to individual investors). In addition UK carry holders will be unable to benefit from the more favourable 28% tax rate on returns of carried interest, unless they receive returns of capital (as opposed to income, such as dividends).
Some jurisdictions such as Luxembourg use share buybacks as a way of returning profit to shareholders in a way that avoids withholding tax on dividends. The share buyback is treated as a capital return, tax free for the shareholder by virtue of the participation exemption, and there is no withholding tax leakage. The use of multiple classes of shares allows the Luxembourg AHC to make returns of capital to investors through staggered share buybacks.
In the UK the issues are different. The aforementioned tax rules on share buybacks mean that where the UK AHC makes a capital gain, the UK AHC is unable to retain the capital nature when repatriating the gain back to the investors and carry holders (at least without a liquidation). The UK AHC therefore effectively ‘converts’ capital into income for tax purposes which can be taxed at the high rates of income tax in some shareholders hands. In addition, as capital gains are ‘converted’ into income, this can also create concerns with respect to consideration of the offshore funds rules as they apply to UK carry holders or individual UK investors, and this would not be applicable if the profits could retain their capital nature when being repatriated up the structure.
The UK government should also look closely at amending the share buyback rules, especially with respect to an AHC in a Fund, to put share buybacks which distribute the proceeds of the sale of shares by an AHC, on the same level from a director’s responsibility or fiduciary duty perspective, as if they were approving the sale of the shares - possibly subject to some “safe harbour” criteria to mitigate the risk of any such relaxation of the capital maintenance regime from being abused to the detriment of HMRC and / or any other creditors of the AHC.
VAT exemption on fund management
The government announced that it will be reviewing VAT charged on management fees. The UK’s interpretation implementation of Article 135(1)(g) of Council Directive 2006/112/EC (which requires EU member states to treat the management of ‘special investment funds’ (SIFs) as exempt from VAT) is markedly narrower than some other EU member states, in particular Luxembourg which provides for an exemption on fund management services provided by the AIFM to the Fund LP (and this includes portfolio management services provided to the AIFM). In the UK, investment funds are very unlikely to satisfy the ‘listing condition’, and will not therefore benefit from the fund management exemption, leading in most cases to irrecoverable VAT at 20%, a hard cost to the Fund’s investors. Sometimes a Channel Islands Fund structure can avoid this charge but Brexit gives a real opportunity to remove this unnecessary and damaging tax leakage and level the playing field.
The regulatory regime governing alternative investment fund managers (AIFMs) is generally fit-for-purpose. One area where some augmentation of the regulatory regime may result in the UK being a more attractive jurisdiction for AHCs is in the approval and disclosure requirements associated with an AIF acquiring control of a non-listed company. Such an augmentation may give the UK some competitive advantages over EU countries which must apply these rules to all non-listed companies. We note, however, the importance also of the UK remaining substantially equivalent with the Alternative Investment Fund Managers Directive (AIFMD).
Part 5 of the Alternative Investment Fund Managers Regulations 2013 which implements AIFMD in the UK outlines the rules applicable to AIFs which acquire control of non-listed companies and issuers. Typically, AIFMs managing AIFs would be subject to these provisions to the extent that they are acquiring control or disposal of control in an existing AHC or even in the potential incorporation of a new AHC. For example, in the amalgamation of funds, Fund 1 may acquire the AHC of Fund 2.
Our view is that the nature of an AHC means they should not be included in Part 5. The requirement of AIFMs of having to notify regulators in respect to effectively holding vehicles for tax purposes represents needless filing as well as compliance burdens and costs. Accordingly, we recommend some consideration be undertaken by HM Treasury on the inclusion of a specific exemption from the requirements in Part 5 where the AIF is acquiring control in an AHC which is domiciliated in the UK. It will be important that this exemption clearly distinguishes the asset holding nature of a UK AHC from other companies with operational purposes where those safeguards remain important. The Financial Conduct Authority may then express appropriate guidance on the scope of this exemption. Together, the guidance and exemption will reduce the filing and compliance costs associated with UK AHCs which should make the UK a more attractive jurisdiction for the domicile of AHCs than certain EU countries. Importantly, the augmentation will not impact the important investor, business and market protections in Part 5 which will otherwise continue to apply.
The capital maintenance rules which apply to English private companies seek to mitigate the risk to creditors by putting individual directors on risk when authorising the buyback of shares and limit the sources of funding that such companies can use to finance any such buyback, notwithstanding that in practise that AHC’s will frequently not have any creditors or carry on any business other than the holding of the Investcos. This is burdensome for directors and the rules which apply to buybacks are relatively restrictive given the nature of the transaction that is being authorised (in the context of a buyback using proceeds from the sale of Investco shares by the AHC).
We would welcome changes that addresses the issues outlined above. Whilst introducing a bespoke regime for Funds could allow for wide-reaching changes, we would query whether this is the optimum approach, as it would impose additional complexity. Simplifying and streamlining existing legislation, could be more quicker to implement, more efficient and lead to a more coherent legislative code.