The HM Treasury document "Offshore funds: further steps" can be found at http://www.hm-treasury.gov.uk/pbr_csr07_ offshore.htm.

As first proposed in the October 2007 discussion paper, and developed in the "Next Steps" paper in March of this year, on 16 December 2008, the Government published draft legislation to provide for a new definition of an "offshore fund" and further revised draft regulations for the new regime.

New definition of an "offshore fund"

Background

The effect of the proposed new definition would be to move away from the current definition which (although modified slightly as a result of the Finance Act 2007 changes) is based upon the regulatory definition of a "collective investment scheme" in the Financial Services and Markets Act 2000 ("FSMA"). The new definition is broadly the same in effect, the major difference being the impact of the abolition of the 7 year "material interest" test on limited/fixed life fund arrangements (see further below).

The proposed new "characteristics-based" approach would, according to the Government, "counter unintended tax advantages being obtained where an offshore arrangement is technically outside the definition of an offshore fund but the arrangements are economically the same". The Government's stated aim is to simplify the regime, make it consistent and provide greater certainty for UK investors and funds.

However, as explained further below, there would appear to be a number of potential issues surrounding the proposed new definition and abolition of the "material interest" test which may cause concern for the funds industry. Although the Government states that it intends to provide "as much certainty as possible" about which types of offshore vehicles would fall within the proposed new definition by the use of detailed legislation and guidance, interested parties with experience of previous guidance on these issues are likely to be wary of such statements.

Scope of the proposed new definition

The proposed new definition would introduce the concept of a "mutual fund", the definition of which would reflect the new "characteristics-based" approach.

Under the proposals, a company, trust or other vehicle or arrangement will (subject to specified exceptions) be caught by the new definition if:

  1. it is not UK tax resident
  2. the "participants" do not have day-to-day control of the management of the property (regardless of whether or not they have the right to be consulted or to give directions);
  3. the purpose is to enable the participants to participate in the acquisition, holding, management or disposal of the property, or to receive income or profits from the same; and  
  4. a "reasonable investor" would expect to be able to realise an investment in the arrangement based "entirely or almost entirely" by reference to the net asset value ("NAV") of the property or by reference to an index of any description.  

It is condition 4 above combined with the abolition of the 7 year "material interest" rule that will be the most concerning for interested parties. The effect of the first three conditions should be to replicate the equivalent requirements in the current regime. The Government states that the proposed abolition of the 7 year "material interest" rule will remove the issue of different investors in the same vehicle receiving different tax treatment.

According to the brief draft guidance issued, the meaning of "reasonable investor" will be broadly based upon existing regulatory guidance. There is currently very limited guidance on the meaning of "entirely or almost entirely" by reference to NAV. The draft guidance provides that it will not be necessary for the investor to obtain NAV directly from the offshore fund. Exchange traded funds where quoted prices are (or are very close to) NAV would potentially be caught although where the disposal value reflects NAV due to commercial factors or market trends, rather than a pre-planned arrangement, it appears that the arrangement would remain outside the definition. The Government accepts that general arrangements to buy back shares at a discount may not fall within the new definition, though the Government has resisted laying down any percentage limit of variation from NAV that would be acceptable. This is most unsatisfactory and it is hoped that further guidance will be given on the reasons of "almost entirely". The key, according to the draft guidance, is what the arrangements are intended to provide. They give the example that if buy-back arrangements normally kick in if the discount exceeds 20% but may also be used in very exceptional circumstances to buy back at a very small discount or at NAV, that will not taint the fund.

Limited exception for winding-up, dissolution, termination etc

Under the proposed new legislation there are to be two exceptions to the definition of a "mutual fund" (and hence to the application of the regime) which apply where "the reasonable investor would only be able to realise his investment on a basis calculated entirely or almost entirely by reference to NAV or an index in the event of the winding up, dissolution or termination of the arrangements". The first exception applies where the arrangements are not designed to wind up, dissolve or terminate "on a date stated in or determinable under the arrangements". The second exception applies where the arrangements are designed to terminate etc. on a date stated in or determinable under the arrangements but where none of the assets that are the subject of the arrangements are "income-producing assets". "Income-producing assets" are defined as assets which produce income and which, if held directly by a UK-resident individual, would attract income tax. There is an exemption where the asset (or income produced) is hedged so that there is no effective income. This exemption may be very important in practice as limited/fixed life funds could be structured so that any income is swapped out although it is not clear yet how the Government see this working in practice. We await more guidance on this provision.

The limited nature of these exceptions means that many limited/fixed life fund arrangements that are outside the current regime are going to be within the new regime (see further below).

Exception for capital only arrangements

As the purpose of the regime is to ensure that income cannot be converted into capital by using offshore arrangements, the Government intends to exclude capital only arrangements from the new definition and is considering whether to introduce a de minimis provision to allow for small amounts of income to be taken into account in determining whether a fund is capital only. This exception may be of great relevance to, for example, private equity funds.

There is a power in the draft legislation to provide for further exceptions by way of regulations.

Fixed share capital companies

The Government's intention is that entities with a fixed share capital will only fall within the proposed new definition if they are structured in such a way that "mimics" open-ended arrangements. Non-UK funds with an indefinite life would therefore only be caught under the new regime if the investor could expect, as a result of the arrangements, to realise at NAV or close to NAV upon demand.

As highlighted above, there is some comfort in the Government paper for share buy-back arrangements where the investor does not have a reasonable expectation to realise at (or close to) NAV or by reference to an index. It is assumed that where such a facility remains at the sole discretion of the fund, this will not be brought within the new regime. The same analysis should also apply to redemptions. It is to be hoped that there will be further, clearer guidance on such arrangements.

However, share buy backs which are specifically designed to allow tracking to NAV will fall within the new definition (though it is presumed the investor must still be entitled to demand the buy-back, in order to satisfy the "reasonable expectation" requirement).

Defined return funds

Under the current rules, investors in such funds are able to rely on the fact that, although they might have an expectation to realise their investments, it would be by reference to some form of defined return as opposed to NAV and therefore outside the offshore fund rules. However, the new definition of "offshore fund" also includes being able to realise by reference to an index of any description. This will affect structured funds which are designed to provide a defined return by reference to an index.

Limited/fixed life companies

As highlighted above, limited/fixed life companies would appear to fall within the regime unless they can benefit from the exception which applies if there are no income producing assets.

The Government has recognised that the proposed changes increase uncertainty surrounding "limited life" companies. It has attempted to provide certainty for certain arrangements, as follows:

  • overseas companies, required by their law of incorporation to liquidate within a certain time frame, will not be brought within the new rules solely as a result of that requirement;
  • a vehicle which goes into liquidation will not be brought within the new rules solely as a result of its liquidation. The key consideration will be whether an investor has the required "reasonable expectation" at the point at which the vehicle is established. The Government makes no express mention of the effect of continuation votes. In our view, these should not cause an issue provided they do not give rise to a "reasonable expectation" of a realisation;  
  • if the rights of an investor change, so that the arrangement subsequently falls within the new definition, the investor will from that date be treated as having an interest in an offshore fund;  
  • conversely, if an investor's rights change so that the arrangements cease to fall within the definition, he will continue to be treated as having an interest in an offshore fund. This seems unfair and inconsistent. The Government has suggested that it is open to requests for clarification in respects of other types of arrangement.

Other points

The current rules in relation to separate share classes, umbrella funds (including protected cell companies) will be maintained within the proposed new regime.

Under the current rules, only trust arrangements which meet the definition of a "unit trust scheme" for the purposes of FSMA are brought within the regime. Under the proposed new regime there would be no such restriction on offshore trust arrangements.

Arrangements that are tax transparent for income tax purposes are to be excluded from the definition of an offshore fund by regulations, provided that they hold no or only a de minimis level of investment in non-reporting funds.

Transitional rules and timing of any change

The Government intends that the new definition of an offshore fund will be introduced by the Finance Bill 2009, to take effect from 1 October 2009.

The proposed changes (and in particular the removal of the 7 year "material interest" rule) would potentially have an impact for investors in existing offshore arrangements. Therefore the Government has announced that any investments made prior to 1 October 2009 will remain outside the scope of the amended rules. Other transitional rules are to be introduced.

Comments on the proposals should be sent by 11 February 2009 to Sue Harper at sue.harper@hm-treasury.gov.uk. HM Treasury have invited interested parties to meet with them also and we propose to meet with them early in the New Year.

Reporting and Non-Reporting Funds - Further draft Offshore Funds Regulations

Background

If (under the proposed new definition) an offshore vehicle is an "offshore fund", the UK tax treatment of UK investors will be provided for in new regulations, to come into effect from 1 October 2009. The Government has published revised draft regulations.

Under the current rules, UK investors with a "material interest" in an offshore fund (as currently defined) will, on disposal of their interest, be charged to income tax or corporation tax on their return. However, it is open to the offshore fund to apply to HMRC for certification as a "distributing fund". If such certification is received, UK investors will retain the more favourable chargeable gains tax treatment upon disposal of their interest (whilst being charged to income or corporation tax on distributions made).

The October 2007 discussion paper proposed, along with the new "characteristics based" definition of an offshore fund, a new regime whereby investors in funds falling within the revised regime could maintain chargeable gains tax status upon disposal of their interest. The original proposals were further modified in a "Next Steps" paper published in March 2008, and partial draft regulations for implementation of the new regime were published in May 2008. Under the proposed new regime, instead of applying for "distributing fund" status in respect of each accounting period, an offshore fund could apply, in advance, for "Reporting Fund" status. The excess of any reported income over distributions actually made to an investor during a reporting period would, at the end of that period, be treated as an additional distribution to that investor and be taxed. An offshore fund which did not so apply, or whose application was refused, would be a "Non-Reporting Fund", investors in which would be charged to income or corporation tax upon disposal.

Changes to proposed regime and clarifications announced

Along with the publication of revised draft regulations, the Government has also attempted to clarify some specific points of confusion regarding the proposed new Reporting Fund regime, arising from the May 2008 publication. There have also been some changes to the proposed regime. The principal points of clarification/change are:

  • the requirement for the annual submission of information for a Reporting Fund is not intended to be an extension of the application procedure;
  • names and addresses of investors will not be required to be reported to HMRC;
  • the 10% "margin for error" does not mean that a Reporting Fund should seek only to report 90% of reportable income;  
  • UK investors in a Reporting Fund are subject to tax on actual distributions made on an arising basis;
  • the Government will continue to explore ways in which a negative amount of reportable income for any accounting period might be carried forward to reduce reportable income in future periods.  

The provisions for breach of Reporting Fund conditions have been revised since the May 2008 draft regulations were published. Any breach rectified without HMRC intervention and within a reasonable period will have no UK tax consequences. "Serious breaches" will result in the offshore fund no longer being allowed to maintain Reporting Fund status. The only occasion in which such status may be withdrawn retrospectively would be where the fund has made a deliberately misleading statement or wilful omission in the advance approval process.

It should be noted that the revised regulations are expressly stated as not yet reflecting the proposed new definition of an offshore fund. For example the definition of a "relevant interest" in a Non-Reporting Fund, the disposal of which would trigger an income tax or a corporation tax charge, is still linked to the concept of the 7 year "material interest" test (which is to be abolished).

Commencement and transitional provisions

It is intended that an offshore fund will be able to apply for Reporting Fund status with effect from 1 October 2009.

Under the latest draft regulations, offshore funds will be able to apply for retrospective approval for Reporting Fund status within three months of the start of the first period of account for which the fund wishes to have such status. In order to allow existing funds to transition into the proposed new regime, HMRC will accept applications for "distributing status" for the first period of account beginning after 1 October 2009. There are proposed transitional rules for existing non-distributing funds to move to being a Reporting Fund. It is proposed that the elective deemed disposal method be extended so that investors will be able to benefit from the change in status from the date of the change.

Comments on the draft regulations should be sent by 11 February 2009 to Sue Harper at sue.harper@hm-treasury.gov.uk.