Whilst there was relatively little in the 2008 Budget that had not been flagged in the Chancellor's Pre-Budget Report or in subsequent announcements, it is worth examining the various measures and their likely impact on the funds industry.  The increase in the effective rate of capital gains tax ("CGT") for those involved in the private equity or hedge fund sectors from 10 per cent (which was perceived as too low to justify any tax planning) to 18 per cent may result in a return to the structuring that was often used before the introduction of taper relief. Further, the reduction in income tax for individuals on foreign dividends from 32.5 per cent to 25 per cent (see below) may mean that in some cases the importance of structuring returns as capital rather than income has diminished, particularly if credit for foreign tax can be taken into account. It remains to be seen whether these matters will indeed affect the manner in which the payment of fees, carried interest and similar benefits to individuals will now change. 

Now that capital gains are to be taxed uniformly at 18 per cent, there is a yawning chasm between the rate at which gains on non-UK funds which are distributor funds are taxed (18 per cent) and the rate on those which do not have this status are taxed (40 per cent).  This makes the Government's proposals for "modernisation" of the taxation of Offshore Funds a matter of keen interest.   Although these proposals have been postponed until April 2009, we do now have a reasonably clear idea of the form that they will take.

As mentioned above, there were few surprises this year, but some nevertheless noteworthy ones, for example, the delay to the new definition of an offshore fund for the offshore funds regime and the extension of the VAT exemption for fund management beyond investment trusts (which will have an adverse impact for managers, particularly managers of Channel Island closed-ended funds which are listed on the London Stock Exchange). 

One absence from the Budget was any measure on the reform of the SDRT calculation for unit trusts and OEICs, which was the subject of recent consultation, although the Treasury has indicated that it is working further with the industry on options for reform.  The Treasury has also announced that it is considering proposals to adapt the tax rules for investment trust companies to enable tax efficient investment in a wider range of asset classes. 

It seems a pity that after a lengthy period of consultation with the industry, the Government did not decide to focus the Offshore Funds tax rules on their original target – cash roll-up funds – instead of seeking to regulate the entire investment universe and compel all open-ended funds to beat a path to the UK Revenue's door.

In this article we examine some of the announced changes in more detail.

The VAT exemption of fund management

A measure will be introduced to extend the VAT exemption for fund management to cover UK-listed investment entities (including investment trust companies and venture capital trusts) and certain overseas funds.  The exemption is currently contained in Items 9 and 10 of Group 5 of Schedule 9 to the Value Added Tax Act 1994 ("VATA") which exempts the management of authorised unit trusts, trust based schemes and open-ended investment companies.  This purported to implement the EU VAT exemption for "management of special investment funds as defined by Member States".  It will now be amended by secondary legislation so that the definition of "funds" for these purposes will exclude trust-based schemes, but include closed-ended investment entities which invest in securities and whose shares are included in the Official List of the UK Listing Authority.  It will also include funds established outside the UK which are recognised overseas schemes under sections 264, 270 and 272 of the Financial Services and Markets Act 2000 (in effect non-UK authorised investment funds such as French SICAVs.  This measure results from the successful JPMorgan Fleming Claverhouse case (discussed in the July 2006 issue of Financial Services Briefing), where the ECJ ruled that excluding closed-ended collective investment funds from the definition of "special investment funds" was contrary to the objective of the exemption and the principle of fiscal neutrality.

In a briefing it issued in November 2007 following the JPMorgan Fleming Claverhouse case, HMRC stated that it remained of the view that the ECJ judgement did not apply to funds other than investment trust companies.  This was good news for those UK resident entitles that are within the extended exemption, although pension funds and endowment funds have been disappointed.  However, this is not good news for managers as it will increase the proportion of exempt supplies that they make and affect their partial recovery position.  It is particularly bad news for managers of closed-ended companies resident outside the EU, for example in Guernsey and Jersey, but listed on the London Stock Exchange.  In such cases management supplies do not currently attract VAT because they are treated as being made where the supply is received.  However, the manager has the right to recover input VAT against such supplies because they would have been taxable supplies had they been made in the UK.  Under the proposed changes, such supplies would be exempt if made in the UK so that the manager will no longer be able to recover input VAT associated with such supplies.  This will also affect the manager's partial recovery position.  It may not be quite such good news for funds within the extended VAT exemption, and even non-EU but UK listed funds, if managers increase their management charges to compensate for the loss of input VAT recovery.  It would, of course, be possible for non-EU, but non-UK listed-funds to change their listing to a different recognised stock exchange, although it is unlikely that many will wish to do so in practice solely for VAT reasons.

The measure will have effect for supplies of services made on or after 1^st October 2008.  However, fund management services supplied to investment trusts may be treated as exempt prior to that date as a result of the JPMorgan Fleming Claverhouse decision.

Capital Gains Tax

The reform of capital gains tax ("CGT") highlighted in the Pre-Budget Report 2007 will now go ahead in the Finance Bill 2008.  This will mean the abolition of taper relief for disposals made on or after 6^th April 2008 and from that date all disposals made by individuals, trustees and personal representatives will be subject to a single rate of CGT of 18 per cent, with the exception of the "entrepreneurs' relief" announced in January 2008 by the Chancellor of the Exchequer.

Entrepreneurs' relief will have effect for qualifying disposals made on or after 6^th April 2008.  This provides for the first £1 million of lifetime gains on qualifying business assets to be charged to CGT at an effective rate of 10 per cent.  Disposals on or before 5^th April 2008 do not affect the lifetime limit.  Gains in excess of £1 million will be charged to CGT at the 18 per cent rate.  For these purposes qualifying business assets include the assets of an unincorporated business, as well as shares in a trading company, provided that the individual making the disposals is or was an officer or employee of the relevant company, owns at least 5 per cent of the ordinary share capital of the company and is entitled to exercise at least 5 per cent of the voting rights.  It will be possible to claim relief on deferred gains where shares or securities are exchanged for other shares or securities (such as qualifying corporate bonds) or where gains are deferred as a result of investment in qualifying shares under the Enterprise Investment Scheme ("EIS").  Transitional rules will also allow entrepreneurs' relief to be claimed where gains have been deferred on or before 5^th April 2008.

Entrepreneur's relief was introduced as a result of public pressure from industry.  Whilst owners of small businesses may find the relief beneficial, the relief is unlikely to be of much relevance to the private equity or hedge fund sectors or many employee shareholders, who under the taper relief regime often benefited from an effective 10 per cent CGT rate.

However, the 18 per cent CGT rate will be beneficial to retail investors in collective investment schemes, who previously had to hold their shares or units for a period of ten years to achieve the minimum effective rate of 24 per cent.

Residence, domicile and overseas income

A number of measures have been announced amending the existing rules relating to the residence and domicile of individuals.  Despite lobbying aimed at delaying the new rules for a year, the changes will, in most cases, come into effect from 6^th April 2008.  These changes will impact on non-UK domicilaries investing offshore.

With effect from the 6^th April 2008, UK resident individuals paying tax on the remittance basis who have unremitted foreign income and gains in excess of £2,000 a year will no longer be entitled to any of the personal income tax allowances, including the basic personal allowance, or the annual exemption for capital gains.

Legislation will be introduced such that non-domiciled, or not ordinarily resident, individuals, aged 18 or over, who have been UK resident for more than seven of the past ten years, will only be able to continue to access the remittance basis of taxation on payment of an annual charge of £30,000.  This new charge will only apply to adults who have unremitted foreign income and gains in excess of £2,000 a year.  The £30,000 tax charge will be a charge on unremitted income and gains, rather than a stand-alone charge.  Individuals paying the charge may choose what foreign unremitted income or gains the £30,000 is paid on.  As a result, the tax paid will either be income tax or capital gains tax and should be treated as such for the purposes of any double taxation agreement.  The unremitted income or gains upon which the £30,000 tax has been paid will not be taxed again when and if it is remitted to the UK.  The £30,000 annual tax charge will be payable through the self-assessment system.  If it is paid from an offshore source directly to HMRC by cheque or electronic transfer, the charge will not itself be taxed as a remittance.  The charge is introduced from 6^th April 2008.

A number of measures will be introduced, some with immediate effect, aimed at removing "loopholes and anomalies" which allow UK residents paying tax on the remittance basis to remit income and gains to the UK without paying tax on them.  These include the following:

·         Foreign savings and investment income which are not currently taxed when remitted to the UK if the source of the income no longer exists in that year, will now be taxed.

·         Currently, relevant foreign income can only be taxed if it is brought into the UK as cash.  Legislation will be introduced so that money, property and services (with certain exceptions) derived from relevant foreign income brought into the UK will be treated as remitted and will be taxed as such.

·         Currently, foreign savings and investment income arising in the year in which the remittance basis is claimed are not taxed if remitted to the UK in a subsequent year in which no claim to the remittance basis is made.  Legislation will be introduced so that such savings and income will be taxed, irrespective of the year in which they are remitted.

·         At present, there are no statutory rules on the treatment of remittances from funds which include some combination of untaxed relevant foreign income, employment income, capital gains, taxed income or gains and capital.  Legislation will be introduced to determine how much of a transfer from a mixed fund will be treated as an individual's income or chargeable gains, and the manner in which these amounts are chargeable to tax.

·         Extensive changes to the capital gains tax regime for non-resident trusts are being introduced.  These include the proposal for non-domiciled beneficiaries of non-resident trusts who claim the remittance basis to be taxed on the remittance basis on all UK and offshore assets (effective from 6^th April 2008).  Settlors and beneficiaries of non-resident trusts will not be required to disclose the information to HMRC about trust assets in relation to which a remittance arose, provided they have made a correct return of their tax liabilities.  However, beneficiaries may be required to provide additional information to HMRC where the trustees choose to make an election to re-base trust assets.

·         Existing anti-avoidance legislation contained in Section 13 of the Taxation of Chargeable Gains Act 1992 will be extended such that UK resident shareholders who have more than a 10 per cent interest in a foreign company which would be a close company were it resident in the UK will be taxed on the chargeable gains accruing to the company irrespective of the shareholder's domicile.  However, if the non-domiciled shareholder elects for the remittance basis, then such a shareholder will only be subject to a charge to tax in respect of a gain on a non-UK situated asset when the proceeds are remitted to the UK.

·         Further anti-avoidance legislation designed to prevent individuals from avoiding income tax by transferring assets abroad will be amended to ensure its application to non-domiciled individuals.

·         Legislation on capital gains tax will be amended so that non-domiciled individuals taxed on the arising basis who have not claimed a remittance basis from 2008–2009 will obtain relief for foreign losses.

·         Currently, individuals paying tax on the remittance basis who borrow money from a non-UK institution can repay the interest on that loan out of untaxed foreign income without giving rise to a tax charge on the remittance basis, even if the loan is advanced in the UK.  Legislation will be introduced so that repayments on such loans will be treated as a remittance on or after 6^th April 2008.

The Investment Manager Exemption revisited

A non-UK fund whose activities are categorised as "trading" rather than "investment" for tax purposes, is in principle taxable in the UK if those activities are carried on here through a UK investment manager.  Tax is collectable from the UK investment manager in respect of the profits of the fund.  The Investment Manager Exemption ("the IME") affords protection against this charge.  The IME and HMRC's revised Statement of Practice on how they apply the exemption was discussed in an article in the September 2007 issue of Financial Services Briefing.

The IME rather confusingly only applies to the profits generated from "investment transactions", although the exemption is of course only in point if those transactions are carried out in such a way as to be "trading."  Some transactions such as dealing in physical commodities are not "investment transactions" so that they are not protected by the IME.  As highlighted in the 2007 Pre-Budget Report, changes are to be made to simplify the approach used in defining such transactions.  A single list will be produced and the process for updating the list will be simpler.  The list is also to be available on HMRC's website.

The other change to be made is that where some transactions that the UK investment manager carries out for the fund meet the IME conditions but others do not, protection will be afforded in respect of those which do.  There was previously an "all or nothing" policy, where even if only one transaction failed the IME conditions, all the transactions carried out for that fund were taxable.

The Offshore Funds tax regime

This regime taxes gains on the disposal of interests in non-UK open-ended funds as income unless the funds concerned are certified as Distributing Funds.  Last October the Government published a Discussion Paper on reforms to this regime.  It had been expected that the reforms would be introduced in the 2008 Budget but they have now been postponed until April 2009.  This year's Finance Bill does however clear the decks for the changes by repealing most of the existing legislation – Sections 757-763 ICTA – and providing for regulations to be made in their stead; this will be with effect from a date yet to be announced – but is likely to be next April as is made clear in a further Discussion Paper "Offshore Funds – next steps".  This was published on 27^th March 2008 and sets out what will be the main changes:

·         A new definition of offshore fund based on "characteristics" – like the present one, it will cover most open-ended non-UK funds.

·         The replacement of Distributing Funds by "Reporting Funds", that is to say funds which report their income to their UK investors (who will have to pay tax on it) rather than actually distribute it.

·         Funds will have to obtain advance clearance from HMRC that they are eligible for Reporting Fund status – this will take the place of annual certification.

·         Reporting Funds will still have to submit annual audit accounts and they will have to accompany them with a declaration that they meet the conditions for Reporting Fund status for that year.

·         It is likely that the UK Equivalent Profits measure of income will be removed – instead Reporting Funds will be able to compute their income on acceptable GAAP principles. 

·         A ten per cent margin of error will be permitted in relation to the income reported.

·         If the Reporting Funds income is seriously understated (by more than fifteen per cent) this could lead to loss of Reporting Fund status going forward; however, only if the fund has made a deliberately misleading statement or wilful omission in the advance approval process, will Reporting Fund status be withdrawn with retrospective effect. 

The Government has decided to retain the distinction between income and capital.  This will be bad news for funds whose activities are categorised for tax purposes as "trading" rather than "investment."  They will in practical terms be barred from obtaining Reporting Fund status just as they were from being Distributing Funds.  The reason is that all their profits would have to be shown as income and UK investors would be taxable on their share of those profits in the year they arose to the fund.1

Taxation of foreign personal dividends

It was announced in the 2007 Budget that provisions were to be introduced to amend the system of taxation for individuals in receipt of dividends from non-UK resident companies.

When dividends from UK-resident companies are charged to tax, shareholders are entitled to a non-payable tax credit of one-ninth of the distribution.  Tax is charged on the gross dividend received, including the tax credit, which resulted in effective rates of tax for individuals on these dividends of zero, zero and twenty‑five per cent for (former) lower rate, basic rate and higher rate taxpayers respectively.

The Finance Bill 2008 will extend the non-payable tax credit of one-ninth of the distribution to UK-resident individuals and UK and other EEA nationals in receipt of dividends from non-UK resident companies.  A person will qualify for the non-payable dividend tax credit if they own less than a 10 per cent shareholding in the distributing non-UK resident company.  The second condition announced in the 2007 Budget, that the individual must in total receive less than £5,000 of dividends from non-UK resident companies in the tax year, will not now be introduced.  The proposed extension of the dividend tax credit will have effect from 6^th April 2008.

The Finance Bill 2009 will further extend the availability of the proposed non-payable dividend tax credit to individuals in receipt of dividends from non-UK resident companies where the individual owns ten per cent or greater shareholding in the distributing non-UK resident company.  This further extension will not apply where the country of residence of the distributing company does not levy a tax on corporate profits equivalent to UK corporation tax.  (This further extension of the proposed dividend tax credit is intended to take effect from 6^th April 2009.)

HMRC have confirmed that the proposed new dividend tax credit will be calculated on the gross amount of the foreign dividends (i.e. before any deduction of foreign withholding tax).  The UK income tax liability of an individual will therefore be calculated on the gross dividend plus the proposed non-payable one-ninth dividend tax credit.  Any UK tax credit available to the individual in respect of foreign withholding tax is then applied to the individual's UK income tax liability, before the deduction of the proposed new dividend tax credit.

Since the Budget Report HM Treasury has now announced that the ten per cent tax credit on foreign dividends previously announced in relation to the taxation of personal dividends has been withdrawn on dividends paid by offshore funds (as defined in Section 756A of ICTA).  This is because the objective behind the original proposal was to eliminate discrimination between the taxation of UK and other EU state-sourced dividends.  However, an unintended side effect of the change would have been to encourage investment by UK investors in offshore cash and bond funds (which would benefit from the additional ten per cent credit) at the expense of UK cash and bond funds.  HM Treasury took the view that the migration of bond funds outside the UK provided an unacceptable tax arbitrage, not only against UK bond funds, but also for bank deposit accounts as compared with offshore money-market funds.  The withdrawal of the ten per cent credit for dividends paid by offshore funds therefore leaves cash and bond funds, but also equity funds, in their pre-Budget 2008 position.  It is understood, however, that the Government intends to examine the issue in the context of the potential disadvantages to offshore equity funds over the next year and return to the matter in the 2009 Finance Bill as part of its ongoing reform of personal dividend taxation alongside the modernisation of the offshore funds tax regime.  If the Government wishes to amend the legislation so that the restriction of the ten per cent credit would apply only to offshore bond funds (ie that the ten per cent credit would be reinstated for offshore equity funds), a potential difficulty would be defining an offshore bond fund.  For UK bond funds, the regime is a relieving provision, so that managers seek to ensure that a fund meets the requirements as to income and assets.  Drawing the boundary for an offshore fund is likely to be more difficult, as the measure will be an anti-avoidance one.

There is also an uncertainty for foreign domiciled remittance basis users introduced by this Budget.    Foreign domiciled remittance basis users were previously taxable at the same higher rate taxpayers' rate of 32.5 per cent as UK-domiciled investors.  However, their rate goes up to 40 per cent in the 2008 Budget.  Whether they qualify for the one-ninth tax credit which would bring their rate back down again to 33¹_/3 per cent is not totally clear.  There is nothing in the Finance Bill (yet) which says they do not.  But 33¹_/3 per cent is an odd rate!

Alternative Investment Funds (FAIFs and Tax FAIFs)

As was announced in February this year, the Government has published draft regulations to provide an additional tax regime for funds of alternative investment funds ("FAIFs") which invest into non-distributing offshore funds.  In March 2007, the FSA issued a consultation paper on FAIFs proposing that managers of certain authorised investment funds ("AIFs") be allowed greater investment freedom, including investing into unregulated schemes.

Under the current offshore fund tax regime, a gain made by a UK AIF on the disposals of an interest in a non-distributing offshore fund is an offshore income gain and subject to corporation tax in the AIF.  The offshore income gain is not available for distribution to the AIF's investors.  When an investor realises a gain by disposing of units or shares in the AIF then he may also be liable to pay tax on any chargeable gain, which will include the increase in value due to the undistributed offshore income gain.

In order to facilitate the new FAIF regulatory regime, a new elective regime is proposed for FAIFs that invest in non-distributing offshore funds.  Under the proposed regulations, AIF electing for the new regime, to be known as "Tax FAIFs", will be exempt from tax on offshore income gains but an investor in a Tax FAIF will then be chargeable solely to income tax on any gain made on disposal of units in the fund.  This effectively moves the point of taxation from the Tax FAIF to the investor so that he is taxed as if he had held the investment in the non-distributing offshore fund directly.

There is no minimum holding requirement on non-distributing offshore fund assets.  However, the Government recognises that this treatment of Tax FAIFs will be suitable for AIFs with a specific investment strategy of investment into non-distributing offshore funds rather than those AIFs that wish to hold a range of assets in both non-distributing offshore funds and other categories of investments.  Nevertheless, the Government is to continue to consider whether, and if so, when, it would be possible to expand the new tax regime to enable mixed funds and more flexible investment strategies to be put in place.

The changes will take effect on a date to be specified by Treasury Order, the date to be determined by the date the FSA's regulatory changes become effective.

It should also be noted that the draft regulations contain provisions for the cancellation of a tax advantage if a participant in a Tax FAIF or the manager of a Tax FAIF has sought to obtain a tax advantage for the fund or any of its participants.

Property Authorised Investment Funds (PAIFs)

Following consultation regulations were laid before Parliament on 12^th March 2008 setting out the tax treatment of PAIFs.  PAIFs were conceived of as a way of applying a tax regime similar to that in force for UK closed-ended real estate investment trusts ("REITs") to open-ended AIFs investing mainly in property and certain property companies.

Currently, a UK AIF investing in property would be subject to corporation tax at 20 per cent on rental income and property income distributions from UK REITs or their foreign equivalents.  The income is distributed by such an AIF as a dividend carrying a tax credit, which exempt recipients, such as pension funds and charities, cannot reclaim.

Under the new regulations, an AIF that invests mainly in property and certain related securities will be able to elect for the PAIF regime so that the point of taxation will move from the fund to its investors with the result that the investors face broadly the same tax treatment as they would have faced, had they owned the property directly.   The PAIF regime will only be available, however, to certain open-ended investment companies ("OEICs").

Under the elective PAIF regime there will be ring-fencing of different types of income, property income, other taxable income (primarily interest and non-UK dividends) and UK dividend income.  Property income, namely rental profit and certain other property related income, will be exempt from taxation in the fund and will normally be distributed to investors under deduction of tax so that basic rate taxpayers will have no further tax liability, non-taxpayers and exempt bodies will have no further tax to pay and some corporates will have a further tax liability to pay.  Other taxable income of the PAIF will also be distributed to investors under the deduction of tax.  UK dividends received by the PAIF will remain exempt and will fund dividend payments carrying a tax credit to investors as at present.

PAIFs will have to meet certain conditions to qualify for the new regime.  This includes carrying on a property investment business, amounting to at least a 60 per cent property holding requirement (but reduced to 40 per cent in the first accounting period) and the net property income being at least 60 per cent of the net income of the PAIF (again reduced to 40 per cent in its first accounting period).  Other conditions require the PAIF to meet a "genuine diversity of ownership" condition so that the fund is not limited or targeted at only a few specified investors and to satisfy limits on the holdings of corporate investors (broadly 10 per cent or more beneficial entitlement to the net asset value of the fund) and on the type and amount of loan financing in the fund.  During the consultation process, shares in non-UK REITs that are overseas equivalents of UK REITs were brought within the property holding requirement and the exempt property income ring-fenced, together with overseas property held through special purpose vehicles.

The regulations will have effect on and after 6^th April 2008.  Existing property authorised units trusts will have to convert to OEICs if they wish to take advantage of the new PAIF regime.  Regulations were laid before Parliament on 12^th March 2008 providing relief from SDLT where a UK authorised unit trust converts into an OEIC or merges with an existing OEIC in the same way that relief is given from stamp duty and SDRT in such situations.

Qualified Investor Schemes

The Government has stated that it intends to simplify the tax rules for a qualified investor scheme ("QIS") by replacing the substantial holding rule.  This rule currently applies to certain investors holding 10 per cent or more of the net asset value of the QIS so that such investors are taxed on changes in the market value of their holding on specified measuring dates.

Unauthorised unit trusts

S.964(5) of the Income Tax Act 2002 currently permits unauthorised unit trusts to make payment to HMRC of the income tax they deduct from payments to unit holders in any year at the end of the following tax year.  This provision will be repealed with effect from Royal Assent of the 2008 Finance Bill so that for the tax year 2008-2009 and subsequent tax years, payments will be required on account of the tax due to HMRC on 31^st January and 31^st July of one year with a balancing payment being made on 31^st January of the following year.

John Carrell

Head of Tax

Farrer & Co

Martin Day

Financial Services Team

Farrer & Co