Briefings
Corporate Tax: New Offshore Fund Reporting Regime
Corporate Tax
Investment Funds
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| September 2008 |
Offshore funds potentially offer a competitive tax advantage over onshore funds. They can reinvest (or "roll up") their income, so that a UK investor does not receive any distributions on which UK income tax is payable, until he realises his interest in the fund. The rate of CGT is 18% on realisation compared with up to 40% for income tax. However, the UK offshore funds tax rules reduce this tax advantage by taxing gains on realising interests in an offshore fund as income instead of capital.
Currently, the rules do not apply if an offshore fund applies for and is certified by HM Revenue & Customs (HMRC) as having "distributor status". This broadly requires the offshore fund to distribute annually at least 85% of its income on which a UK investor will then have to pay income tax. The distributor status requirements are seen by many funds as unduly burdensome.
The Government has recently published draft regulations that would allow funds merely to "report" and not physically distribute their income to UK investors, who would then pay tax on their share of this reported income.
Replacement of distributor fund status with reporting fund status
Under the proposed new regime set out in the regulations (the Offshore Funds (Tax) Regulations), the exclusion from the offshore funds rules for distributor funds will be removed. It will be replaced with an exclusion for a fund approved by HMRC as a "reporting fund". This will be an offshore fund that reports its "reportable" income both to its investors and HMRC. The figure for reportable income will be derived from the amount of income shown in the fund's accounts, but these accounts will have to be drawn up in accordance with either international accounting standards or another generally accepted accounting practice approved by HMRC. They will then have to be adjusted by reference to the UK Investment Managers Association's Statement of Recognised Practice. Having established its reportable income, the fund will have to notify UK investors of their share of the fund's income. These investors will then be taxed on this amount - whether or not it has been distributed to them.
Leeway and breaches of the rules
Recognising the practical difficulties in ensuring that an offshore fund faithfully reports 100% of its income, the draft regulations allow a 10% margin for error. If the error is more than 10% but less than 15%, an adjustment must be made to bring the figure up to 90%. An error of greater than 15% could result in a fund losing its approved status. A fund can also lose its approved status if it breaches other requirements of the regulations, such as failing to submit the required reports on time. Breaches which are "minor or inadvertent" will be disregarded unless there are three such breaches in a ten-year period.
Deemed disposal election
Loss of approved status could mean that the whole of any gain on disposal would be taxed as income instead of capital. This could operate harshly if the fund were approved for some or even most of the period during which the interest was held. To mitigate this harshness, a special facility has been included in the regulations: this enables an investor to elect that he should be treated as having made a disposal of his interest on the date the fund lost its approved status. Capital treatment would in this way still apply to the gain that had accrued up to the time when the fund stopped being approved. A similar election would be available to an investor if a fund starts off as a non-reporting fund and subsequently opts into the regime.
Investment by offshore reporting funds in other offshore funds
Currently an offshore distributor fund is not allowed to invest more than 5% of its assets in an offshore non-distributor fund. This rule will be abolished. It will be replaced by a requirement for an offshore fund to treat movements in the fair value of its investments in other non-reporting funds as income. This means that investors would not benefit from capital treatment on the capital growth within those underlying funds – a significant disadvantage. However, the requirement to "fair value" an interest in another (non-reporting) offshore fund will not apply if the income of that underlying fund can be readily ascertained.
Final Observations
The proposed new regime for reporting offshore funds clearly does offer some benefits for distributor offshore funds, although two major caveats are in order. First, an offshore fund wishing to maintain approved status as a reporting fund will still have a fairly heavy administrative burden – less than the burden today but not significantly less. Second, UK investors will be taxed on income they have not actually received and may indeed never receive – a problem that cannot currently arise.
The Government has invited comments on the draft partial regulations and has stated that it intends to publish a further set of draft full regulations. Although we expect the current version of the draft regulations will look very like the final set of rules adopted, we will keep monitoring the situation and publish further updates if necessary.