Alternative Investment Management Association
In the winter 2007 issue of AIMA's Journal, Mark Stapleton outlined the key reforms tabled in the offshore funds consultation document released on the 9th October 2007. The consultation document sought responses by the 9th of January 2008. It is clear from the level of participation in the debate on those reforms that this is a key issue for both investors and fund promoters and managers both in terms of potential impact on existing products in the market and the new FAIF product which the FSA had envisaged launching in 2008. One of the key ingredients in wider tax reforms fuelling the debate is the proposed reduction of the Capital Gains Tax rate for individuals to 18 percent.
While tax reform measures are inevitable and indeed desirable in maintaining an effective tax system in the UK, reform should ideally be implemented with minimum disruption to business communities and a clear understanding of the potential impact of those reforms in the context of other proposed tax reforms, while also ensuring that the timing of the reform is appropriate. Uncertainty surrounding the potential application of reform needs to be adequately debated and clarified in advance of its introduction.
We do not propose to revisit the substance of the offshore fund rules and the proposed reforms already outlined by Mark. This article will focus on some of the key issues raised in the debate surrounding the consultation and the potential impact that some of those issues may have on the hedge fund sector. We will explore the issues relating to the timing of the reforms.
Impact of the proposed capital gains tax rate reduction
The proposed reduction of the CGT rate to 18 percent has introduced a dynamic which will mean that achieving capital treatment for UK investors in funds will now become critical to the successful marketing of fund products to UK individuals.
The offshore fund regime was introduced to prevent investors from converting income into capital through rolling up investment in an offshore fund.
Where the offshore fund rules applied and the fund did not meet the conditions to be certified as a distributing fund (one of which was to distribute the greater of 85 percent of income per the accounts or UK equivalent profit), the gain on disposal was not subject to capital gains tax but was instead subject to income tax at the investors marginal rate of tax (potentially 40 percent). In effect, the offshore fund rules enabled HMRC to do the exact opposite of what they were aiming to prevent investors from doing, granting the power to HMRC to convert capital into income.
Where capital treatment applied on disposal, the UK investor benefited from taper relief and the annual CGT exemption and consequently had a lower tax bill.
Historically, the tax rate differential between income and capital treatment was not always a critical factor in investment decisions (excepting investors who are exempt from Capital Gains Tax). The rate differential between income and capital treatment on exit was generally between 16 percent where the investment was held for a 10 year period and 6 percent where the investment was held for 5 years. However, the benefit of the rate differential was countered by the annual UK tax charge at 32.5 percent on the annual dividend paid by a fund, which had to seek distributor status to achieve capital treatment.
With the proposed reduction of the CGT rate and the abolition of taper relief the rate differential between income and capital treatment becomes a much more compelling factor in investment decisions made by UK individuals, as the rate differential moves from a range of 16 percent - 6 percent, to an absolute rate differential of 22 percent. For investments which are not held for the longer term, this is likely to have a very significant impact on the overall return for the investor.
More importantly, the new reforms propose that offshore funds who wish to offer capital treatment will have to report income to UK investors; however, they are not necessarily required to pay that income out to investors by way of dividend. This creates a scenario where although an investor may obtain capital treatment if the fund has reporting status, as outlined in the proposal, the investor may be exposed to what is called the "dry income" scenario, namely, an income tax liability on the reported income but no actual cash dividend to discharge the tax liability with.
In terms of what this means for hedge funds, it is expected that there will be a major drive for hedge funds to seek reporting fund status without giving rise to other adverse consequences for their investors, e.g., dry income and a higher tax rate associated with income tax treatment. While it may not be an issue for hedge funds which are marketed to UK institutional investors, (unless they are UK institutions which are exempt from capital gains) as UK institutions are subject to corporation tax on income and gains, it will have a significant impact on UK resident individuals invested in the hedge fund sector, unless the way in which the reporting fund regime will calculate income accommodates hedge funds and FAIFs in obtaining reporting fund status.
Vehicles within scope of the proposed reforms
Another key issue highlighted is the uncertainty as to which vehicles will be in scope under the proposed regime. There are concerns that the characteristics based approach will be open to interpretation and the consultation paper does not give a clear indication on how a characteristics based approach will be applied. The consultation also makes references to bringing within the scope of the reforms arrangements where investors are able to realise substantially the net asset value of their interest.
The consultation paper has indicated that income transparent vehicles will be excluded from the definition of offshore fund and this has been well received. However the paper is unclear as to whether it is merely sufficient for all vehicles to be simply income transparent or whether there is a requirement for some vehicles e.g., contractual arrangements, in addition to be transparent for capital in order to fall outside the scope of the offshore fund rules.
It is preferable that there is clarity at the outset as to which vehicles are within scope of the reforms, otherwise the scope and application of the reforms are likely to go through an evolution process through the administration of a clearance procedure with the possibility of differing treatments being awarded to funds which are similar in nature and purpose.
Timing and impact of proposals – in the context of other tax reforms
The Finance Act 2007 contained reforms in relation to the definition of a material interest in an offshore fund, which caused some concern and confusion in the industry as to their impact and scope, until HMRC clarified their application in BN 29.
The proposed reforms in the consultation document are currently scheduled for implementation in the Finance Act 2008 giving little time for due consideration of the impact of the reforms, let alone the systems changes that may be required to comply with the proposed reforms. Neither do they take account of potential timing issues on other ongoing relevant consultations, on Property Authorised Investment Funds (PAIFs) and Funds of Alternative Investment Funds (FAIFs).
Given the scale of UK institutional investment in seeding hedge funds it would also seem practical to defer the introduction of the reforms until there is clearer direction on HMRCs taxation of foreign profits discussion document.
Finally, the recent and current legislative flux surrounding offshore funds is such that there are widespread concerns that accelerating further tax changes to the regime could prove to be harmful for the industry, particularly in view of the proposal to reduce the Capital Gains Tax rate to 18 percent. There are also EU considerations which must be borne in mind. The EU Commission Communication issued on the 10th of December 2007, emphasised the need, "to strike a proper balance between the public interest of combating abuse and the need to avoid the disproportionate restrictions on cross border activity within the EU". The consultation document, however, makes no reference to principles of EU law.
Given the issues outlined above, it is key for the hedge fund industry that any reforms implemented should take account of the fact that the tax rate differential of 22 percent would have a very significant impact on appetite for a hedge fund product on the part of UK individual investors. A more onerous approach in how reportable income should be calculated for hedge funds, by seeking to re-characterise gains as income at fund level, could result in distorting the market as between long only and certain alternative funds for tax purposes and ultimately have the effect of acting as a barrier to investing in hedge funds when the UK, as a jurisdiction, is in fact striving to introduce Funds of Alternative Investment Funds, to facilitate access to hedge funds to the retail market.