As published on pinsentmasons.com/out-law, Thursday 11 February, 2021.
The UK government wants to make the UK a more attractive location to set up, manage and administer investment funds and has asked for input into the tax and regulatory changes needed to achieve this.
It has published a call for input, which makes it clear that any tax reforms need to be compatible with the government's "robust" approach on avoidance and evasion and also ensure that the UK can effectively exercise taxing rights over UK source income. Any changes to regulation need to support the UK’s commitment to upholding the highest standards of regulation and appropriate supervisory oversight and investor protection, it said.
The call for input is wide-ranging, covering direct and indirect tax and fund regulation, reflecting the fact that firm-level and fund-level decisions are taken by reference to the overall commercial, tax and regulatory environment for funds. It also considers broader issues important to the success of the regime such as the roles of industry and government to make the UK regime a global success, such as through trade promotion.
The document recognises the importance of the tax neutrality principle – that an investor investing through a fund should be in a similar tax position as if they had invested in the underlying assets of the fund directly. This aim is not always achieved under the current regime, especially in relation to funds that hold a mixture of equity and debt investments – multi-asset or balanced funds. Such funds can suffer tax leakage in relation to income from interest-bearing investments and derivative contracts if they do not hold sufficient debt investments to qualify as a 'bond fund', as they cannot make tax-deductible interest distributions.
The government previously introduced the Tax-Elected Fund (TEF) regime, which was intended to overcome the issues raised for balanced funds, by moving the tax point up to the investors and requiring the TEF to make two distributions: a dividend distribution and a non-dividend distribution. However, there has been low take-up of TEFs and the government has asked for views on why this is the case and whether additional reforms could improve the position, whilst having a proportionate impact on HMRC.
"No doubt the general complexity of the TEF regime is a contributing factor to the low take-up," said Hatice Ismail, a funds tax expert at Pinsent Masons, the law firm behind Out-Law. "The document alludes to the difficulty faced by investment platforms in dealing with the investor reporting requirements that apply to TEFs."
The government said it is open to considering more fundamental changes such as exempting funds from tax altogether or introducing an unauthorised tax-exempt fund structure for investment in alternative assets.
"The lack of a tax-exempt UK fund has long been seen as a barrier to successfully marketing UK funds to investors who are used to investing in tax exempt funds in other common fund jurisdictions," Ismail said.
"Introducing a tax-exempt UK fund could, however, pose obvious challenges in terms of maintaining access to the UK's network of double tax treaties in relation to the international investments made by the fund," she said.
UK-resident funds benefit from the UK’s extensive double taxation treaty network. The Treasury has asked whether there are any specific considerations that the government ought to take account of in the context of the UK’s double taxation treaty network.
The Treasury said that the number of registrations of UK-domiciled limited partnership funds (LP funds) has declined over recent years. The introduction of the private fund limited partnership (PFLP) in 2017 sought to enhance the attractiveness of the limited partnership as a UK domiciled fund vehicle. However, LP funds and PFLPs are subject to the same tax regime as non-fund limited partnerships.
According to the new consultation document, the government wishes to explore if the introduction of bespoke partnership taxation rules could provide the opportunity for improved tax administration and certainty of tax outcomes for fund managers and investors. Feedback is sought on the barriers to the use of UK-domiciled LP funds and PFLPs, as well as views on how tax changes might help to address them.
The government has also committed to reviewing the VAT treatment of fund management fees.
Under the current rules, if the fund is located in the UK, UK VAT is payable on the fund management fees unless the fund is one of the specific types listed in the legislation, in which case the services are VAT exempt.
The government said it is aware that the UK approach to VAT on fund management services can create incentives for the domicile of funds outside of the UK. In addition, assessing the correct UK treatment is currently complex, leading to high administrative burdens and significant volumes of litigation. It said that leaving the EU presents an opportunity to deliver simplifications and other potential reforms.
The government is currently conducting research, ahead of potentially conducting a separate formal consultation on the options for changes to the VAT system at a later stage.
"The current disincentive to set up a fund in the UK is caused because the VAT exemption doesn’t apply to UK partnerships so it is easier to set funds up overseas, rather than as a result of the complexity of the system," said Richard Croker, another Pinsent Masons tax expert.
"The review of the VAT treatment of funds is potentially very good news, however, as it looks as if the penny has dropped regarding widening the fund management exemption. Arguably if they don't take this opportunity then litigation could continue," Croker said
Also considered in the call for input is the regulatory regime for funds. The government has asked for views in relation to the Financial Conduct Authority (FCA) authorisation process for funds and for views on the Qualified Investor Scheme (QIS), a type of authorised fund structure. Wider reforms are also considered with a view to promoting UK fund administration jobs.
The call for input closes on 20 April 2021. It was first announced in Budget 2020 and follows a consultation on the tax treatment of asset holding companies in alternative fund structures. The government published its response to this consultation together with a second stage consultation in December 2020.