UK: Financial Services And Markets Group Bulletin, May 2007

Last Updated: 23 July 2007

In This Issue

MiFID – opportunity or challenge?

A practical guide to completing returns FSA009

Employee remuneration

CRD – pillar 2 requirements on investment firms

VAT – should investment trust management be exempt?

Firms still have a significant amount of work to do if they are to implement the extensive MiFID and CRD pillar 2 requirements in time for their respective November and January deadlines. We discuss the implications of MiFID for UK firms and how the principles of pillar 2 can be applied in practice.

MifId – Opportunity Or Challenge?

What Is MiFID?

The Markets in Financial Instruments Directive (MiFID) was once famously described by a financial journalist as "a horror story as awful as Day of the Triffids". Indeed, MiFID is probably the most significant regulatory event since N2 and will present the UK financial services industry with one of its biggest challenges to date. Firms will be required to carry out a massive reassessment of their businesses and to change their documentation requirements in a wide range of areas. But it is not all bad news. MiFID will offer opportunities in the arena of cross-border marketing and should contribute to a more level playing field for financial services.

MiFID will bring about major changes to the FSA Handbook, including an extensive rewrite of the conduct of business rules for investment services. It also broadens the scope of the European passport to include additional services and financial instruments. It applies to a wide range of firms and financial institutions and there are comparatively few that will not be affected in one way or another.

Key Provisions Of MiFID

MiFID’s impact on UK firms will depend upon the type of firm and its business. The following sections take a brief look at some areas of MiFID that are likely to have the most impact on the majority of firms.

Client Classification

As with the current requirements, MiFID provides for a three-tier system of client classification: retail, professional or eligible counterparty. However, boundaries between categories will be different.

Best Execution

The proposed rules differ significantly from existing UK rules. The new rules will apply to professional and retail clients and to all traded instruments.

Information Disclosure And Transparency, Pre- And Post-Trade

Once MiFID is implemented, equity pre-trade and post-trade transparency requirements will be based on three types of execution venue: regulated markets, multilateral trading facilities and over-the-counter.

Organisational Requirements

The MiFID requirements are more extensive than the FSA’s current handbook in relation to organisational requirements, although the new requirements should not need too much fundamental change. Nevertheless, firms will need to review their systems and procedures with MiFID in mind. The main areas of impact for most firms will be:

  • governance, internal controls and organisation
  • conflicts of interest
  • risk management and compliance
  • employees and agents
  • outsourcing
  • record keeping.


The progress of MiFID has been extremely long and drawn out, with a lengthy process of consultation, debate and much disagreement among the Member States. Even though the final rules have now been published, there is still a good deal of uncertainty in a number of areas, e.g. best execution as to how MiFID will be implemented in the UK. Nevertheless, firms will be required to implement MiFID by 1 November 2007, which is not that far away now, and for most firms, there is still a great deal of work to be done. Despite the remaining uncertainties, MiFID preparations should be well underway in all firms, and if not, they should start now!

A Practical Guide To Completing Returns/FSA009

Whether your firm has adopted one of the new approaches to credit risk introduced by the CRD on 1 January 2007, or it is taking advantage of the transitional provisions, you will have noticed some changes in the way you report to the FSA.

In addition to submitting their usual monthly or quarterly return, which will have been grandfathered from their previous regulator, firms are now required to submit data item FSA009: ‘Key data for 2007’.

Data items are the FSA’s new term for regulatory reporting forms. FSA009 contains key data required to calculate a firm’s capital adequacy under the new rules, as existing reporting formats do not allow for this.

It has a number of initial questions which allows the FSA to identify the categorisation and type of firm that is reporting, in addition to establishing whether the firm is reporting on an individual or consolidated basis. It also requires the firm to confirm whether or not it has adopted a new approach to credit risk, before providing a series of boxes in which the user is required to insert the firm’s capital resources – calculated in accordance with the relevant sections of GENPRU 2.2.

FSA009 then requires the user to input the variable risk requirements using either the new rules introduced by the CRD or the transitional provisions which incorporate aspects of the pre 1 January 2007 rules and those introduced by the CRD. This is where the form can appear complicated, although there are separate guidance notes available on the FSA website.

The following areas have been highlighted during our experience.

  • Illiquid assets could have previously been deducted from a firm’s financial resources. Under the new rules, firms can calculate their financial resources by either deducting material holdings or illiquid assets. If the material holding deduction is followed (this is the default position), then on data item FSA009, the liquidity adjustments on both fixed and current assets are now included in box 26 ‘Credit risk under existing rules’.
  • Under the transitional provisions, full scope firms will continue to apply their expenditure base requirement (EBR) rather than an operational risk capital requirement. However, as EBR does not exist under the CRD, the previously calculated EBR should be included in box 28 ‘Other capital requirements’.
  • Under the previous rules, the other asset requirement (OAR) for investment management firms represented a measure of credit risk attached to such balances. Therefore, the OAR calculation should be incorporated within box 26 ‘Credit risk under existing rules’.

A point to note is that as the financial resources and the financial resources requirement on the legacy form and data item FSA009 will have been calculated using different bases, the level of surplus or deficit reported on each is likely to be different.

An example of where this may arise is in relation to the illiquid asset point highlighted above. However, it is the deficit or surplus on FSA009 that the FSA will take as the firm’s financial resources position.

Another new data item that has been introduced is FSA028. It contains similar information to FSA009, but is specifically for firms that report on a consolidated basis and have a non-EEA sub group within their consolidation group. The form allows the FSA to gather capital adequacy and large exposures information on group entities outside of the EEA.

Both of these forms can be found in the Integrated Regulatory Reporting (IRR) section of the FSA’s website: uk/pages/Doing/Regulated/Returns/ IRR/index.shtml

The data items are in Excel format and should be downloaded from the FSA’s website, completed offline and submitted electronically using the Early Reporting System (ERS). In January 2007, firms affected by the CRD should have received an email from the FSA informing them of their reporting requirements, in addition to providing a user name and password to access the ERS.

In the transitional period both the data items and current returns should be submitted in accordance with existing submission deadlines.

Finally, if firms are reporting on a consolidated basis, they will need to submit two copies of FSA009 at the consolidated reporting deadline, one on an individual basis and another on a consolidated basis.

Employee Remuneration

The start of a new tax year is always a good time to review your remuneration packages and benefits and expenses policies. It allows you to determine if your existing arrangements are in line with current market trends and to take into account HMRC’s present way of thinking.

The Finance Act 2006 saw the introduction of the first retrospective legislation with regard to what HM Revenue & Customs (HMRC) considers to be unacceptable tax and National Insurance (NI) avoidance relating to the way earnings and bonuses are paid. This does not, however, mean that employers should just pay cash and accept the tax and NI consequences.

There are still tax and NI-efficient ways to remunerate employees and best practice is to maximise these. There are a number of benefits which have special tax treatment, such as childcare vouchers and parking near a place of work, but these have limited application due to monetary limits and the nature of the benefit provided. The most effective benefits for providing more significant savings for each employee are employer contributions to a registered pension scheme, and HMRC-approved share option schemes.

Unlike pension contributions made by an employee, which are subject to NI, employer contributions to a pension scheme do not incur a NI charge for either the employee or employer. It is therefore possible to maximise NI savings by arranging for what would have been an employee contribution as an employer contribution through a salary or bonus sacrifice.

HMRC-approved share schemes remain an effective way of providing significant tax and NI savings. Often the gains arising on the sale of shares acquired under an HMRC-approved scheme can be subject only to capital gains tax at an effective rate as low as 10%. For those employers who find the HMRC schemes too restrictive, or where the monetary limits have been fully utilised, there are additional methods of providing tax and NI-efficient remuneration through, depending on the employing company’s tax position, employee benefit trusts and unapproved share plans. We are finding employers are considering a combination of these unapproved arrangements as a useful addition to their overall reward strategy and structure.

While reviewing your benefits and expenses policy, it is important to keep in mind current HMRC trends. We are, for example, aware of a change in attitude towards the provision of taxis home when an employee has been required to work late (beyond 9pm). HMRC is challenging the late night exemption where some groups of employees are expected to stay late when working on specific projects. So, for example, it may contend that for employees whose work is transaction based and who stay late to ensure a deal is completed, the provision of a taxi home is a taxable benefit. This approach is new and should not be accepted until HMRC provides further guidance.

On a positive note, the provision of free or subsidised meals can still be tax-free if certain conditions are satisfied.

  • The meals must be provided in a canteen or on the employer’s business premises.
  • The meals must be on a reasonable scale.
  • All the employees at a particular location must receive either a free or subsidised meal or a voucher/token to receive such a meal.

We have, however, recently experienced HMRC challenging a client who provided breakfast to all employees in the office at a specified time each morning. Although breakfasts were available to all staff, HMRC argued that it would only be certain staff, such as traders, who would be in the office early enough to benefit. In the end, HMRC accepted that if evidence was available to demonstrate that all employees were aware of the facility and their right to use it, then the exemption would apply. It would then be the employee’s choice not to make use of it. This simple example clearly demonstrates the advantages to reviewing your policies on a regular basis and ensuring you are minimising the tax and NI exposure for you and your employees.

CRD Pillar 2 Requirements On Investment Firms

Firms are now well advanced in understanding the pillar 1 requirements and have started reporting to the FSA on that basis. However, few firms have given significant thought to pillar 2 or 3. This article explains the pillar 2 principles, how they can be applied in practice and why you should start preparing now.

The CRD came into force on 1 January 2007. This introduced a risk sensitive approach to the way firms assess, monitor, calculate and disclose the capital needs of their business.

The implementation of these rules into the UK was staggered by the use of certain transitional provisions. Most firms have opted for the transitions provisions as shown below, although they could have adopted the full CRD early.

Timing And Transitional Provisions

Pillar 2 Principles

Pillar 2 establishes a joint supervisory process between the firms and the regulator to ensure they hold sufficient capital in respect of their related risk profile.

Underlying this are two key principles.

  1. The overall financial adequacy rule – GENPRU 1.2.26

    "A firm must, at all times, maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due."

  2. The overall pillar 2 rule – GENPRU 1.2.30

    "A firm must have in place sound, effective and complete processes, strategies and systems:

    To assess and maintain on an ongoing basis the amounts, types and distribution of financial resources, capital resources and internal capital that it considers adequate to cover:

    1. the nature and level of the risks to which it is or might be exposed
    2. the risk in the overall financial adequacy rule
    3. the risk that the firm might not be able to meet its capital resources requirement in the future; and

    that enable it to identify and manage the major sources of risks."

Pillar 2 Process

This is a two-stage process.

Internal Capital Adequacy Assessment Process (ICAAP) is the firm’s own assessment of the internal capital it needs to hold against its risks.

Supervisory Review and Evaluation Process (SREP) is how supervisors (FSA) assess the overall prudential risk of a firm/group, covering inherent business risk, control factors and oversight/internal governance.

Preparing Your ICAAP

BIPRU 2.2 contains the relevant rules and requires firms to carry out regular assessments of the amounts and type of capital it considers adequate to cover the nature and level of risks.

A proportionate approach should be adopted according to the degree of complexity of a firm’s activities. In BIPRU 2.2.25 to BIPRU 2.2.27, the FSA has provided some guidance of the level of detail firms will need to go into, depending on their complexity.

In producing the ICAAP, the firm should:

  • identify the major sources of risk to the business, including those risks listed in GENPRU 1.2.30, and previous losses that are likely to recur
  • conduct stress and scenario testing that will quantify the potential impact of the major risks, considering in each case what action will be taken if one of the major risks materialises
  • consider how the firm’s capital resources requirement may alter under these scenarios
  • document and communicate the ICAAP
  • ensure that the entire process is an integral part of management, i.e. it forms part of the board agendas.

The lack of specific guidance is likely to pose the biggest challenge as there is no generic calculation that can be applied. Each ICAAP will be specific to the firm and, as a result, there will inevitably be a broad range of approaches, forms of documentation and overall assessment of capital.


Pillar 2 applies from the time that a firm adopts the new approaches to credit risk (under pillar 1). The last possible date for this is 1 January 2008. It is likely to require a significant amount of input from both senior management and compliance staff, so firms should not delay in starting the process.

VAT - Should Investment Trust Management Be Exempt From VAT?

The Advocate General (AG) of the European Court of Justice (ECJ) has released her opinion in the case of JP Morgan Fleming Claverhouse. The taxpayer had argued that the management of an investment trust company (ITC) should be treated like the management of an authorised unit trust (AUT) or an Open Ended Investment Company (OEIC). Both qualify as ‘special investment funds’ and are therefore exempt from VAT. The AG, somewhat surprisingly, agreed with the taxpayer that not only could the UK have exempted such services, but that they should have always been exempt.

Article 13 B (d) (6) of the Sixth Directive exempts "the management of special investment funds as defined by Member States". This has generally been interpreted as granting each Member State the power to decide for itself which funds should benefit from the exemption. In the UK, items 9 and 10 of Group 5, Schedule 9 to the VAT Act apply the exemption only to AUTs and OEICs.

The Court was asked four questions, which the AG proposes to answer as follows (paraphrased for the sake of brevity).

  1. Can an investment trust be defined as a ‘special investment fund’ for the purposes of the VAT exemption? As most of us were expecting, the AG’s answer here is yes.
  2. If so, does the phrase ‘as defined by Member States’ mean that a Member State (in this case the UK) can decide for itself which funds fall within the exemption or that each Member State must identify all such funds within its territory and apply the exemption to all of them? The AG’s answer here (again, no surprise) is that each Member State has the power to decide.
  3. If the Member State can select which funds benefit from the exemption, how do the principles of fiscal neutrality, equal treatment and the prevention of distortion of competition affect that discretion? The AG considers that these principles actually apply directly and restrict the UK’s discretion, to the extent that investment trusts, being in many respects similar to (and in competition with) unit trusts, should have been exempted all along. In other words, the UK has the discretion but has applied it incorrectly. If this is true, then the management of other forms of pooled investment, including pension funds, could also be affected.
  4. Do the relevant exempting provisions of the Sixth Directive have direct effect? The AG’s answer here is yes, which means that (if adopted by the Court) the decision will have retrospective effect in the UK. The provisions of the Sixth Directive do have direct effect where they are sufficiently precise and unconditional, but it is surprising that this applies here given that Article 13 B (d) (6) appears to allow the Member State some discretion.

What Next?

The AG’s opinion is not always followed by the ECJ, and there are some aspects of this one that will be hotly debated behind the scenes. But if the ECJ agrees, this case looks set to have very important consequences for the fund management industry. If you think your business might be affected should the exemption apply more widely, please get in touch.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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