UK: Financial Services And Markets Group Bulletin - Pillar 2 Support

Last Updated: 27 September 2007
Financial Services And Markets Group Bulletin - Pillar 2 Support

In this issue:

  • Need a hand with your ICAAP?
  • Calling all non-residents and investment managers
  • Regulatory reporting
  • IFRS 7: preparers be warned
  • Management of investment trusts

In this edition, we discuss the guidance documents published by the FSA in response to many firms experiencing difficulties with their ICAAPs. We also review IFRS 7’s disclosure requirements and the ECJ’s ruling in the JPMorgan Fleming Claverhouse case.

Need a hand with your ICAAP?

With firms starting to focus their attention on ICAAP requirements, the FSA has published guidance documents to help those firms encountering difficulties.

As we are now in the second half of 2007, BIPRU firms appear comfortable with the current Pillar 1 obligations, having experienced reporting under the transitional provisions. They are now turning their attention to implementing the full set of rules under the Capital Requirements Directive (CRD), which take effect from 1 January 2008. In accordance with this deadline, BIPRU firms need to finalise their Internal Capital Adequacy Assessment Process (ICAAP). However, it appears that a number of firms are having difficulty understanding exactly what is required.

The lack of precise guidance has been one of the biggest challenges as, due to the ICAAP being firm-specific, there is no generic calculation that can be applied. Consequently, there will be a variety of approaches taken, forms of documentation used, and overall assessments of capital. The Financial Services Authority (FSA) has now published three documents to assist firms with developing their ICAAP. These are outlined below and can be found at: international/basel/info/pil2/index.shtml

1. The FSA’s Pillar 2 Assessment Framework
This covers the Supervisory Review and Evaluation Process (SREP) and is intended to help firms understand the rationale behind the SREP and the various levels of supervisory review, which depend on the size and complexity of the firm.

2. Initial observations on ICAAPs received to date – areas of weakness
The FSA has made some useful observations regarding the ICAAPs they have received, which include some obvious areas that have been overlooked. For example, a firm’s overall minimum capital requirement being lower than its Pillar 1 requirement; firms not projecting their business and capital plans for the recommended three to five years; and the ICAAP not being signed off by the board.

3. ICAAP: suggested format for smaller firms
Following on from the ICAAP submission template, published for firms whose activities are complex or moderately complex, the FSA has developed a similar template for smaller firms. While use of the template is not mandatory, it provides the headings that the FSA would expect to find in an ICAAP, in addition to the information it would expect under each heading.

Calling all non-UK residents and investment managers

Revised guidance on the IME

We examine HMRC’s revised Statement of Practice on the IME, which was issued as a result of legislative changes in the Finance Act 2003.

The Investment Manager Exemption (IME) allows non-UK residents to employ investment managers without incurring a UK tax charge, providing certain conditions are met. Without the exemption, nonresidents would fall within the scope of UK tax in respect of trading income conducted through a branch or agent, i.e. an investment manager.

Exemption requirements
To qualify for the exemption, the following conditions must be met (S127 Finance Act 1995 and Schedule 26 Finance Act 2003, which have been re-written, in part, in the Income Tax Act 2007).

  • The UK investment manager is in the business of providing investment management services.
  • The transactions are carried out in the ordinary course of that business. The investment manager acts in an independent capacity in relation to the transactions.
  • The investment manager receives remuneration for providing the services at a rate customary for such business.
  • The investment manager is not the non-resident’s UK representative for any other income or transaction chargeable to UK tax for the same period.
  • The requirements of the 20% test (the agent may have up to 20% interest in the income) should be met.

If a non-resident fails only the 20% test, the exemption is merely restricted, not removed.

Revised SP1/01
These requirements were originally addressed in Statement of Practice 1/01. However, due to legislative changes in the Finance Act 2003 that affect non-residents and market developments, HM Revenue & Customs (HMRC) has issued a revised statement.

The revised SP1/01 provides guidance on the application of these tests. In particular, it gives HMRC’s views on:

  • the extent to which trading through a UK investment manager does not make the non-resident liable to a tax charge on the arising income
  • factors to be taken into account when determining whether active management of a portfolio on behalf of a nonresident constitutes exercise of a trade in the UK by the non-resident
  • the circumstances in which an investment manager is considered to be acting in an independent capacity
  • application of the 20% test and the customary rate of remuneration.

The revised statement replaces the original SP1/01 with immediate effect, except where the statement requires a nonresident or his/her investment manager to make changes to current circumstances or contractual arrangements in order to comply. In such cases, the original SP1/01 may be applied until 31 December 2009.

Implications of the new SP1/01
There are various consequences of the new SP1/01 that need to be taken into account. It provides a hierarchy of tests that are broadly based on the safe harbours set out in the old statement, including the independent capacity test. Funds must be widely held, or being actively marketed towards that end in order to meet the test in the new statement.

The new statement also requires documentation to support the customary remuneration based on the Organisation for Economic Co-operation and Development’s transfer pricing guidelines. This is likely to have a big impact on most investment managers, who will need to ensure such documentation is in place. The additional guidance in the new statement allows for funds to be planned more effectively, although current arrangements should be carefully reviewed with regard to compliance with the 2009 deadline. Where the new SP1/01 creates uncertainty around whether a fund is trading or not, careful consideration will be required.

SP1/01 is for guidance only and cannot be relied upon as law. Therefore, we recommend that care and advice is taken where appropriate.

Regulatory Reporting- An update

The FSA recently changed a number of start dates for the new reporting requirements, and issued a consultation paper on where external assurance is required on regulatory returns.

The FSA has changed the start dates for some of the new reporting requirements scheduled to begin in January 2008 and January 2009.

For reporting that was due to start in 2008, with the exception of data items FSA003 (Capital Adequacy) and FSA004 (Additional Information on Credit Risk) for investment firms, the start date for data items has been deferred from 1 January 2008 to 30 June 2008. As such, BIPRU firms will continue to submit their old IPRU (INV) returns for the first half of 2008, but will not submit FSA009, as this will be replaced with FSA003.

For reporting due to start in 2009, the FSA has brought forward the start date for these data items from 1 January 2009 to 31 August 2008. This will affect the following firms.

  • From 31 August 2008, investment firms not subject to the CRD or Markets in Financial Instruments Directive (MiFID) should stop submitting their ‘old’ returns.
  • Exempt CAD firms will no longer be required to submit FSA043 (Key Data) from January 2008, but will continue to submit their ‘old’ returns until the new reporting begins on 31 August 2008.

The FSA has listed the changes in reporting start dates on its website: pages/doing/regulated/returns/irr/dates/ summary/index.shtml

External assurance on regulatory returns

There is currently a mismatch between the FSA’s risk-based approach to supervision and the type of firms required to have their annual regulatory returns audited.

To level the playing field, the FSA has issued consultation paper CP07/15, which proposes to remove the regulatory audit requirement in SUP3.9 for non-BIPRU firms. The aim is to make more use of reports by experts in the form of Return Assurance Reports (RARs).

It is envisaged that RARs will be used in two ways.

1. s.166 RARs will allow the FSA to exercise its right under s.166 of the Financial Services and Markets Act to review specific firms where there is a perceived risk. This is expected to be used in instances where there have been historic problems with regulatory returns or where regulatory returns have never been subject to external audit.

2. Thematic RARs will form part of the FSA’s thematic reviews. Firms falling within the scope of the reviews may have their regulatory returns assessed.

The FSA also plans to remove the SUP3.9 requirement for auditors to submit a management letter to firms on matters concerning internal controls. Similar letters for client asset audit work will still be needed, but these will be a requirement of SUP3.10 rather than SUP3.9. This will not impact on the current requirement for audit reports on client assets for MiFID firms.

Although it is not directly related, it is worth noting that under TP1 of the transitional provisions of the SUP handbook, BIPRU firms are not required to submit annual returns, or balance sheet reconciliations, if applicable, between 1 January and 31 December 2007.

Finally, the Auditing Practices Board has at last issued a consultation draft of the revised Practice Note 21, The Audit of Investment Businesses in the United Kingdom. The most significant change is the inclusion of new guidance on reporting on client assets under SUP3.10. Guidance on reporting to the FSA under SUP3.9 has not yet been removed from the draft, but will be excluded from the final version if the FSA’s proposals in CP07/15 are implemented.

IFRS preparers be warned

IFRS 7 introduces further demanding requirements

IFRS 7, which replaces IAS 30 and IAS 32, has a number of new disclosure requirements that companies need to take into account.

IFRS 7, ‘Financial Instruments: Disclosures’ combines the disclosure requirements arising from IAS 30 and IAS 32 in a new standard. As a result, IAS 30 and paragraphs 51 to 95 of IAS 32 have been superseded. The remaining paragraphs of IAS 32 are still effective as ‘Financial Instruments: Presentation’ (IFRS 25).

IFRS 7, issued on 18 August 2005 and adopted for use in the European Union on 27 January 2006, is now in force, effective for periods beginning on or after 1 January 2007. The standard has been available for early application in the UK for some time, and though take-up was encouraged (but not required), only a few companies chose to adopt it early. For many IFRS preparers, the new standard will result in more onerous disclosure requirements.

There is no exemption from presenting comparative information unless the standard is adopted for a period beginning before 1 January 2006.

IFRS 7 applies to all IFRS-compliant financial statements that include financial instruments not specifically excluded from the scope of the standard. IFRS 7 has also been incorporated into UK GAAP as FRS 29 and needs to be applied by UK companies implementing FRS 26.

New requirements

Management approach
For each type of risk arising from financial instruments, entities must disclose summary quantitative data about exposure to these risks at the reporting date. This disclosure should be based on information provided internally to key management personnel (as defined in IAS 24 Related Party Disclosures).

Disclosing information on this basis should save companies time and money, provided that the information they supply internally surpasses the minimum required by IFRS 7.

New information to capture
IFRS 7 necessitates disclosure of information not previously required. Unfortunately, some companies may find that their existing financial reporting systems do not capture all the information they now need to disclose.

For example, entities now have to disclose an aged analysis of financial assets that are past due, but not impaired at the reporting date. Thus, they will have to prepare an aged analysis of any outstanding trade debtors who have not settled their debts within the stated credit terms. So, if an entity issued a sales invoice (with credit terms of 30 days) 40 days before the year-end, and it hadn’t been paid as at the year-end, that debtor would be disclosed as past due.

Sensitivity analysis
Entities need to produce a quantitative analysis of how profit or loss and equity would have been affected by ‘reasonably possible’ changes in market movements.

The standard does not stipulate how such an analysis should be performed or presented, but an illustrative example is provided in paragraph IG36.

Maturity analysis
Companies are required to show a maturity analysis based around future undiscounted gross contractual cashflows arising from financial liabilities, i.e. what will actually be paid in the future, and not the amounts at which the liabilities are stated in the financial statements.

For example, a bank loan of £100,000 is initially recognised in a company’s financial statements at fair value (normally the amount received) and subsequently measured at amortised cost. If the interest is paid at 9% per annum over five years, with the principal repaid at the end of that period, then, if the loan was entered into at the balance sheet date, the total amount to be disclosed in the balance sheet would be £100,000. However, £145,000 would be disclosed in the maturity analysis, as this is the total of the future payments to be made under the loan.

In some cases, entities may have to do extra work to identify these amounts, as they may not be captured by their accounting systems.

Other significant changes

  • Entities need to disclose the carrying amounts of financial assets and liabilities by category, either on the face of the balance sheet or in the notes. (The word ‘category’ refers to the categories of financial instruments defined in IAS 39, i.e. financial assets or liabilities at fair value through profit or loss, held-to-maturity investments, loans and receivables, available-for-sale financial assets, and financial liabilities held at amortised cost.)
  • There are extra disclosure requirements relating to items designated at fair value through profit or loss. Some of these are potentially onerous as they require the component of fair value movement relating to fluctuations in credit risk to be calculated.
  • There are new disclosure requirements relating to any difference between the fair value of a financial instrument at initial recognition and the amount at that date using a valuation technique.
  • When entities record an impairment on an individual or group of financial assets through an allowance account (e.g. a bad debt provision), as opposed to recording a direct reduction in the carrying amount of the asset, they need to disclose, for each class of financial asset, a reconciliation of changes in carrying amounts in that account during the period.
  • Companies need to make new disclosures for hedge ineffectiveness, and gains and losses in fair value hedges.
  • Entities now have to disclose separately the net gain or loss for the following categories of financial assets and liabilities: held-to-maturity investments, loans and receivables, and financial liabilities measured at amortised cost.

As IFRS 7 introduces so many ‘extra’ disclosure requirements, companies that didn’t opt for early adoption should not delay in starting the process.

Management of investment trusts - VAT exempt

We look at the implications of the ECJ’s ruling in JPMorgan Fleming Claverhouse.

The European Court of Justice (ECJ) released its judgment in the case of JPMorgan Fleming Claverhouse in June. Following the Advocate General’s (AG) opinion, the court concluded that management services supplied to investment trust companies (ITCs) in the UK should be exempt from VAT – and indeed, should always have been.

Current UK legislation restricts the VAT exemption to the management of authorised unit trusts and open-ended investment companies, but with this ruling, it breaches the principle of fiscal neutrality. Taxpayers are now able to rely on the fact that the Sixth Directive has direct effect.

A number of businesses have already lodged protective claims and are eager to press HMRC for their refunds. However, some questions remain. If ITC management services should always have been exempt, then HMRC can claw back any input VAT recovered on such operations, and reject claims if they do not take account of the reduced input tax entitlement.

Some businesses will also want to claim for periods going beyond the three-year cap. Such applications in similar circumstances have been the subject of several cases, but such claims are likely to be resisted.

The JPMorgan Fleming Claverhouse case only dealt with the management of an ITC. However, the decision has made it clear that UK legislation in this area is deficient and needs to be reviewed urgently.

There was speculation that the ruling could apply to various other forms of collective investment, including pension funds. However, HMRC has now issued Brief 58/07, confirming that it will reject VAT exemption claims for fund management services supplied to vehicles other than ITCs.

Further litigation may be needed to address the treatment of other forms of investment, but the more likely next step is consultation between HMRC and affected businesses.

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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