UK: The Offshore Funds Regime: Changes To The Distributor Status

Last Updated: 17 July 2008
Article by Supriya Broadbent

Historically, offshore funds have been used as investment vehicles to minimise the impact of UK tax by keeping income profits offshore.

The UK's offshore funds rules were introduced in 1984 to ensure rolled-up income was taxed as income, not gains, when there was a substantial difference in tax rates. As such, it has not been tax efficient to hold offshore funds in certain areas. However, if an offshore fund meets certain annual distribution tests, such as distributing all or most of its income, it can be classed as a 'distributing fund'.

This distributor status offers better tax treatment, as the gains arising on the disposal of a fund can be treated as capital rather than income. To qualify, an offshore fund has to pay a minimum of 85% of its net income to UK investors and obtain an annual certification from HM Revenue & Customs (HMRC). But obtaining distributor status is complicated. Thus the Chancellor's plans to amend the regime has come as welcome news.

The Treasury outlined proposals for changing the existing offshore funds regime on 21 March 2007. It produced a consultation document in October outlining the changes. Following industry response and a detailed consultation, in May 2008, it announced draft regulations for a reporting fund regime to be introduced in spring 2009. The distributing fund regime continues for the current period, with HMRC also consulting on other aspects of the existing regime.

The New Reporting Regime

The new regime is attractive as funds will have the ability to elect in advance to qualify as a reporting fund, rather than retrospectively applying for distributor status certification.

For the purposes of the new legislation, an offshore fund is defined as any offshore vehicle that is a collective investment scheme. However, the new regime proposes that this definition be based on certain key characteristics of a fund and not on definitions contained in the Financial Services and Markets Act 2000. This has not yet been finalised.

The reporting fund regime retains the distributing fund approach to investor taxation, but the rules determining the fund's status have been changed. This can result in a beneficial treatment for the fund's investors. The new reporting fund rules differ from the current regime in the following ways.

  • A fund will not be required to distribute 85% of its income. Instead, it will have to report 100% (with a 10% margin of error) of the income for the relevant period to HMRC and its investors.

  • The income will no longer need to be physically distributed as the new regime allows for deemed distributions or a combination of physical and deemed distributions. Deemed distributions should help those funds that seek to accumulate income and reduce the administrative burden that physical distributions create. A UK investor in a reporting fund will be taxed on his/her share of income in the fund even if an actual distribution is not received.

  • Under the distributing fund regime, the fund has to calculate the UK equivalent profits (UKEP) and distribute 85% of this amount if it is higher than accounts income for the period for which the distributor status certification was sought. This will no longer be necessary, thus reducing the administrative burden.

Additional Amendments

The new reporting fund regime makes several other amendments to the offshore fund regime.

  • The restriction on a fund holding a maximum of 5% of net asset value in non-qualifying investments will be removed.

  • The de minimis exemption is being removed, but a fund will need to report 'nil' income to its investors if this is the case.

  • The idea of an investor holding a 'material interest' in a fund is being abolished, although the seven-year time limit to realise investments remains.

  • A fund will no longer be required to operate 'reinvestment mechanics', which currently presents another administrative issue.

Simpler And Better, But Still A Few Snags

The new regime seeks to simplify the rules and lessen the administrative burden created by a UKEP calculation, although the requirement to ascertain the 'reported' income based on UK GAAP/International Financial Reporting Standards remains. While the idea is to ease the way these regulations are applied, it has created several issues. These include the definition of an offshore fund, which the authorities continue to consult on, and calculating 'reported' income, as most industry respondents to the consultation document preferred the familiarity and certainty that the UKEP calculation for distributor status applications provided.

Introducing this new regime has shown HMRC's willingness to consult and engage with the financial services industry in relation to these rules. This is to be welcomed in preference to other legislative changes recently introduced with little or no consultation.

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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