UK: Banking And Capital Markets Insight, September 2009

Last Updated: 15 October 2009
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Welcome to the September 2009 edition of Banking and Capital Markets Insight, which focuses on technical issues currently coming out of the banking, capital markets, securities and fund management arenas. This issue again is a wide ranging one, covering significant issues in respect of the regulation of regulatory capital, client money, European regulation of funds and the responsibilities going forward of the Senior Accounting Officer for relevant tax balances.

Our articles cover the following diverse areas:

  • Kush Patel on the discussion paper produced by the IASB on IAS 39 Financial Instruments: Classification and Measurement (IAS 39) on reducing the complexity in reporting financial instruments, which is due for finalisation as a standard by the end of 2009 and for mandatory adoption by 2012;
  • Eric Wooding on the proposals being worked on by the International Accounting Standards Board for an expected cash flow approach to expected loss provisioning, and by the European Commission for a dynamic provisioning approach to expected losses;
  • Mike Williams on the current deliberations by the FSA and HM Treasury on the potential improvements to the current UK client money and asset regime and the potential changes to the clarity of customer disclosures, reporting, speed of access to assets post administration but also the maintenance of sufficient flexibility in contract terms where it is appropriate;
  • Paul Leech on the greater opportunities under UCITS IV for the passporting of traditional funds in Europe, but at the same time the potentially significantly greater burden of capital requirements and restrictions on alternative investments funds which are operated within the requirements of the proposed Alternative Investment Funds Directive; and
  • Mark Kennedy and Brigit Lucas on the significant responsibilities placed on the Senior Accounting Officer under HM Treasury requirements to oversee the calculation of tax liabilities within qualifying UK corporate entities from 2009/2010 year ends. The role is an executive one and may well not fall to the tax director.

We look forward to your comments on the current edition and your suggestions for future articles.

IAS 39 re-written

The International Accounting Standards Board (IASB) has long intended to simplify the reporting of financial instruments. In March 2008 it issued a discussion paper on reducing complexity in reporting financial instruments setting out for comment various thoughts and considerations on how IAS 39 Financial Instruments: Classification and Measurement (IAS 39) could be simplified. However, momentum for the project to replace IAS 39 gained pace with the onset of the financial crisis with criticisms of the standard coming from all angles, most notably politicians, due to instability in the world's banking system. This culminated in a clear message from the G20 Leaders for the IASB to take action to improve and simplify the accounting of financial instruments by the end of 2009.

Responding to the G20 Leaders comments the IASB has committed to a timetable for a phased replacement of IAS 39 with a new financial instruments standard. The phases that breakdown the project in to more manageable chunks cover (1) classification and measurement; (2) impairment and (3) hedge accounting. Replacing the derecognition rules of IAS 39 is formally part of a separate project, but the revised rules will be included in the new standard. The timetable for each phase is summarised on the following page, illustrating that a final new standard is expected in 2010.

The objective of the first phase, which got underway with the issue of the exposure draft (ED) in July 2009, is to have a new classification and measurement model finalised and available for early adoption by the end of 2009. The IASB have indicated that mandatory application of the whole new financial instruments standard would not be before 2012. However, what is currently unclear is whether an entity early adopting the classification and measurement model would be required to early adopt other parts of the standard once they are finalised.

Classifications removed

The Board did not hold back the red pen when it revisited the past wisdom on which the current classification and measurement model is based, casting a number of now familiar terms and concepts to the history books. The first cut of the new model sees the number of classifications reduced.

Available-for-sale (AFS) was always first in line to go. A source of significant complexity with its split recognition of gains and losses part in equity and part in profit or loss, the classification was further exposed in the downturn for its shortfall in measuring and recognising impairment losses.

For debt instruments the AFS classification combines fair value measurement for the balance sheet with amortised cost and effective interest rate (EIR) for recognising interest in profit or loss. This combination ran into difficulty in the downturn as impairment is recognised based on fair value which includes discounts for other factors such as liquidity. Yet confusingly post impairment the EIR for income recognition resumes.

This gave rise to significant differences to the impaired carrying values determined under the amortised cost measure. For AFS equity investments it has long been challenging to assess whether a decline in fair value below its cost is "significant or prolonged" – the criteria for recognising impairment – resulting in divergence in practice. The rules on reversing impairment charges through profit or loss for both debt and equity investments, which will become increasingly relevant in a recovery, are also unpopular, especially for equity investments where no reversals are permitted.

Another classification to disappear is held-to-maturity (HTM). Not used by many its unlikely to be missed by most, particularly because it is replaced by a broader classification that results in the same amortised cost measurement but without the unpopular restrictions (such as the tainting rules that can force all HTM assets to be reclassified to AFS if they are sold before maturity and the restrictions on hedging such assets). However, the criteria for classifying an instrument at amortised cost are different to that for HTM and therefore there is no guarantee that all current HTM assets will be measured on the same basis under the new model.

The new model

So what have the classifications been replaced with? The ED proposes a three-classification model applicable to all financial assets and financial liabilities in the scope of IAS 39. The classifications available for an instrument depend on a combination of the characteristics of the instrument, the entity's business model and elections made by the entity at initial recognition of the instrument. The model, which can be summarised in many different ways, is summarised left by type of nonderivative instrument showing the classifications currently permitted by IAS 39 against the proposed permissible classifications in the ED. This shows the reduction in possible measurement and recognition bases including a single requirement for measuring and recognising impairment which applies only to debt instruments measured at amortised cost. The proposals introduce further simplification by prohibiting reclassifications after initial recognition.

Equity investments

Of the proposed three classifications, one introduces a new measurement and recognition basis that is permitted, by election on initial recognition, for equity investments that are not held for trading. This classification, called fair value through other comprehensive income (FVTOCI) results in an equity investment being measured at fair value on the balance sheet with all fair value gains or losses (including dividend income and impairment losses) recognised in equity permanently with no recycling to profit or loss – not even on disposal. This classification provides an alternative to the otherwise mandatory classification of fair value through profit or loss (FVTPL).

The ED also proposes that no equity investments may be held at cost less impairment as currently required for some unquoted equity investments – all must be recorded on balance sheet at fair value. This change is another simplification, however, some have commented that the cost of producing fair value information that may be not sufficiently reliable will outweigh the benefit.

Debt instruments

For debt instruments (both assets and liabilities) the model requires all those with non-basic loan features or those that are not managed on a contractual yield basis to be recorded at FVTPL. All other debt instruments must be held at amortised cost unless the fair value option, available if FVTPL significantly reduces an accounting mismatch, is elected on initial recognition. The ED provides some guidance on these new criteria.

Basic loan features are terms that result in the payment of principal and interest on principal outstanding. Examples cited include single, unleveraged market rates of interest (eg. UK LIBOR), fixed rates of interest and combinations of the two such as floating rates with caps, floors or fixed margins. The ED implies that inflation linked instruments may qualify for amortised cost accounting depending on the specific terms of the instrument. Controversially instruments issued from entities as part of multiple contractually subordinated interests (ie tranches), that are not the most senior (ie. not at the top of the waterfall) will automatically fail the basic loan features test. This is due to the credit risk leverage that is considered to arise in these instruments by virtue of them providing credit risk protection to other tranches.

Managed on a contractual yield basis includes those instruments whose performance is managed and reported to key personnel on a contractual yield basis and excludes those instruments that are held for trading. Unlike the basic loan feature assessment this criterion is not applied on an instrument by instrument basis. Instead it is applied at a business unit or portfolio level. The ED also clarifies that distressed debt purchased with incurred losses would not qualify as being managed on a contractual yield basis.

The criteria for amortised cost accounting sound pretty straightforward, however, the challenge will be in the practical application. Are the principles clear enough to result in consistent application or will significantly more application guidance with examples be needed like there currently is for the separation of non-closely related embedded derivatives? The lack of a clear principle and an excessive number of examples could undo the work done in the ED on simplifying the accounting for embedded derivatives in financial hybrid contracts.

Embedded derivatives

The ED proposes an end to the separate accounting of non-closely related embedded derivatives from financial host contracts. Instead the entire hybrid contract is assessed to determine the classification and measurement basis for the entire instrument such that if it contains non-basic loan features it must be recorded at FVTPL in its entirety. As a result, most non-closely related embedded derivatives in financial hybrid contracts will still be recorded at FVTPL but as part of the whole instrument, including the host contract, as the entire instrument would most likely fail the basic loan features test.

The requirement to fair value the entire financial instrument, as opposed to just the embedded derivatives, may introduce volatility in profit or loss for some reporters that hedge non-closely related embedded derivatives in hybrid debt instruments with standalone derivatives. Under the current standard the entity may have got a natural hedge as the standalone and embedded derivative are both FVTPL but the debt host contract is measured at amortised cost. Assuming the hybrid does not pass the basic loan features test the new proposals would require the entire hybrid to be FVTPL resulting in fair value volatility in profit or loss arising if the host contract is not also fully hedged.

Derivatives

The accounting of derivatives is not impacted by the proposals except for derivatives over certain unquoted equity instruments that are physically settled which would be required to be held at fair value instead of cost as currently permitted.

Transition

One third of the ED's main paragraphs are devoted to transition. The general principle is retrospective application with some exceptions. The complexity of transition will vary amongst entities depending on the changes in classification that arise. Most challenging will be determining amortised cost retrospectively for debt instruments with incurred impairment losses that are currently FVTPL, although this is where some practical relief is available. Entities that reclassified instruments as part of the October 2008 reclassification amendment to IAS 39 are not likely to find transition any easier.

However, they will have an opportunity to reclassify debt instruments that were previously designated at FVTPL (under the fair value option) to amortised cost (if the criteria are met) – a reclassification that did not qualify under the October 2008 amendment.

With a short comment period of 60 days which ended on 14 September 2009 there is not a long wait to see how well the new model is received – as with IAS 39 it's unlikely to please everyone.

Kush Patel

Update on expected loss provisioning

One of the key lessons many have drawn from the crisis is that banks should adopt a more forward looking approach to providing for loan losses than the incurred loss model currently required by accounting standards. For example, in April the G20 called on various global bodies, including the Financial Stability Board and the Basel Committee, working with accounting standard setters, to "take forward, with a deadline of end 2009, implementation of the recommendations published today to mitigate pro-cyclicality, including a requirement for banks to build buffers of resources in good times that they can draw on when conditions deteriorate."

As a result the IASB is considering alternatives to the incurred loss impairment approach with, in the IASB's words, "particular emphasis being given to an expected cash flow approach". A key feature of this approach would be that that interest income would be initially recognised on the basis of cash flows expected when a loan is made, ie. taking into account expected loan losses. Subsequent changes in expected losses would result in a charge or credit to the profit and loss account.

The IASB is also considering a fair-value based approach (ie. not full fair value accounting but a fair value based approach to impairment of assets booked at amortised cost). Under this approach, if an impairment trigger were activated, book value would be revised to fair value if lower. In times of market turbulence write-downs would include the effect of declining market liquidity and hence might result in larger write-downs than would occur under the expected cash flow approach.

The IASB issued a Request for Information on the expected cash flow approach in June with responses to be received by 1 September. An exposure draft is planned to be published in October.

The IASB has not been the only organisation working on this matter. In July the European Commission issued for consultation an "exploratory draft" of proposals to amend the Capital Requirements Directive (CRD) which includes a requirement for banks to use through-the cycle (TTC) expected loss provisioning. This would not be an accounting requirement, that is to say, it would not affect the audited financial statements. But it would be a prudential requirement ie. banks would be required to maintain a buffer based on TTC expected loss provisioning for prudential purposes.

The Commission's draft proposal is to require banks to use what is essentially the Bank of Spain's standard system of dynamic provisioning (see box right) or a simplified version of it. The provision would not be regulatory capital as the job of regulatory capital is to absorb unexpected losses whereas the provision would be to cover expected losses. Thus, in essence, the provision would be a buffer in addition to regulatory capital. It would be built up in good times and could be drawn on in a downturn without reducing a bank's regulatory capital.

The Commission's consultation paper requests responses to a number of questions, two of the most important being:

  • whether banks should be allowed to use their own internal methodologies, subject to supervisory validation) to calculate counter-cyclical factors (α and β) as an alternative to the standardised approach summarised in the box right; and
  • whether expected loss provision requirements should apply not only to assets subject to an impairment test but also to other assets (i.e. those booked at fair value) and to off-balance sheet items.

The closing date for responses was 4 September with a formal proposal to amend the CRD to require TTC expected loss provisioning to occur as early as October although one would think the timing will depend on the responses received to the Commission's consultation and on the contents of the IASB's exposure draft.

Although the details are still to be finalised, it seems highly likely that EU banks will soon be required to undertake expected loss provisioning in some form for prudential purposes. It also seems probable that expected loss provisioning, in a different form, will be required under IFRS. However, the latter is more uncertain, particularly in the longer term, as the US FASB's tentative decision in favour of fair valuing substantially all financial instruments, which would include loans, confirms.

Eric Wooding

The Commission's proposal for a Spanish-style system of dynamic provisioning The proposal is that banks should charge or credit the profit and loss account with the TTC expected loss provision.

The first step is to divide the loan book by country of borrower and then within each country by risk class (there are 6 risk classes ranging from negligible to full). For each risk class within a country the charge or credit to the profit and loss account is calculated by adding two elements:

  • the historical average estimated loan loss rate (α) applied to the growth or contraction in loans for which no specific provision has been made over the year; and
  • the difference between the historical average rate of specific provisions (β) and the actual rate of specific provisions made during the year, applied to the year's balance of loans.

Element 1) is designed to compensate for the failure of the incurred loss method of loan loss provisioning (which is currently required by accounting standards) to recognise from the time a loan is made the fact that on average, if 100 loans are made, some of them will not be collected in full. It will add to the buffer in years of economic expansion when the loan book grows but will reduce the buffer in a period of economic contraction when the loan book shrinks.

Element 2) is designed to address the fact that the rate at which latent losses in the loan book emerge as specifically identified bad debts varies over the economic cycle. In years of expansion the actual rate of specific provisions will be lower than the average over the cycle so that element 2) will add to the buffer.

But when the downturn arrives the actual rate of specific provisions will increase to a level above the average so that element 2) will reduce the buffer. While the two elements will commonly operate in the same direction (both adding to the buffer in expansionary years and both reducing it in sharp downturns) there may be years in which one is positive and the other negative.

For example this could happen in a year in which loan growth slowed greatly but remained positive in which case element 1) would be positive but 2) might be negative. The Commission proposes that the alphas and betas be set by the authorities rather than assessed by individual banks. For a portfolio of loans to borrowers from a given Member State, α and β would be set by the banking authorities in that Member State while the Committee of European Bank Supervisors (CEBS) would set the factors for each non-Member State.

The simplified method contains only element 2). As stated earlier, the Commission contemplates using this method only if the IASB introduces an expected cash flow methodology for provisioning which recognises average credit losses over the life of each portfolio and hence makes α (ie. element 1) redundant.

Reconsideration of client money on the agenda

Consideration of the need for improvements to the client money and assets requirements in the UK has moved up the regulatory agenda in the last 6 months. This is partly because of the FSA's concerns about underlying deficiencies in client money controls, arising from a lack of clarity around the client money rules' application in a number of firms. This resulted in the April 2009 Dear Compliance Officer letter and the themed visits to a number of firms on client money issues in mid 2009. It is also to a significant degree based on the reconsideration of the insolvency regime in the UK by HM Treasury and the FSA in the wake of the failure of Lehman Brothers and others.

A Consultation Paper on proposed revisions to the FSA Client Assets regime is tabled for publication in the last quarter of 2009. This is likely, inter alia, to reconsider the balance between the commercial drivers for flexibility of client asset protections, particularly in the area of margin and collateral balances, and the need for clients to better understand, and to be better insulated from, the potential for loss of assets in an insolvency. They can potentially be disadvantaged as a result of not knowing the basis on which their assets are held or as a result of failing to gain swift enough access in order to protect their assets at the time of the firm's failure.

The impact of the insolvency of a major investment bank and the concomitant effects on client asset protections was considered in the HM Treasury Paper Developing effective resolution arrangements for investment banks which was published in May 2009. While noting the regulatory initiatives such as the proposals for a comprehensive regime for dealing with failures in the Banking Act 2009, the supervisory and regulatory proposals in the Turner Review and the progress made at G20 and international level on the broader issues of strengthening the financial system, the Paper also notes that a resolution is also likely to be market led as investors and depositors are more cautious about the risks they take with their assets and firms seek to provide greater clarity around their contractual terms.

What are the main areas of discussion? Key practical issues include the following:

  • The proposal for gross margining of client positions and for clearing houses to maintain designated client accounts as set out by the FSA in their Discussion Paper 09/2. There are clearly a number of advantages in having the facility for client and firm margin run through the same account, on the basis that the client benefits from the net margining of positions and the firm is also able to provide financing itself on behalf of the client in the (likely) event that margin needs to be provided to the clearing house quickly. There are risks, however, associated with this approach, which potentially require greater disclosure to clients.

    A common alternative is that the client gives full title to the collateral to the firm, which then transfers it to the clearing house, but, in that event, the client will only rank as an unsecured creditor subject to a right of set-off in the event of the firm's insolvency.

    In practical terms also, some of European clearing houses (eg. Eurex) do not give the facility for the maintenance of separate firm and client accounts. This is one of the most difficult areas for practical resolution and will need both regulatory and market input.
  • The improvement of record keeping by firms and the information provided to investors/depositors to include regular reporting of areas such as:
    • assets held, the basis on which they are held, who is holding them (eg. custodians), and in which jurisdictions they are held;
    • what rights of set-off exist over assets, the aggregate value of assets in respect of which a right of use has been exercised, and the amounts at a CUSIP level;
    • the value of rehypothecated securities compared to segregated custody positions;
    • the exposures which are taken into account in determining the net liabilities against which any rehypothecation limit is set;
    • net claims; and
    • the extent of any lien over assets.

The onus of this additional reporting on firms could be potentially significant, although they are likely to already be providing at least part of this information already on a daily basis to their more significant clients.

  • The Paper also discusses the possibility of enhancing risk warnings in contractual agreements, emphasising the implications of removal from client asset protections, of the exercise of the right of use over assets and of the full title transfer of assets. This proposed requirement has moved on from the spirit of the post-MiFID CASS rules, which allow the use of title transfer provisions for retail clients, as long as it is in the client's best interests, and thus at least implicitly leads to the conclusion that the use of title transfer arrangements is not regarded as inherently overly risky.

    For professional customers, there is a good argument to say that they already receive clear documentation of the basis of their client money and collateral arrangements in their existing terms and conditions (which are often negotiated individually) and supporting industry body master and netting agreements.

    A number of the major forms of master agreement, which include ISDA and OSLA master agreements, also give firms the right to treat client money and assets as their own and certain rights to net off or set-off assets against liabilities.
  • Restrictions on the ability of firms to hold above a certain level of client money and assets with affiliates, and the proposal that firms are required to report their list of banks with which they hold client money and assets and the level of client money held at individual banks daily so that clients can assess their level of credit risk to individual banks. In addition, there should be regular reporting of where client assets are held, and, most far reaching, firms should have an ability to ring fence different pools of client money in the event of a primary pooling event to allow the corralling of risk related to some products, and the return of client money balances to clients trading in other, lower risk products more quickly.

    Again, the restriction on the use of affiliates harps back to previous versions of the FSA client money rules, when restrictions around affiliate balances, and then disclosure of group relationships, were put in place. The revival of these restrictions may not, however, necessarily be in the client's best interests, where they are using a firm providing global custody services to protect their assets on a consistent and commercially efficient basis across a number of separate jurisdictions. The revised reporting requirements also sound relatively onerous for firms to manage on a daily basis across their client base.

    In terms of the separate pooling provisions, these have a strong element of common sense to them, but how easy it will be to actually segregate different client interest groups is in practice a very difficult area. For example, some firms may well segregate money balances held in excess of margin requirements where clients undertake derivative transactions. Do these belong to the same or different segregation pools, where you are dealing with the same client's balances?

    In practice, there are also likely to be a number of significant clients which have amounts due for segregation across different categories of client money. It will be a difficult task in practice to tell a significant client that some of its balances across different asset classes will not be ring fenced or returned to them to the same timescale. No doubt there will also be a number of legal arguments about the preferencing of one individual investor group over another, even if the arrangements are very obviously kept to just retail investors dealing in very simple investments, which appears to be the initial intention.
  • Changes to the way in which the set-off rules are applied to customers assets when an investment firm fails, given customer uncertainty as to how the administrators intend to apply the right of set-off in practice, in particular which of their assets may be sold first to repay margin loans.
  • Establishment of a time date bar for the crystallisation of claims is also discussed, with the potential that pure custody assets will be returned within a shorter period of time than other asset classes.
  • Restrictions on the regime around hypothecation are also discussed, including a cap on the extent of rights of hypothecation, with clients' legal agreements with brokers clearly setting out how the cap is to be quantified. The Paper, however, does acknowledge the arguments of firms that the degree of rehypothecation for professional client assets is a purely market driven matter.

    Ultimately, the Treasury Paper raises a number of questions about how London maintains its market presence while at the same time improving the transparency of client disclosures and the speed of access of investors to recovery of assets, both very important issues. The Paper recognises that flexibility of approach, particularly where professional investors are involved and the rules of caveat emptor most clearly apply, is the most important consideration in maintaining the commerciality of arrangements. Hopefully, this thinking will also come to the fore when FSA issues its own Consultation Paper in the last quarter of 2009.

Mike Williams

The future of fund regulation in Europe

Overview

UCITS ("Units in Collective Investments in Transferable Securities") have become a brand name in the last 20 years. Europe has recognised the benefits of the brand and has tried to develop it alongside market forces. However, the effects of the 'credit crunch' have lead some to question the future direction of UCITS and the need to regulate other non-UCITS funds. Many see the proposed scope and form of recent regulatory proposals as a potential death knell for parts of the European funds industry. This paper discusses some of the recent changes and what they may mean bearing in mind that many of the proposals still lack detail.

UK background

Within the UK, the FSA, regulates both managers and investment managers/advisers of Collective Investment Schemes (CIS). However, the schemes themselves are not all subject to regulation but, to be able to sell to retail clients, a CIS must be authorised by the FSA.

European background

In Europe, regulation has been to date directed at the funds themselves. Since 1985 funds have been subject to the UCITS Directive. The original Directive set out the principle that to be sold across Europe funds must meet certain investment criteria to qualify as a UCIT.

The UCITS Directive providing a "passport" for funds recognised in one EEA member state to be marketed in other member states, subject to certain notification requirements.

The managers of such schemes were not themselves subject to European regulations, indeed the management of a UCITS Scheme was specifically carved out of the Investment Services Directive (ISD) when it was implemented in 1996. The activity of managing a UCITS has continued to be carved out under the Markets in Financial Instruments Directive (MiFID) when it replaced the ISD in 2007.

Regulatory approach

This different regulatory approach has meant that the funds industry has different regulatory responsibilities subject to home state regulations where the fund and/or the manager are based. One offshoot of this is that managers in the UK are more aware of regulatory requirements. Managers of non UCITS schemes in the UK, whether authorised funds or not, are regulated by the FSA.

UCITS III and UCITS IV

UCITS III brought with it two main elements, the management of schemes across borders – the management passport and the sales of schemes across borders – and the product passport. The product passport was not a new idea rather UCITS III was aimed at simplifying the cross-European passport arrangements for funds with such facilities as the simplified prospectus. Unfortunately, the management passport fell foul of individual host state intervention and hence became difficult to operate. UCITS IV proposes ways to build on UCITS III and attempts to resolve some of the difficulties arising from its implementation.

UCITS IV was adopted by the Council of the European Union in late June 2009 and is aimed at updating the UCITS regulatory framework to:

  • improving investor information by creating a standardised summary information document "key information for investors";
  • creating a genuine European passport for UCITS management companies;
  • facilitating cross-border marketing of UCITS by simplifying administrative procedures;
  • facilitating cross-border mergers of UCITS;
  • facilitating asset pooling – master feeder fund structures; and
  • strengthening the supervision of UCITS and of the companies that manage them, through enhanced cooperation between supervisors.

While the UCITS IV Directive is now in place there is still a lot of detail in the process of being finalised. Once UCITS IV is fully implemented, there appear to be a number of opportunities for the funds industry and for the future structure of UCITS themselves.

i) The management passport. Under UCITS IV the intention is for the management passport process to become one purely of notification. Subject to such notification being made, a manager in London would be able to manage a scheme set up in Milan. This structure to the management passport was the subject of significant discussion in developing UCITS IV and has been accepted on the basis that managers will be subject to harmonised risk and governance arrangements across Europe. However, the potential problem remains that host state regulators still retain the power to approve marketing material and there are those that think this will provide enough of a restriction to limit the success of the revised management passport.

Whether the new management passport arrangements will lead to structural changes we need to wait and see, but certainly a manager with UCITS funds in four or five different EEA countries at present tends to have a management company in each state or a self-managed fund. The management passport presents opportunities to streamline such management arrangements with the potential cost savings and concentration of experience.

ii) Master-feeder funds. It appears that UCITS IV will allow much greater flexibility for managers to adapt to local conditions and particularly the use of masterfeeder fund structures within UCITS. Some see the opportunity to use feeder funds in a number of EEA countries structured to suit individual country investor preferences and feeding into a master fund. The master-feeder rules should provide the opportunity to address the perceived cultural resistance to cross-border fund investment.

The Alternative Investment Funds Directive

i) Introduction. In April 2009 the EC issued a proposed Directive on the regulation of alternative investment funds (AIF). The scope of this directive took many in the funds industry by surprise by being drafted in a way which brings under regulation the managers of all non- UCITS collective investment schemes which are marketed within the EEA. Such managers are classified as Alternative Investment Fund Managers (AIFM). There are a number of de minimi exemptions, although how useful these are is debatable. Managers of funds which in aggregate come to less than 100 million euros can remain outside the Directive but will not be able to use the passport arrangements. This limit is raised to 500 million euros where there is a restriction on redemptions in the first five years. This latter limit may be of benefit to some smaller private equity and venture capital funds, although once again the European passport will not be available.

ii) Types of funds. The AIF Directive's objective is to catch all types of collective investment scheme which do not qualify as UCITS. Thus it applies to managers not only of hedge funds and private equity funds but also real estate funds, infrastructure funds, and commodity funds. It also captures managers of non-UCITS retail schemes (NURS) in the UK. What is not included are managers of pension schemes or managers of nonpooled investments such as sovereign wealth funds or assets held on own account by credit institutions, insurance or reinsurance undertakings.

iii) Valuation. The directive introduces the concept of a valuator whose role is to act as an independent valuer of a funds assets. Such valuations must be carried out at least once a year and on at the point in time when shares are issued or redeemed. As drafted, it is the role of the valuator to ensure this happens rather than the manager.

iv) Audit. The proposals set out a requirement for all funds to have an annual audit and prepare as set of reports and accounts. The current drafting requires the auditor to be based in the EEA.

v) Regulatory capital. The directive sets regulatory capital requirements which will increase the minimum levels under which some managers operate. The minimum regulatory capital for an AIFM will be the higher of:
(i) €125,000 plus 0.02% of the amount by which the value of the assets under management exceed €250 million; and
(ii) a quarter of the AIFM's annual fixed expenditure.

vi) Outsourcing/Delegation. The directive brings in a requirement for prior authorisation from the regulator before one or more of the AIFM's functions is delegated to a third party. It should be noted that the Directive specifically states that the AIFM shall not "delegate its functions to the extent that, in essence, it can no longer be considered to be the manager of the AIF."

vii) Fund information provided to the regulator. AIFMs will have to disclose to the regulator information about the identity and characteristics of AIFs they manage. The exact detail of these requirements remains to be developed but it is clear that this disclosure of information will be time consuming and potentially costly. Regular reports are proposed in respect of the principal markets and instruments in which the AIFM trades, details of exposures, performance data and concentrations of risk.

viii) Depositary. Each AIF will be required to appoint an EU credit institution as a depositary of its cash and other assets. The depositary may sub-delegate its tasks to other depositaries which, on the face of the draft, must also be an EU credit institution.

ix) How does the AIF Directive interact with MiFID? The short answer is that it is proposed to restrict the MiFID passport such that it will not be available for funds which do not meet either the UCITS Directive or the AIF Directive.

x) Timescale. While there is significant lobbying going on to change some of the 'unworkable' aspects of the proposed Directive, it seems clear that the AIF Directive in one form or another is likely to receive approval towards the end of 2009 or early 2010. If so, it could be implemented into UK law in as early as 2011. There are views that it will take longer than this but there is clearly strong political pressure behind this Directive.

Paul Leech

The Senior Accounting Officer legislation arrives

After a short period of consultation, the Senior Accounting Officer (SAO) legislation is here. The measure seeks to address a perceived accountability gap, requiring senior management of large corporate entities to take personal responsibility for the processes and systems which enable tax liabilities to be calculated accurately. What it takes to comply is clearer now than when the proposals were first announced. We have final legislation which includes the objective measures regarding scope and commencement, and final HMRC guidance which seeks to set out its interpretation of the more subjective elements, including what is understood by 'reasonable', 'appropriate' and 'accurate'.

We will look at both the objective and subjective elements and specifically how these apply to financial services businesses as well as reflecting on how affected companies can best respond.

Which companies are in scope?

The legislation applies to 'qualifying companies'. A qualifying company is one which in the preceding financial year had, on its own or when aggregated with UK group companies (without adjustment for intragroup items), turnover of over £200m or a balance sheet total in excess of £2bn. Given that banks and insurance companies do not normally show turnover on the face of the accounts, the asset test alone will determine whether or not they are a qualifying company for the purposes of this legislation. The relevant balance sheet total for these companies is as set out in section B, Schedule 1, Parts 2&3 SI 2008/410.

With only UK incorporated companies being included, UK branches of overseas groups escape the rules, and therefore some foreign owned banks will not need to comply despite having large UK operations. Equally, UK tax resident companies which are incorporated overseas and non-corporate entities are excluded. However, many SPVs used in securitisation structures and indeed dormant entities will be included and will be required to be covered by appropriate certificates.

Who is the SAO?

For companies in a group, the SAO is the 'group director or officer' who, in the company's reasonable opinion, has overall responsibility for the financial accounting arrangements of the company. In effect this means that a group might have one SAO for all UK companies, one for each company or somewhere in between. If a group has more than one SAO then each can incur a penalty for failing to comply.

In reality, the relevant director or officer is very likely to be the CFO. The draft guidance refers to the role being 'appropriately delegated' but this would only be possible where this truly reflects the underlying facts, ie. the CFO does not have overall responsibility for the financial systems. Even in such cases it seems very unlikely that the role could be delegated to a Head of Tax or similar.

What are the duties of the SAO (and their company)?

The main duty of an SAO is to take reasonable steps to ensure each of the companies for which he is responsible establishes and maintains appropriate tax accounting arrangements. A £5,000 penalty assessable on the SAO personally applies in case of a failure to comply with the main duty.

The SAO must submit a certificate to HMRC, in a specified format, stating whether the company had appropriate tax accounting arrangements for the financial year, and providing an explanation if it did not. The deadline for submission is the date on which the accounts for the financial year must be filed, but can be later with agreement of HMRC. A £5,000 penalty applies where the SAO fails to provide a certificate within the time limit or submitting one with a careless or deliberate inaccuracy.

A qualifying company must notify HMRC of the name of any person acting as SAO for each financial year and file that notice at the same time as the above certificate. Failure to comply will result in a £5,000 penalty payable by the company. When does it come into effect? The rules apply for financial years beginning on or after 21 July 2009, meaning that some groups are already within the regime. Taking a qualifying group with a calendar year end, its first year within scope would be the year ended 31 December 2010 (ie. from 1 January 2010).

There is a slight relaxation of the rules for the first financial year immediately following their introduction. For that period only, an SAO will be deemed to have taken reasonable steps if they commence a review of the appropriateness of the tax accounting arrangements in place during that year. Many groups will not want to rely on this concession, however, as it could mean filing a qualified certificate in year one.

What taxes?

A company's "relevant liabilities" are the following taxes and duties: corporation tax, VAT, PAYE, Insurance Premium Tax, Stamp Duty Land Tax, Stamp Duty Reserve Tax, Petroleum Revenue Tax, Customs Duties and Excise Duties. Where taxes are administered by a qualifying company, even though the liability of a third party, they will fall within scope, eg. SDRT on brokerage activities will be covered by the legislation.

Notable exceptions are income tax other than PAYE, Stamp Duty and National Insurance Contributions. Of particular relevance to financial institutions is that reporting requirements for schemes operated for relief and deduction of tax at source, such as Individual Savings Accounts and Child Trust Funds, are explicitly taken out of scope.

What are reasonable steps?

HMRC's guidance gives examples of what might be considered reasonable steps. However, the list is neither exhaustive nor comprehensive, as it will clearly vary from one entity to the next with their differing sizes, complexities, systems, personnel, etc. The broad interpretation is that reasonable steps are those normally expected to be taken to manage tax compliance risks properly and enable tax returns to be prepared with an appropriate degree of confidence. These will include having people with appropriate qualifications, training and experience using tax specific software with access to data to a sufficient level of detail to enable them to make appropriate judgements.

The guidance includes two specific examples which refer to bank and how it (and other corporate entities) might take reasonable steps to deal with two different types of tax risk:

  • Low risk – A bank has little liability to VAT in its normal course of business but has opted to tax a building for VAT purposes in order to claim the input tax. The business has assessed the risks of noncompliance as low. In this case the risk is adequately managed by one person in the tax department who has a good knowledge of VAT.
  • High risk – The same bank operates very sophisticated remuneration schemes involving share options and internationally mobile employees. The business has assessed the risks to tax as high. In response they have sensitised their ERP to ensure relevant information about employees, their movements and their share awards is tracked and this is reviewed periodically by Internal Audit.

What is appropriate in terms of tax accounting systems can therefore differ markedly across taxes and situations.

What is appropriate?

Appropriate tax accounting arrangements are defined as those that enable the company's relevant liabilities to be calculated accurately in all material respects. No definition is provided within the legislation for "accurately" or "material" although HMRC say they do not intend it to mean anything more than that already required in preparing returns. The phrase "in all material respects" is explicitly not to be interpreted as the materiality used in an accounting or auditing context.

In general, low value, non-recurring errors in processes with a high volume of transactions will not be considered an issue. For example, the guidance acknowledges that errors will occur in employee expense systems but confirms that this will not be a problem for SAO compliance as long as appropriate preventive (eg. training, appropriate codes set-up) and detective (periodic testing) controls are in place and errors are investigated and resolved.

In contrast, one-off transactions with a high value, eg. whether the disposal of an investment qualifies for SSE, will be regarded as significant for these purposes and the implications of getting the wrong tax result could pose a problem for the SAO.

I am the SAO, what do I do now?

The message put out by ministers and senior HMRC officials is that they do not expect the SAO requirements to create any additional work for "responsible" businesses. They anticipate most are already in a position to certify on the understanding that things are already well managed, with only a few needing to do readiness work of any significance.

Even in the financial services sector, where systems for the management of tax risk are relatively sophisticated, SAOs and their tax teams are less sure, concerned about the financial and reputational impact, for both individual and company, of any failures. We would expect most to take steps then to assess their risk, draw up a plan of action, address those risk areas, test the effectiveness of their actions and then consider how such improvements can be sustained, with appropriate reviews and controls embedded in day-to-day systems and activities.

Conclusion

We now have far greater clarity on which companies will be impacted by the regime and the specific duties of their SAOs. Uncertainty remains around the subjective areas but this should diminish over time as SAOs and their tax teams develop an understanding as to what is reasonable and appropriate in the context of their business and areas of tax risk. Some groups who are already within the regime are managing this as they go, liaising closely with their CRM. Those with more time before they enter the regime are taking the opportunity to review their positions and make changes where needed.

Mark Kennedy
Brigit Lucas

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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