As the Government embarks on ambitious reforms to the UK pension fund investment sector, with major implications for the private capital industry, the tax treatment of pension fund returns may not be uppermost on the agenda but should not be neglected by policymakers. Fund sponsors across asset classes in the UK and abroad will also be taking note as the world's third-largest stock of pension assets is dramatically reshaped.
Megafunds: The Policy
In her first Mansion House speech to the UK business and finance community on 14 November 2024, the UK Chancellor Rachel Reeves announced "plans to create Canadian- and Australian-style "megafunds" to power growth in our economy" in line with recommendations set out in the Pensions Investment Review Interim Report (the Interim Report), the first fruits of an initial period of consultation under the new Government. The Interim Report recommends broad consolidation measures for both the UK's £392 billion Local Government Pension Schemes (LGPS), currently administered across 92 local authorities, and its similarly-fragmented £600 billion workplace defined contribution (DC) schemes.
From the Chancellor's speech and the accompanying further consultation documents, the creation of the megafunds is currently expected to involve:
- Supercharging (through increased size, enhanced delegation, and reformed governance and investment mandates) the existing eight LGPS asset pools which were first created in 2015 and which current hold only about half of LGPS investable assets and
- Imposing minimum size and maximum number requirements on DC scheme default funds.
Legislation is expected to follow in 2025 in the form of the previously-announced Pension Schemes Bill, with the LGPS reforms potentially in place by early 2026 and the DC scheme reforms taking full effect by 2030. The Government's forecasts suggest AUM in LGPS and DC schemes may hit a total of £1.3 trillion by 2030 – "mega" numbers indeed.
The Interim Report is clear on the dual intended benefits of consolidation – increasing saver returns and UK domestic investment. As the Chancellor's speech puts it:
"Through consolidation of the DC market and Local Government Pension Schemes into megafunds ... previous domestic and international experience suggests ... that we could unlock around £80 billion for investment in private equity, including exciting growth businesses ... and in vital infrastructure projects including transport, energy and housing projects here in the UK."
The extent to which the twin aims of improving returns and domestic investment work in harmony remains to be seen and it is notable that the Government is currently looking to laissez-faire economics rather than strict mandation to ensure that the investment flows to UK businesses. This aspect of the reforms may yet develop further as the second phase of consultation progresses.
Current UK Government policy – the "vision" set out in the Interim Report – is therefore to actively promote pension fund investment in private capital funds and projects in order "to achieve better outcomes for members and maximise investment opportunities", with the chosen mechanism being comprehensive regime redesign via primary legislation rather than piecemeal reforms over time. Thus far, however, with the exception of some speculation as to potential tax incentivisation (possibly including National Insurance Contributions savings) of contributions into prioritised sectors, tax has been conspicuously absent from the consultation and policy-making process. This may be as expected for a generally UK tax-exempt sector of the economy, but there is nonetheless a clear opportunity for the industry to identify opportunities and make the case for improvement to its interface with the tax system.
Megafunds and other pension funds: Tax considerations
Registered pension schemes qualify for exemption from UK taxation on income and gains on investments held for the purposes of the scheme, but are taxable on other categories of income and gains. The key tax consideration for UK pension funds when deploying assets on behalf of members is therefore to ensure that, to the maximum extent possible, the return to the fund represents an investment for UK tax purposes and not (for example) profit from a trade or other source.
In practice reaching this determination may be riddled with complexities and there are frequently grey areas over which pension funds and their advisers spend considerable time agonising. The distinction between investment and trading returns also causes considerable head-scratching among non-UK fund sponsors facing requests from UK pension fund investors for contractual (e.g., side letter) and structural measures to mitigate the risk of returns in a form that is unexpectedly taxable. Comparisons with non-UK concepts such as US "effectively connected income" are unfortunately of limited degrees of usefulness here.
HMRC guidance helpfully clarifies some points of uncertainty, including the conditions under which stock lending fee income, returns from certain derivative contracts and underwriting commissions may qualify as investment returns, but there are a host of common private capital investment scenarios where the lack of a clear answer has the potential to skew decision-making and delay deal timetables. It is common, for example, for private equity funds to rebate certain fees to investors and equally common for UK pension funds (which may not otherwise have filing obligation) to disclaim that fee income due to its potential taxability and the attendant administrative requirements.
Or alternatively pension funds investing into tax-transparent structures (operated through UK or non-UK partnership-type vehicles) may conservatively set up and bear the ongoing costs of running blocker entities in order to avoid the risk of realising trading income, even where the underlying return is generally expected to be of an investment nature. These are surely not desirable aspects of the current regime or consequences that are calculated "to achieve better outcomes for members".
Potential improvements: Guidance, rulings, treaty reliefs
Given the entrenchment of the investment/trading divide within the UK tax system and its centrality to the pensions tax regime in place since 2004, it does not seem likely that the megafund reforms will see any major rethinking of this approach – welcome though that might be for the industry – but there is certainly scope for changes that could benefit funds and their members. The guidance provided by HMRC on its interpretation and application of the law in this area is useful but could be expanded and made more specific.
Pension funds considering anchor investments, perhaps particularly in the credit fund space but also in many common co-investment scenarios, would certainly welcome any expansion of the scope to seek specific clearances or rulings from HMRC on the basis of the fund's investment parameters. Change in this area would be in line with the Government's recent commitment, in the Corporation Tax Roadmap published at the Autumn Budget, to "develop a new process for increasing the tax certainty available in advance for major investments" into infrastructure and renewables projects.
Any enhanced ruling procedure might also extend to certainty as to the tax transparency or opacity of overseas entities for UK purposes, an area in which pension fund investors similarly depend on valuable but incomplete HMRC guidance. Although facilitating non-UK investments by the new megafunds does not serve the policy aim of promoting domestic investment, it will be essential to the other aim of improving returns so opportunities in this area should also be considered.
Accordingly, and in particular, ongoing UK tax treaty renegotiation efforts should seek to achieve relief, where available, from source state withholding taxes and other investee jurisdiction taxes applicable to non-residents. Change in this area is notoriously slow, but the advent of the megafunds may mean negotiation teams find fairer hearings especially as various treaty partners already actively incentivise the investment of superannuation funds.
There are a host of other areas where the Government could consider investment-friendly tax changes for the pensions industry, including the residential property sector and infrastructure-adjacent investments in plant and machinery. The opportunity to input into the Government's two ongoing consultations (LGPS: Fit for the future and Unlocking the UK pensions market for growth) as part of a root and branch rethinking of a major area of the UK asset management industry is unlikely to recur soon.
In a business world where size undeniably matters, the new megafunds may yet focus thinking – at home and abroad – on ways in which tax could better serve the UK pension fund investment sector.
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