Are advertisers caught in a tangled web?
By Claire Aquilina

Venture Capital Trusts – The Financial Services Authority (FSA) condemns online advertising for lack of balance

The FSA has gone to press with sharp criticism of recent online promotions for Venture Capital Trusts. The FSA cited a number of intermediaries who were accentuating the positive, but significantly underrating the negatives in their online communications. Claire Aquilina reports on the FSA’s concerns.

In a press release in November 2005, the FSA raised concerns over web-based financial promotions for Venture Capital Trusts (VCTs) and highlighted a number of shortcomings in the web advertisements placed by 11 intermediaries that market VCTs.

VCTs are funds listed on the stock market that invest in promising start-up and small companies with assets of less than £15 million. The objective is to achieve capital growth and then either sell-on the business or float it on a stock market with a significant profit and return the cash generated to their investors. VCTs are attractive as they offer investors 40% upfront tax relief (provided the investment is held for 3 years), however the nature of the investments is relatively riskier and investors might need to wait three to five years before getting their money out, unless a buy-back share offer is in place to improve liquidity.

The FSA was concerned that firms promoting VCTs were not giving investors a balanced view of investing in these vehicles and that in a number of cases the potential benefits were being emphasised whilst the possible risks were minimised through their web-based adverts.

Vernon Everitt, the FSA's Director of Retail Themes, commented on the findings: "All financial promotions must be clear, fair and not misleading and – particularly with investments such as Venture Capital Trusts – must be balanced. Most of the web-based promotions we reviewed did not explain all the main risks prominently. This needs to be fixed quickly and we are contacting a number of the firms to establish what action senior management will take to put things right."

The FSA’s specific concerns on the web-sites reviewed included the following:

  • Some sites did not prominently mention that the investment must be held for the full three year period to qualify for tax relief;
  • Some sites failed to mention that the investment was in small, unquoted companies and the risks associated with investing in such companies;
  • In some instances, the risks of investing in VCTs were not adequately described and in other cases these were concealed in small print;
  • Most promotions failed to mention the long-term nature of the product and the difficulties involved in reselling the investment; and
  • In addition, few websites provided an indication of the likely charges involved in the management of these funds.

Following the identification of the potential risk to consumers earlier in 2005, the FSA also looked at VCT distribution channels and investor profiles. The review provided reassurance on advised sales, however, a shift of sales to a direct, non-advised, basis was identified which emphasises the importance for promotions of VCTs to be clear, fair and not misleading. The FSA has also provided information to consumers on its website regarding the risks associated with VCTs.

A Catalyst For Change: Europe wakes up to MiFID
By Lou Kiesch

Next year, the EU Commission’s Markets in Financial Instruments Directive (MiFID) – will replace the EU’s existing directive for investment services (ISD). Designed to promote easier cross-border trading, it will almost certainly create fundamental changes to institutional and retail transactions, with potentially radical consequences for both traders and regulators. Lou Kiesch and Alastair Woodward assert that 1 November 2007 is closer than it seems, and the fund industry should start preparing a pragmatic approach now – or risk being caught out.

The European fund industry is facing many challenges today with the raft of new legislation and regulatory requirements coming into play, not least with the ongoing conversion process to UCITS III but also with the upcoming Capital Requirements Directive. European asset managers and fund promoters have therefore learned that the transposition of European Union ("EU") directive frameworks into EU Member State national legislation is a long and sometimes tortuous process. In practice, the resulting laws and regulations, as we have seen, are in many cases far from perfect.

Given these general, practical implementation issues confronting the financial services industry over the next few years, the EU Commission ("Commission") along with the Commission of European Securities Regulators ("CESR") have made a commitment to promote harmonisation where possible and "to remove regulatory overlaps, conflicts duplication and ambiguities."1 In this vein, and taking account of the volume of new financial services legislation in process or pending, it has been encouraging to see the Commission advocating the necessity for a pragmatic, targeted approach to new directives.

Background to MiFID

MiFID forms one of the central pillars of the Commission’s Financial Services Action Plan and will replace the original Investment Services Directive of 1993 ("ISD"), to provide a more representative framework to address changes and developments that have occurred in European financial markets over the last 12 years. The MiFID directive 2004/39/EC came into being in April 2004 and the intention was to have foreseen an implementation date of 30 April 2006. However, given the current new regulatory and legislative burden being addressed by the financial sector, the Commission wisely pushed this date back to 30 April 2007. This revised date has now itself been moved back by a further six months, to 1 November 2007, at the request of the UK (and supported by the EU Parliament) during its recent presidency of the EU.

In terms of content, MiFID contains some 73 Articles (twice as many as the ISD) and there is little doubt, for better for worse, that the directive will be a catalyst for change in European financial markets. Broadly speaking, MiFID has four key aims:

(i) to provide a degree of harmonisation needed to offer investors a continued high-level of protection, while permitting investment firms to provide services throughout the EU on the basis of home country supervision;

(ii) to ensure that investor transactions receive "best execution";

(iii) to provide a ‘coherent and risk-sensitive framework for regulation of order execution arrangements’ in European financial markets, not just on regulated markets but also multi-lateral trading facilities ("MTFs") and other trading systems; and lastly

(iv) to uphold the integrity and overall efficiency of the European financial system.

These are all very worthy but ambitious objectives, and are intended to address the increasing sophistication of today’s financial markets in Europe, but additionally to cater where possible for future developments.

Some of the key impacts of MiFID

Taking a closer look at some of the detail of the directive, there is little doubt that MiFID will cause some fundamental changes to the way both institutional and retail transactions are conducted in European financial markets, not only for market participants but also for national regulatory authorities.

  • Home and Host Regulator/EU Passport: There is a clearer demarcation line between home and host regulation. Investment firms will now be able to passport investment services throughout the EU based on home country supervision. Host country supervision will apply, for example, where an investment firm establishes a local branch in a host country. Discussions are still ongoing as to how the home country supervision will work in practice, as several national regulators have expressed concerns on how regulatory monitoring of activities in host countries might be achieved successfully by the home regulator.
  • Definitions and scope: MiFID expands on the definitions and scope of transferable securities and financial instruments, to include derivatives traded Over-The-Counter (including Contracts For Difference (CFDs)) and derivatives based on both commodities and climactic variables or similar. Investment advice is now defined as a ‘core’ investment service (it was an ‘noncore’ service under the ISD) and will therefore benefit from the EU passport;
  • EU passport for investment services: MiFID will permit any investment firm to perform investment services in other EU Member States, based on its home country authorisation. This is one of the key drivers of the directive to provide a catalyst to realising one single internal market for European financial services.
  • Extension of market transparency: In contrast to the ISD, MiFID extends the scope of coverage of "regulated" markets, to encompass not only recognised stock exchanges but other types of trading platforms, such as MTFs, Electronic Communication Networks ("ECN"), and investment firms themselves where a significant proportion of client trades are routed internally (‘systematic internalisers’); In terms of transparency on client orders on these markets, MiFID also imposes new requirements that all investment firms (including systematic internalisers) publish firm pre-trade bid and offer quotes in securities in which they trade during normal business hours. On a post-trade basis investment firms will have to publish the volume, price and time of trades within three minutes of their execution. Moreover, relevant transaction data will need to be retained by investment firms for a period of at least five years;
  • Best execution: "Member States shall require that investment firms take all reasonable steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order."2 As stated, the directive places a greater burden on investment firms to prove that they have provided investors with best execution. The growth in increased trading automation based on algorithms will go a long way to addressing this issue, but clearly the bigger players will benefit at the expense of smaller investment firms in the market.
  • Conduct of business rules: MiFID will impose new obligations on investment firms in terms of their organisation and internal controls, policies and procedures, management and disclosure of conflicts of interest as well as management of operational risk.
  • Investor protection: For the increasing sophistication of investment products, MiFID introduces new Suitability and Appropriateness criteria to reinforce investor protection. Investment firms must now gauge whether a product is suitable for an investor. Should an wish to invest in a product deemed unsuitable by the investment firm, the firm must formally inform the investor of the fact. In terms of appropriateness, investment firms will have to obtain more in depth information on their clients than previously required, depending on the types of service that they provide (e.g. execution only versus full discretionary management).

How does this affect the fund industry?

Given the concerns surrounding MiFID, where should the fund industry focus its attention?

At first glance, the directive lists the applicable exemptions and Article 2 (h) states that "this Directive shall not apply to collective investment undertakings ("CIS") and pension funds whether co-ordinated at Community level or not and the depositaries and managers of such undertakings." This would seem to be unequivocal but digging a little deeper in Article 66, it reveals that UCITS management companies carrying out collective investment management and ancillary services (discretionary portfolio management and investment advice) do fall within certain requirements of the directive. MiFID will apply in terms of capitalisation requirements, organisational requirements (policies, procedures, resources, outsourcing) and conduct of business rules. MiFID also poses some interesting possibilities in that the directive would seem to indicate that ‘in scope’ management companies may qualify as ‘eligible counterparties’, although professional client status could still be considered an option...

On this basis, we could therefore logically assume that management companies who restrict themselves only to collective investment management are untouched by MiFID. In practice this argument may prove more difficult to defend as MiFID implicitly covers the other main actors with whom a fund or its management company interact. Consequently, it is likely that funds and management companies will be indirectly affected by changes affecting investment managers, brokers, and fund distributors. It is however difficult at present to gauge the extent of the repercussions, until a thorough assessment has been made of the draft Level 2 implementing measures texts that were published on 6 February 2006.

On another level, the Commission’s Green Paper issued in July 2005 posed the question as to whether MiFID could provide a useful ‘toolbox’ for enhanced investor protection and increased transparency in the distribution, sales and promotion of investment funds. The Commission took this further by also raising the possibility that MiFID could be used as "a basis to improve transparency on the distribution process, via its rules on management and disclosure of conflicts of interest and on ‘best execution’."3

Looking at the draft Level 2 texts, management companies will be subject to the record keeping requirements (for clients and transactions) as described in the Regulation text, while the Directive document will apply the MiFID organisational requirements (i.e. outsourcing, safeguarding of client assets, conflicts of interest) to management companies.

The draft Level 2 measures leave a big question mark hanging over the Fund Industry. If MiFID transparency and disclosure requirements are forced upon reasonable, well-disclosed UCITS funds, we should consider that there is a very real chance that new money flows (from distributors) may start to gravitate towards products outside the scope of MiFID. Life assurance and pension products will be viewed as products that are easier to sell. UCITS III legislation already provides for improved product disclosure for UCITS funds, as found in the simplified prospectus and requirements for increased total expense ratio ("TER") transparency. The simplified prospectus is itself, admittedly, in need of revision and improvement while TER calculations require a more harmonised approach. Nevertheless in both of these cases the industry needs more time for these tools to evolve and improve to demonstrate their value as a useful investor protection tool.


The 1 November 2007 deadline is looming and it is clear that the financial services industry in Europe is only now waking up to the ramifications of MiFID. This directive will entail fundamental structural changes to Europe’s financial markets and it is questionable whether all firms will be able to achieve full compliance in time, given the ongoing regulatory compliance burden with other legislation.

The draft Level 2 measures have now been published (one month later than planned). There is therefore still a sense of a "race against time" and MiFID remains somewhat of a moving target for the industry, as the Lamfalussy Process progresses. It was recently reported in the press that an economic advisor to HM Treasury suggested that some Member States may miss the November 2007 deadline for implementation of MiFID, as the punitive powers of the Commission are limited . However this should not provide room for complacency, as it is important that financial services firms start work now on assessing the impact of MiFID on their businesses. The emphasis will clearly have to be on a focused, pragmatic approach to the directive, considering its ultimate scope and the latitude that Member States may have in implementing the directive.

For the fund industry, the investment managers and distributors are likely to bear the brunt of the impact from MiFID. Directly or indirectly therefore, this may affect the way funds and their management companies are organised. It is encouraging to see that regulators are now moving forward to set out how they will approach the changes (e.g. the UK FSA issued a planning guide in November while the French Autorité des Marchés Financiers intends to issue a brochure in the coming weeks) and to engage with the industry, but we believe ultimately the responsibility rests with financial firms themselves and funds and management companies should be no different.

1. Annex III to the EC White Paper on Financial Services Policy (2005-2010)

2. 2004/39/EC, Markets in Financial Instruments Directive, Article 21

3. European Commission Green Paper on the enhancement of the EU framework for investment funds (SEC (2005) 947) – 12 July 2005, Section 2.2.2., page 5-6.

New Markets Open Up New Prospects
By Richard Gilroy & Gary Campbell

VAT threatens to sap the energy out of new funds markets

As the cross-border energy and commodity markets attract greater interest from funds, traders are discovering that they can face multiple VAT compliance obligations. Richard Gilroy and Gary Campbell advise that if funds engaged in energy trading do not adopt appropriate procedures for risk management, then the costs of VAT registration, administration and compliance can outweigh profits.

The desire for diversification away from traditional equity and fixed income markets has led many funds to invest recently in the energy and commodities markets. However, trading in these products means dealing with a different set of VAT issues from those funds traditionally face.

In the past couple of years, there has been significant growth in the global energy markets. Increased deregulation and the denationalisation of continental European power and gas companies; surging oil and metal prices and a whole raft of new products related to the reduction of carbon-based emissions have made this sector particularly attractive. As a result, many fund managers and investors are significantly increasing their activity in these markets or indeed are entering them for the first time.

So what are the VAT issues which funds need to consider?

Physical contracts

Unlike trades in ‘traditional’ financial products such as debt and securities, trading in energy and commodities will often involve making supplies of goods. If a contract leads to the actual delivery of a commodity, this is a supply of goods for VAT purposes. VAT would then be due in the country in which delivery occurs. This in itself should not be a problem for financial institutions, as one would not, in the normal course of events, expect a fund to take delivery of barrels of oil or megawatts of power (although this has been known to happen). The main concern in this area instead lies with contracts which are capable of delivery, i.e. futures and forwards contracts. Where these specify a place and time of delivery, these contracts are also treated as taxable supplies of goods, regardless of whether delivery actually takes place.

Therefore, a fund trading futures which could go to delivery in the UK will be required to account for output tax on its supplies and issue VAT invoices (although the paperwork can be avoided through selfbilling). One problem which has existed for sometime now has involved the value on which VAT should be accounted for. Traders net off their sales against their purchases and there has been a tendency for VAT to be accounted for on this "net position". HM Revenue & Customs (HMRC) are quite clear that VAT should be accounted for on the "gross position". This means that for a purchase of 1,000 barrels of oil at £33 a barrel, which is then sold on at £35 a barrel, the VAT to be accounted for is £6,125 (£35,000 x 17.5%) of output tax and £5,775 (£33,000 x 17.5%) of input tax, and not £350 of output tax based on the net position.

Energy trading can therefore change the entire appearance of a fund’s VAT return. Getting the VAT return wrong can lead to interest or penalties, and if the counterparty goes into liquidation owing VAT to the supplier, a trading loss. With average VAT rates in the EU hovering around 20% it is then vital that the VAT liability of supplies is considered early in the transaction process to avoid unexpected losses.

The terminal markets order

VAT will not always be due on supplies of physical commodities in the UK. It was recognised at the time that VAT was introduced in the UK that the cash flow implications of accounting for VAT on commodity sales could adversely impact the UK commodities market. As a result, the UK was permitted to introduce law (the Value Added Tax (Terminal Markets) Order 1973), allowing the zero rating of certain supplies of physicals on its major commodities exchanges. The TMO or equivalent reliefs do not, however, grant zero rating over all onexchange supplies, so businesses need to be careful not to assume that their contracts are automatically zero rated. They should also remember that the TMO does not apply to over the counter (non-exchange) trades, or trades which, although conducted on a UK exchange, result in delivery in another country.

Place of supply

If a fund trades physicals, it will be faced with increased VAT compliance if it undertakes cross-border transactions. As the energy market is global, this is more than likely.

Take, for example, a UK fund entering into a futures contract for coal from a Polish supplier. If the coal is located in Poland and the contract envisages the coal being delivered in Poland, then the fund will incur Polish VAT. If it sells the contract to a UK bank, that subsequent sale will also be subject to Polish VAT. Thus, the fund will be required to register and account for VAT in Poland. Similar VAT liabilities will arise in other EU Member States, as well as many non-EU countries which have VAT-type tax systems. A business can therefore face the prospect of multiple VAT registrations, the cost of administering the compliance thereof potentially outweighing the profit made on the trades.

Thus, it is important that the VAT treatment of new contracts is established at the outset to ensure that there are no surprises later on. If not, the deal could prove to be a costly overhead, and damage the business relationship with the tax authorities.

Some of the compliance issues and potential costs can be managed by trading commodities within a fiscal or customs warehouse. However, it should be noted that not all commodities are eligible to be included in these types of warehouse and, in some Member States, businesses still have to be VAT registered in that country to take advantage of warehousing This protects the business from having to manage VAT cashflows and exchange rate exposures (VAT generally having to be paid in the currency of the jurisdiction in which it is due, while the underlying commodity is traded in a different currency), but does not mitigate the compliance costs.

Cross-border supplies of gas and power

To take account of the issues arising from the VAT rules on intra-EU supplies of gas and power, after lobbying from the industry, the EU introduced a directive (2003/92/EC) which came into force on 1 January of this year. The aim of this legislation was to simplify cross-border trades and allow greater access to the European gas and power markets. Under this new legislation (Article 8(1)(d) of the Sixth Directive) the place of supply of gas and power to "taxable dealers" (essentially other traders) is now where the counterparty of the trade is located.

Thus, these supplies are treated as though they are taxable Article 9(2)(e) services, meaning that the supplier does not have to register and account for VAT where the gas or power is physically located but instead the customer can self-account for both the input and output tax under the reverse charge mechanism.

However, as with a number of EU initiatives, the main problem with the gas and power directive lies with how the various Member States have implemented it. One of the major issues for the financial services industry involves the "force of attraction" rules. These impact those financial services businesses which have traders in one country but have a branch network across the EU. Currently about half of the Member States have adopted these rules and in a number of cases they apply to supplies of gas and power. This means that funds need to be wary of the VAT accounting associated with such supplies.

Carbon-based emissions allowances

The Kyoto Agreement on limiting the emission of greenhouse gases has created a whole new range of products which many financial institutions are beginning to trade. As with many new products, there is a degree of uncertainty over the VAT treatment.

Within the EU, the main mechanism for reducing emissions is the EU Emissions Trading Scheme (ETS). The ETS is divided into phases, with Phase 1 running from 1 January 2005 to 31 December 2008. In each phase, the EU allocates a number of allowances to each Member State and the Member State then allocates these allowances to various energy and manufacturing companies which emit greenhouse gases. The issue of these allowances is generally not a supply for VAT purposes.

However, there are penalties of €40 per tonne of carbon dioxide equivalent emitted over a business’ allocation. There is therefore an incentive for businesses to ensure they have sufficient allowances to cover their output, and this need has created a new market in allowances. As this is still an immature market, there has been some debate regarding the VAT liability of trades in these allowances.

In the UK, the generally accepted view is that if the trade of the allowance involves the transfer of the allowance and gives the purchaser the right to use the allowance, it is a physical contract and should be taxable. Otherwise, it is an exempt financial contract. The EU has directed that emissions trades are Article 9(2)(e) services, and therefore VAT should usually be self accounted for by the customer. However, only five Member States have published official guidance on this issue to date.

In addition, non-EU countries have introduced their own emissions reduction schemes under the Kyoto Agreement. These schemes (such as the Joint Implementation initiative and the Clean Development Mechanism) may permit allowances obtained outside the EU to be traded by EU businesses, by exchanging them for EU ETS allowances. As this is a very new area, there is a question over the VAT treatment of trades in these allowances outside the EU.


In summary, from a VAT perspective, energy trading can be quite hazardous for the funds industry. There is a very real risk that if VAT is not considered from the outset, potential VAT exposures could wipe out the profits arising from trades. And, the risk of this occurring when undertaking crossborder trades is more significant.

Funds, therefore, need to have appropriate risk management procedures in place for VAT (and indeed other indirect taxes which have not been covered here) in respect of energy contracts. A tax or VAT manager with a background in "pure" financial services should ignore energy trading at their peril. The tax rules are global, complex and illogical. The value of underlying trades tends to be high and the potential tax bill, correspondingly large.

Tax Remains An Issue: EU Green Paper gives green light to UCITS

By Davood Eslami

UCITS legislation may have laudable aims, but 20 years on, the prospect of a fully integrated European fund market still remain distant. The EU’s own Green Paper established to examine UCITS progress sees no need for a legislative overhaul. Instead, progress will be incremental and occur within the existing framework. But while this is a sincere effort to promote a single market, it arrives at a time when the tax landscape is becoming ever more complex. Unless the EU commissioners engage with tax issues, this could be as good as it gets.

The need for action

Since its inception in 1985, the overarching aim of the UCITS legislation has been to establish a single, harmonised, and cost efficient European fund market based on the UCITS product passport and underpinned by robust investor safeguard principles.

Whilst the UCITS legislation has facilitated the emergence of a sizeable and nationally-focused European fund industry, the rate of progress towards a genuine single European fund market has been glacial. Less than a fifth of UCITS are true cross-border funds and of these, the market share in most host Member States is often small.

The European Commission’s Green Paper on the enhancement of the EU framework for investment funds ("the Paper") evaluates the relative success of the UCITS Directive to date and highlights the areas where the Commission believes warrant remedial action. The feedback report for this consultation is expected some time in the first quarter of 2006

The measures proposed by the Commission

The Commission’s favoured route in addressing UCITS’s problems is one of effecting incremental corrective changes within the existing framework as opposed to a fundamental legislative overhaul.

Actions already in progress

The Commission proposes to leverage off the following areas of immediate priorities already identified and being actioned:

  • Eliminating the uncertainty of recognising funds launched during the transition from UCITS I to UCITS III, to which end the Committee of European Securities Regulators ("CESR") has published guidelines regarding the treatment of these "grandfathered funds";
  • Simplifying and streamlining the notification procedure for passporting UCITS. Difficulties, costs and delays associated with the notification procedure are proving major obstacles to the creation of a single market. CESR has started work to build up consistency of approach among national regulators in this area;
  • Further promotion of the implementation of the Commission’s recommendations on the use of derivatives and the simplified prospectus to improve risk management standards and fee transparency;
  • Clarifying the definitions and parameters of UCITS eligible assets. There are tensions between the additional flexibility permitted by UCITS III and the previously understood requirement of the legislation that UCITS should primarily invest in liquid financial instruments. The Commission is working on "legally binding" clarifications of asset eligibility by early 2006, in connection with which CESR is scheduled to submit its final advice to the Commission by January 2006.

Development of the current legislative framework

The Commission is looking to tackle the two main areas where the need for further work has been recognised; namely the inconsistent implementation of the Management Company Directive across Member States and the structure for distribution, sales and promotion of funds, Although the UCITS III Management Company Directive seems to prima facie enable managers to set up and operate a corporate UCITS in another EU jurisdiction, it does not provide sufficient certainty and detail as to how this could be put in to effect. Consequently, other than the rather limited solution of delegation arrangements, these opportunities have not materialised.

More long term challenges and opportunities

The Commission considers the more long term challenges and opportunities facing the industry such as, inter alia, removing obstacles to cross-border fund mergers and pooling to assist with cost efficiency, and looking at the possibility of passporting depositary services.

The perception is that the European fund industry must seek a better way to exploit synergies and economies of scale so as to reduce costs and improve fund performances.

The Commission proposes that facilitating greater consolidation through cross-border mergers and/or fund pooling are some of the ways to counteract the proliferation of sub-optimal sized funds and maximise cost efficiency. To date, legal, fiscal and supervisory barriers have prevented this from taking place on a larger scale.

There are perceived opportunities in rationalisation of fund custody and depositary services. Although the UCTIS Directive requires the management company and the depositary to be in the same Member State, the Commission is prepared to examine the possibility of splitting and passporting supervision, depositary and custody functions across Member States.

The Commission also takes the opportunity to acknowledge that alternative investments, in the shape of private equity and hedge funds, are now a very substantial and important segment of the European fund industry. There is concern however that, unlike UCTIS, the diverging spectrum of regulatory regimes across Member States could hamper the development of these vehicles.

Accordingly, the Commission intends to set up a working group to study whether a common regulatory approach would facilitate the development of European markets for hedge funds and private equity funds. It will also look at how to overcome cross-border barriers for this market.

Some tax considerations

Though the Commission has acknowledged the potential impact of tax legislation in its analysis, the importance of the domestic and pan-European fiscal framework as a potential barrier to its proposals cannot be under estimated. As UK operators are only too aware, the consequence that uncertainty of tax treatment has had on Qualified Investor Schemes is a graphic illustration of this point.

Passporting management services

Whilst the opportunity of managing offshore UCTIS whose jurisdictions permit more unfettered access to derivative strategies and a broader category of asset class than a UK fund could be appealing, UK managers should be mindful of the provisions in UK tax legislation which could deem an offshore fund to be "trading" in the UK by reference to activities of the UK investment manager and hence expose it to UK tax.

As to what constitutes trading activity within an investment fund has long been the subject of debate in the UK. In particular, HM Revenue and Customs ("HMRC") has previously expressed unease about a disproportionately high portfolio churn and certain derivative strategies, such as naked shorting. Whilst HMRC’s recent update to Tax Bulletin 60 is certainly helpful in reaffirming the correlation between tax and accounting treatment, there has to date, been no changes to the wording of the Finance Act 2002 Schedule 26 which addresses the lingering doubts once and for all as to the tax treatment of derivatives in UK funds.

Fund mergers

When considering a cross-border merger, operators have to bear in mind its potential impact vis-à-vis the European Savings Directive ("EUSD"), UK offshore funds legislation, VAT, stamp duty and access to double tax treaties.

Whilst it is easier to predict the EUSD status of an entity arising from the merger of two funds which were already in scope of the EUSD, this may not be the case where one of the funds was previously out of scope. In addition, there are compliance implications if there are two in scope UCITS merging, one of which is in a reporting jurisdiction and the other in a withholding jurisdiction. This is exacerbated if the two funds have differing distribution policies. In view of this, the reporting/withholding implications of the income accrued on merger, has to be considered carefully.

The first EUSD report from UK paying agents is due by 30 June 2006 in respect of the period 1 July to 5 April 2006. Subsequent HMRC audit visits are expected to commence in the autumn of 2006 and any incorrect returns submitted could potentially result in penalties of up to £3,000.

By the same token, mergers of offshore funds, one of which did not have "distributor status" under the UK offshore fund rules, could have material implications for the tax treatment of UK investors. The implications for taxable UK investors in offshore funds which do not have distributor status (throughout the period of ownership) is that on disposal any gains would be chargeable to income tax without access to any of the capital gains tax reliefs such as the annual exemption, utilisation of capital losses, indexation allowance, taper relief, and indexation allowance (for corporate investors).

Cross-border mergers are also very likely to give rise to changes in the double tax treaty for the fund whose jurisdiction is changing and the potential impact of this for the fund’s performance has to be borne in mind when considering mergers.

Direct impact of mergers on investor taxation

There is no EU wide symmetry of tax treatment for investors whose funds have merged. Though a UK investor is generally not taxed on such an event, this treatment is not replicated for investors in many other EU jurisdictions.


Whilst the Paper is undoubtedly a genuine attempt to ensure the future success of UCITS, it comes at a sensitive time when fresh enthusiasm for anti-avoidance tax legislation and a plethora of European Court cases have made the tax landscape ever more complex. In view of this, and as illustrated above, it is essential for the Commission and European operators to fully engage the potential tax issues if the Paper is to become a launching pad for a fully integrated pan-European fund market, rather than the high water mark

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