18% or 50%?

Capital gains or income tax treatment for hedge funds

JORGE MORLEY-SMITH, SENIOR MANAGER, DELOITTE LLP

When Alistair Darling introduced a flat rate of capital gains tax of 18% it was widely reported as an increase from 10%. However the 10% rate of capital gains tax applied only to trading assets, and not typically to investments in funds. For those holding non-trading assets, the capital gains tax rate was 40%, reducing to 24% after 10 years by virtue of taper relief. For these assets, the introduction of a flat rate of 18% was a significant reduction in capital gains tax.

On the other hand, the income tax rate was unchanged, thereby increasing the divide between the rate of tax applied to income and that applied to capital gains arising on the disposal of investment assets.

This divergence between the capital gains tax rate and the income tax rate was further amplified in this year’s budget by the introduction of a 50% tax rate for those earning more than £150,000 from 6th April 2010. The difference will be a staggering 32% which is a hefty incentive to make investments in assets yielding capital gains (and which are taxed as such) rather than income.

Are holdings in hedge funds capital gains tax assets?
Hedge funds are generally regarded as offshore funds for tax purposes. This means that UK investors disposing of their interests will be subject to tax as income (taxed at 40% or 50% from April 2010) rather than capital gains (taxed at 18%), unless the fund obtains ‘distributor status’ – an annual certification from HM Revenue & Customs (HMRC).

There are various reasons why hedge funds have not traditionally obtained distributor status – it is a filing requirement with the UK tax authorities, many investors are not UK taxpayers, and the benefit in terms of difference in the tax treatment of UK investors was not as striking as it is today.

In addition, there are technical reasons why a hedge fund might not have been able to qualify. The main one of these is that the fund must not be a trading fund to be able to get the benefit from obtaining distributor status. The traditional view is that hedge funds are trading and not investing – a key distinction in UK tax – and therefore cannot gain any advantage from obtaining distributor status.

Is a hedge fund trading?

However, these impediments are falling away. Firstly the benefit of capital gains tax treatment over income tax treatment in the UK is so substantial that the practicalities of filing an application to HMRC for distributor status are now seen as less of a hindrance.

Secondly there has been some change, or clarification, of what HMRC views as ‘trading’. Previously any fund that shorted was normally seen as carrying out a trade. HMRC have now stated that, in their view shorting is no different to going long. A long/short strategy is therefore no more likely to be trading than a long-only strategy.

Consequently, whilst the trading versus investment distinction still requires careful consideration, we have seen some changes in HMRC’s approach to certain hedge fund strategies that might open up opportunities to obtain distributor status.

The new offshore funds rules
The offshore funds rules are currently in the process of being overhauled, with a new regime due to come into force for accounting periods beginning on or after 1st December 2009. The new offshore funds rules will replace the concept of ‘distributor status’ with ‘reporting funds status’.

One of the main changes introduced by the new regime is the removal of the requirement to make distributions of income. Instead funds will be required to report income to UK investors, who will be taxed on the amounts reported irrespective of whether they have received a distribution. This may have some appeal for hedge funds which do not typically pay dividends. Howevermost hedge fund strategies are not heavily income generating so in many cases there would be no income to distribute, even under the old regime.

Another change will be that certain funds which are regarded as equivalent to UK authorised funds will always be regarded as carrying out investment activities and not trading, provided the transactions are within a broadly drafted ‘white list’ of permissible transactions. This may pave the way for many offshore funds previously thought to have been trading to obtain reporting fund status.

Although the rules have not yet been finalised it is expected that this treatment will only apply to other EU funds, and not most existing hedge funds (many of which are Cayman domiciled). Given the obvious tax benefit, this might be an incentive to domicile funds within the EU if the fund has UK investors and would otherwise be regarded as trading.

There is also a less welcome change to the definition of an ‘offshore fund’, which determines which overseas entities are subject to the offshore funds rules for the purpose of establishing whether investors are subject to income tax on disposal and not capital gains tax. The new definition is ‘characteristics based’ – and has caused some concern that it does not provide sufficient certainty. In some cases investors in closed ended funds (which may include some hedge funds) that have a fixed life, or share buy-back arrangements might struggle to know whether they have invested in an ‘offshore fund’ or not.

Looking at prior periods
Until the new regime is introduced however, funds will need to continue to use existing rules and guidance to apply for distributor status. Although a fund is usually required to submit an application annually and within six months of its year end, the legislation permits investors to apply for distributor status on behalf of the fund after that time (with no apparent limit on how far you look back). Because of this HMRC has been willing to accept late applications for distributor status made by the fund (in some cases over a number of years), where the fund has met the conditions. In summary the principal conditions are that:

• The fund is regarded as investing and not trading.
• The fund has no net income, or has made a distribution of at least 85% of any net income.
• The fund has not invested more that 5% of its net assets in other non-distributing offshore funds.

This has presented some funds with the opportunity to get capital gains tax treatment for UK investors (which may include the investment management team) when they dispose of their interests.

In conclusion, distributor status and reporting fund status is due to become increasingly important for offshore funds with UK investors (including hedge funds) now that the difference between income tax rates and capital gains tax rates is so significant.

There will be a number of issues that need to be addressed for a hedge fund that wishes to apply, but where there is an opportunity to do so, the tax savings for UK investors is an enticing 32%.

Jorge Morley-Smith has over 10 years’ experience in investment management tax. Before joining Deloitte, he worked in the investment management tax practices of Robson Rhodes and Ernst & Young. His areas of expertise include alternative asset management, UK and offshore fund and manager structures, and the investment manager exemption.