The Rise Of The Reporting Funds

UK tax changes spark interest in reporting fund status

Originally published in the July | August 2016 issue

Many UK investors in non-UK funds are already keen to ensure that the shares they acquire have UK “reporting fund” status. However, two changes to the wider UK tax code mean that 2016 has seen a surge of interest from investors (including fund of funds targeting the UK market) who haven’t previously been focused on this point.

Below we take the opportunity to review the rules and explore why managers may see an upswing in investor queries on this topic.

1. Let’s re-cap: what’s an offshore fund for UK tax purposes?
The UK has specific tax rules which apply to investments in offshore (i.e. non-UK) funds. The definition of an offshore fund is complex and characteristics based, but it is usually safe to assume that a typical open-ended offshore corporate fund will be an offshore fund for these purposes.

A fund or sub-fund (in respect of an umbrella fund) if it has a single class of shares, or each class of shares where a fund or sub-fund has multiple share classes, is treated as a separate “offshore fund” if it falls within the definition.

2. So what’s the impact of the offshore funds rules on UK resident investors?
The key feature of the offshore fund rules is that a UK resident individual investor who disposes of an interest in an offshore fund without reporting fund status and realises a gain will not be subject to UK capital gains tax, but will instead be treated as realising an “offshore income gain”, which is subject to income tax at rates of up to 45%. In short, gains from offshore non-reporting funds are taxed at a higher rate.

For reasons explored further below, it’s important to note that UK tax resident but non-UK domiciled investors claiming the remittance basis of taxation should not suffer UK tax on either capital gains or offshore income gains unless and until these amounts are remitted to the UK.

3. Reporting fund status sounds good, but surely there’s a downside?
If a fund has reporting fund status, gains realised on disposals by UK investors of their shares are subject to capital gains tax.  

The quid pro quo for access to the lower capital gains tax rates on disposals is an annual income tax charge for investors on the fund’s “reportable income” (an amount computed by reference to the fund’s accounts that includes interest, dividends and trading income), whether or not such amounts are actually distributed. (By contrast, UK investors in funds without reporting fund status only pay income tax on amounts actually distributed to them, as opposed to income accumulated in the fund).

4. Why the likelihood of increased investor appetite now?
There are two reasons why reporting fund status might currently be moving up the UK investor agenda.

(a) The applicable rate of capital gains tax has just dropped.
As of 06 April 2016, the highest rate of UK capital gains tax payable on gains realised from share disposals dropped from 28% to 20%.  As a result there is now a full 25% differential between the tax payable on disposals of interests in offshore funds with and without reporting fund status.

(b) As ofApril 2017, more UK investors may be subject to UK tax on their worldwide income and gains.
As a group, UK resident but non-domiciled investors claiming the remittance basis of taxation may currently be neutral on the question of reporting fund status, on the basis that such investors should pay no UK tax on gains realised from offshore fund investments (assuming any amounts representing such gains are retained offshore and not remitted to the UK).

However, as of April 2017 changes to the UK’s rules on domicile, in particular the introduction of a general “deemed domicile” concept, will result in some long-term UK tax resident individuals coming fully within the UK tax net for the first time. It would be surprising if the potential for an increase in tax on gains from disposals in offshore funds from effectively zero to 45% did not focus the minds of these investors on the potential savings offered by investments in reporting funds that can access the 20% capital gains tax rate.

Fund managers would therefore be wise to ensure they are positioned to respond to queries and requests for access to reporting fund share classes from this population of investors in the run up to and following April 2017.

5. How do I go about making sure existing investors in non-reporting funds can get the benefit of reporting fund status?
It is possible for an application to be made to the UK’s HM Revenue & Customs (“HMRC”) for recognition of an existing offshore fund (or sub-fund/share class) as a reporting fund for the current and future accounting periods. If granted, reporting fund status will generally apply from the beginning of the accounting period of the offshore fund in which the application is made, or a specified future date – it’s not possible to obtain reporting fund status for earlier periods.

In these circumstances, interests acquired by a UK investor before the fund entered the reporting fund regime are outside the regime, so that on a disposal any gain will still be taxed as an offshore income gain. However, reportable income arising after the date of entry into the regime is nonetheless subject to an annual income tax charge, even if not distributed. Interests acquired after the fund entered the reporting fund regime are within the regime (so new investors or additional shares issued to existing investors don’t have this problem).  

However, it is possible to extend the benefits of reporting fund status to existing investors – at the time an existing offshore fund enters the regime an investor can elect to be treated as having sold and reacquired their interests at market value on that date – with any resulting gain taxed at income tax rates (or in the case of a non-domiciled investor, no tax on the resulting gain unless the proceeds are remitted to the UK). The “reacquired” interests are within the reporting fund regime.

6. What’s the exact timing I need to bear in mind in relation to the changes to the domicile rules?
In the case of investors who are currently non-domiciled but who are expecting to become UK deemed domiciled from 06 April 2017 it’s expected that a market valuation re-basing option should be available for all relevant assets, meaning that reporting fund status would only be needed for gains arising from 06 April 2017. However, many investors may prefer to ensure that they are already holding reporting fund shares at the date they become UK domiciled or deemed domiciled.

To address this, managers may wish to consider undertaking the conversion of relevant existing non-reporting funds to reporting funds prior to 06 April 2017, at a time when any gain realised by a non-UK domiciled investor claiming the remittance basis and making the election referred to at Q5 above for a deemed market value disposal of their shares should be free from UK tax.

In practical terms this means that the manager of a fund with a 31 December accounting reference date should apply during 2016 for the relevant fund(s)/share class(es) to have reporting fund status from 01 January 2017 (or 01 January 2016, if preferred).

7. What about investors who are already UK domiciled, are there downsides for them?
UK resident investors who are already UK domiciled may also benefit from an existing sub-fund/share class obtaining recognition as a reporting fund if they make the election for a deemed market value disposal. However, for this group access to the lower capital gains tax rate needs to be weighed up against the potential income tax charge arising on reportable income prior to eventual disposal. Crucially, any investor who chooses not to make the election will nonetheless suffer potential income liabilities annually on reportable income for the remaining duration of the investment, which may be unpopular (depending on the level of income that is expected to arise). Managers may therefore prefer to establish a new share class for those investors who opt for the benefit of future reporting fund status, so that investors have a choice between reporting and non-reporting treatment.

8. What are the tax consequences of switching investors into a new reporting fund share class?
A new share class can be an attractive option, as an application can be made for such a class to have reporting fund status from inception. If existing UK resident investors are switched into a new class of shares which has reporting fund status, the exchange of the old non-reporting share class will constitute a disposal for UK tax purposes, and income tax will be payable on any offshore income gain realised.

However, for the non-UK domiciled investors, as long as this is done before non-domicile tax treatment is lost, no UK tax charge should arise.
9. That’s clear in relation to investors – what are the compliance burdens for the fund and the manager?
The principal obligations on reporting funds include requirements to:

(A) prepare annual accounts;
(B) prepare an annual computation of reportable income;
(C) provide reports to investors; and
(D) provide certain information to HMRC.

Reporting funds must make a report available to investors within six months of the end of each reporting period (usually the accounting period) to enable UK investors to include their share of the reportable income on their UK tax return – publication on a website is sufficient. Typically the fund engages its administrator or accountants to prepare the reportable income calculation.

10. Anything else to bear in mind?
It is important to appreciate that reporting fund status will not be suitable for every fund. For example, certain funds with strategies that are viewed as trading for UK tax purposes may result in such high levels of reportable income that (i) the annual income tax burden on investors is unacceptably high and (ii) the complexity of the reportable income calculation makes the exercise administratively impossible or too costly to undertake. In practice, whilst we have not yet seen HMRC challenge the reportable income calculations of funds in any meaningful fashion, a failure to compute reportable income correctly could result in a loss of reporting fund status.

11. I’m convinced – how do I actually apply for reporting fund status?
Applications for reporting fund status are made on a relatively simple HMRC form that can generally be completed without too much difficulty (though complexities can arise where the fund does not account under IFRS, or where the fund wishes to operate equalisation arrangements or make equalisation adjustments). It is possible to make an application in respect of multiple share classes or sub-funds in the same fund on one form. The form should be submitted to HMRC by the fund’s investment manager (or an adviser acting on its behalf) together with the fund’s prospectus or other offering document.