Figures indicate that the hedge fund sector is once again in rude health – hedge fund assets are reported to be close to their previous all-time high – and this return to strong performance coincides with a broad reassessment of traditional options for fund domicile.
In particular, we are witnessing a widespread increase in interest in UCITS funds (especially in light of the greater flexibility of UCITS III) – one which is not limited to EU-based fund managers. Investors are becoming increasingly attracted by the UCITS offering, with its reputation for greater protection and regulation. Attracted by what is seen as superior governance, the past few months in particular have seen a marked increase in interest from US investors, among others.
The draft Alternative Investment Fund Management Directive is of course another factor still playing a significant role in this context, with a large number of points still open and ongoing concern within the industry regarding possible restrictions on the marketing of offshore funds within the EU. For as long as there is a concernthat offshore funds may be disadvantaged in this way, there will be an incentive to domicile funds within the EU.
A further factor encouraging the use of onshore locations is the international clampdown on tax havens. In circumstances where – for a number of different political and economic reasons – attitudes generally towards offshore locations are changing, and there is increasing pressure to use an onshore, well-regulated vehicle, there is an obvious appeal about the EU as a fund domicile.
The question is, which of the EU Member States is going to reap the majority of the benefits of this refocusing? Those rewards will be of significant value to the winner: the fiscal and employment-related benefits associated with a strong hedge fund domicile are well documented and are clear to be seen in those jurisdictions, such as Ireland, which have taken full advantage of the opportunities presented by a flourishing onshore funds industry.
UK tax regime – significant improvement
To start with the positive: there is now a much-improved UK tax regime for hedge funds domiciled in the UK, when one compares the current position with the fairly negative state of affairs that pertained only a relatively short time ago. To HM Treasury (HMT) and HMRC’s credit, notice was taken of certain comments made by the industry and, following the implementation of a number of significant changes to the UK tax regime, we are now in a much improved position. A number of fundamental changes have been implemented over the past twelve months in particular.
The creation of the tax elected fund (TEF) regime, and the introduction of a “white list” of transactions treated as investment, rather than trading activities, are probably the most significant developments from the perspective of the UK authorised fund. The creation of the TEF regime represents an important development in the UK tax landscape so far as the appeal of UK-domiciled funds is concerned, as it represents an acknowledgement on the part of HMT and HMRC that tax neutrality at the fund level is vital if a jurisdiction is to become a serious competitor in the fund domicile market. The TEF regime thus goes a long way in improving the position for UK-based funds.
The “white list” relates to the distinction drawn by the UK tax regime between the concepts of trading and investment, which has always been an area of uncertainty for UK hedge funds and meant that the fund would be faced with the task of ascertaining whether or not the transactions entered into by it would be regarded as investment or trading transactions for tax purposes (the latter giving rise to income profits on which the fund would then be subject to UK corporation tax). The law on the investment / trading divide is complex and not entirely clear, and therefore determining the answer in a given case would be time-consuming and often, ultimately inconclusive.
Thanks to the introduction of the “white list” this uncertainty has been removed as regards the majority of activities of most authorised investment funds (AIFs). The list represents a material step forward in achieving certainty of tax treatment for UK funds (even if certain asset classes are not included and will therefore not have the benefit of the list).
There have been other positive developments too, such as those in connection with UK-based funds of hedge funds. The previously unattractive position for a fund of hedge funds domiciled in the UK was that the fund’s gains on a disposal of interests in offshore funds that were not “distributing” or “reporting” funds would be taxed as income, with the same resulting tax cost for institutional and overseas investors, among others.
By virtue of new rules made earlier this year, the position is improved, in certain circumstances, for an AIF that invests in such offshore funds. Where relevant conditions are met, an AIF will no longer be chargeable to UK corporation tax on such offshore income gains, with the point of taxation being moved to the investor instead.
Mention should also be made of the proposals announced in this year’s Budget for a contractual fund, and for reform of the Schedule 19 stamp duty reserve tax regime. The contractual fund may be of particular appeal to non-UK resident institutional investors, such as pension funds, so that the institutional investor is no worse off than if it had invested in the relevant assets directly. It can also be advantageous for the master fund in a master-feeder structure to be transparent in this way.
The Schedule 19 SDRT reform relates to the fact that the charge is currently paid by UK funds investing in other funds, even where those other funds are not invested in UK equities. This aspect of the regime is to be abolished.
While not without their imperfections (more of which below!), these developments are all significant steps in a positive direction and at the very least bring the UK back into the realm of jurisdictions that can reasonably be considered when selecting fund domicile.
Not quite there…
There is still room for material improvement, however. Although a form of tax neutrality is now available by virtue of the TEF regime, the route to achieving and maintaining this status is complex. The tax compliance obligations in connection with satisfying the rules are materially greater than those required in Ireland, Luxembourg or the Cayman Islands. If a fund is to be marketed primarily outside the UK these obligations would be seen as burdensome and unnecessary, and would discourage fund establishment in the UK.
Separately, a question mark that remains over the UK regime, even after implementation of the changes described above, is its attractiveness to non-UK resident investors. It is a fundamental point that any successful UK based fund needs to be attractive to non-UK, in particular US tax resident, investors, and therefore needs to be compatible with their needs. For example, it is not clear that investment via a UK TEF will be an attractive proposition from the perspective of a US investor. There are also certain specific aspects of the UK tax regime for funds domiciled here that require reform, most notably the Schedule 19 SDRT rules.
The Schedule 19 SDRT regime is a unique feature of the UK tax regime. Compared for example with the equivalent charge in Luxembourg, it is perceived as a high and complex charge (whether or not this is in fact the case).
The Government indicated in this year’s Budget that it was open in principle to further reform of the regime, and it is to be hoped that the fund industry’s concerns with the regime as a whole will be addressed.
There is however one further barrier that risks preventing the UK from becoming as popular a choice as Luxembourg and Ireland, and that is the sense among industry participants that the UK tax system is unstable and uncertain. This perception is intensified by developments such as last year’s bank payroll tax announcement which, even though not directed at the hedge fund industry, caused significant concern, largely as a result of the manner of its introduction, which gave rise to considerable uncertainty regarding its scope.
There remains the lingering fear that the UK tax system is susceptible to sudden and wide-ranging changes. Much good work can be undone in this way, and in a very short space of time.
Conclusion
The UK’s chances of succeeding in winning a share of the fund domicile market are much stronger now than was the case 2-3 years ago, in view of the significant improvements that have been made on the tax side in that period.
It would therefore be all the more unfortunate if an inability on the part of the UK to take the last – but vital – step across the finishing line meant that the UK lost out on this rare opportunity to win back a sizeable share of a market which has, for a considerable number of years now, been the preserve of other jurisdictions. A convergence of the favourable circumstances that are encouraging people to look afresh at the onshore option is unlikely to recur in the foreseeable future.
Political will is of course key to progress here. The uncertainty generated by the inconclusive general election, unwelcome as it is to almost everyone, is particularly inopportune where quick and decisive action is required. When (if?) the post-6 May dust settles, those concerned will need to hit the ground running if the UK really is to become a serious option in the fund domicile market.