Designing a UK asset holding company regime

HM Treasury has published a response to its spring consultation on the possible introduction of a tax regime for UK based asset holding companies (AHCs) within broader collective investment structures. The response sets out the government's intention to proceed with the introduction of a special regime for AHCs which will seek to address a number of the current tax challenges to setting up and operating such vehicles in the UK. The response also discusses a number of possible changes to the existing REIT regime to make it more attractive, facilitating the use of REITs as AHCs for property fund structures.

The consultation response is the first in a number of expected consultations on possible changes to the tax treatment of UK funds and fund structures following the end of the transition period. The government is clearly keen to ensure that the UK retains, and indeed enhances, its attractiveness for fund management activities in the longer term, taking advantage of possible wider reform made possible outside the EU ruleset. The wider review of the UK's fund tax regimes announced at the spring Budget and expected to be published shortly is also expected to include consultation on the VAT treatment of fund management fees which will be taken forward during 2021.

Background

AHCs are companies used as intermediate or asset holding entities in investment fund structures. Their role is to facilitate the flow of capital, income and gains between investors and underlying investments. There are many commercial drivers to the use of AHCs, including segregation of assets, the general benefits of an opaque entity, funding and borrowing flexibility and exit strategies.

Respondents to the March 2020 consultation explained that funds will aim to ensure that their investors do not achieve a worse outcome than if they had invested directly in the underlying investments. AHCs are therefore generally located in jurisdictions where they will pay no more tax than is commensurate with their intermediate role in the fund structure, facilitating the flow of capital, income and gains between investors and underlying investments.

The March 2020 consultation sought to identify barriers to the use of the UK as a jurisdiction for the location of AHCs within a wider fund structure. The consultation recognised that the UK was, in principle, an attractive location for AHCs, given the scale of the UK's asset management sector, its good infrastructure and skilled workforce. In addition, the establishment of AHCs in the UK could bring economic and fiscal benefits, primarily by bolstering the asset management sector and creating additional jobs in associated service sectors. Furthermore, in light of international tax developments, including an increased focus on substance and measures arising from the OECD's BEPS initiative, locating such vehicles in the UK could bring commercial, financial and operational benefits to asset managers located there.  However, it was also recognised that UK tax system currently creates a number of barriers to the establishment and operation of AHCs. The government, therefore, sought to better understand these barriers and how best they might be addressed.

A long list of tax barriers were identified as part of the consultation, most prominent amongst these being:

• uncertainty over the taxable income of an AHC, with the role of results dependent returns on debt being a particular feature as well as lack of clarity around the application of transfer pricing (TP) rules;
• tax on capital gains made by an AHC;
• withholding taxes on interest payments; and
• the inability to return gains made by an AHC to investors in capital form.

Having reviewed the responses, the consultation response accepts that there is both a clear policy justification and a strong economic and fiscal case for reform to make the UK more attractive for the location of AHCs. As such, the government has decided to take forward reforms in this area with a view to introducing a new regime for AHCs. The government's objective is to deliver "an effective, proportionate, and internationally competitive tax policy for AHCs that will remove barriers to establishment of these companies in the UK."

New AHC regime: eligibility

Having considered the responses to the original consultation, the government has decided to introduce a new standalone tax regime for AHCs. The consultation identified a wide range of potential tax barriers to their use at present in the UK and seeking to address each of these individually by amending existing rules (rather than introducing a separate regime) was not the preferred approach. In particular, it was clear that in some areas general reform of the tax rules was not the right approach and any changes would need to be limited to a closely defined concept of an AHC in any event.

The response document suggests that the bespoke regime should focus on the use of AHCs in structures where capital from diverse or institutional investors is pooled and managed by an independent, regulated or authorised asset manager, in which the AHC plays an intermediate, facilitative role. These could be structures set up to enable numerous unconnected investors to benefit from the expertise of the manager and from the economy of scale that comes from pooling funds. Alternatively, they could be structures set up to provide independent investment management for the capital of institutional investors who effectively act as an investment channel for others rather than on their own behalves, and are not actively involved in the conduct or operation of any portfolio companies held via the AHC.

The new regime will need to clearly identify those entities which qualify as an AHC for these purposes including rules to address:

• criteria for the investors making investments via an AHC;
• how the investors should be identified;
• criteria to identify the asset manager; and
• the character and activities of an AHC.

Two possible approaches are set out by the government. The first looks to require a fund vehicle above the AHC in the investment structure. The second looks directly at investors' interests in the AHC itself.  The first approach would involve looking for entities who invest their capital using a fund vehicle that is a Collective Investment Scheme (CIS) or an Alternative Investment Fund (AIF), as defined for the purposes of UK regulation. In other words, the regime could require that an AHC be wholly owned by a fund or number of funds that meet one of these definitions. However, the document recognises that this would exclude some common arrangements where investment managers and other investors may invest directly into the AHC. Accordingly, the document also considers alternative eligibility criteria which would look directly at the AHC to determine whether it was set up to benefit diverse or institutional investors, rather than requiring that the AHC be owned by a fund set up for that purpose.

Criteria will also need to be set to identify investors in an AHC. The document anticipates that, broadly, a person making investments via an AHC will be a person who has an interest in and participates in the results of investment assets that the AHC acquires. Advancing a loan at a fixed rate of interest to an AHC on arm's length terms will not mean that a person is investing via the AHC, since they will simply receive a fixed, commercial return on the money they have advanced. However, a person who advances a loan to an AHC and receives a variable rate of return depending on the results of the investments will generally be making investments via the AHC. The document seeks feedback on how best to achieve this aim, whether through the concept of "participation" or a more bespoke test.

The government proposes that an AHC should sit within an investment structure that uses an independent asset manager who provides investment management services, including managing fund assets, in return for an investment management fee. The government proposes that investment assets held by an AHC should be managed by an undertaking that is both authorised or registered for the purpose of asset management and subject to supervision in their jurisdiction. In addition, the government proposes that the manager of investment assets held by an AHC should be required to be independent of the investors.

The government's intention is that an AHC regime should only apply to entities that serve to facilitate flows of capital, income and gains between investors and investment assets. A company should not, for example, be eligible for the regime if it is owned by a private equity fund with diverse ownership, holds independently managed investment assets but also carries on significant other activities that form part of the trade of a portfolio company invested in by the fund. One option to achieve this would be to require that an AHC's purpose be to enable the investors to participate in or receive profits or income arising from the acquisition, holding, management or disposal of investment assets. Alternatively, the regime could use a condition that all, or substantially all, of the business of the company be investing its funds in shares, land or other assets with the aim of giving members of the company the benefit of the results of the management of its funds. The government is also considering whether it would be appropriate to specify that an AHC should not trade. The government is additionally considering a range of other eligibility criteria, including a policy or practice of reinvesting or returning capital to participants when investment assets are sold.

It is expected that a company would need to make an election as part of its company tax return to be treated as an AHC.

New AHC regime: tax

The government intends that the new regime should ensure that any taxable profit recognised by a qualifying UK AHC is proportionate to its role involving facilitating the flow of income and capital between investors and investment assets. Depending on the activities of the AHC and the investments it holds, this could mean it will recognise a small taxable profit of the kind an independent entity might make if it fulfilled the same role for investors, in recognition of the value it provides. However, it should not result in a situation where use of an AHC creates a significantly worse tax outcome for investors than if they had invested in underlying assets directly.  Generally, respondents to the consultation preferred a taxable AHC rather than a fully tax exempt AHC, no doubt with one eye on the ability of the AHC to access benefits under the UK's double tax treaty network.

The two main issues identified in determining the taxable profit of the AHC in this context are:

• deductions an AHC can make against its taxable income; and
• transfer pricing (TP) and how these rules should apply to an AHC.

The government is considering whether to allow deductions for results-dependent instruments (where the deduction would normally be disallowed as a distribution) or whether a broader approach, applying to a wider range of payments to investors, would be more appropriate. A simplified example of a results dependent instrument would involve an investment fund lending £20m of investors' capital to an AHC to acquire a portfolio of assets. Rather than pay a fixed amount of interest, the AHC might commit, in return, to pay the fund 95% of the income produced by the investment portfolio. The payments made by the AHC would therefore depend on the results of the investments. An AHC regime could include rules enabling deductions specifically for this kind of instrument. However, the government is open to a broader approach rather than attempting to tie legislation strictly to a particular form of debt or other funding instrument. Examples considered include allowing an AHC to make deductions for any distributions other than dividends or allowing AHCs relief against taxable income for amounts returned to investors, regardless of the particular method. Instead of depending on the form of payment, this might treat the full amount returned as an expense of the AHC, with a limit on deductions determined according to TP principles.

In terms of TP itself, the government essentially asks for further feedback on how best to achieve an appropriate TP result for AHCs.  Given the need for certainty as to the AHC's taxable margin, this will be an important issue to address.

The government accepts that an AHC should not pay tax on capital gains on disposal of relevant investment assets. Investors who dispose of their interest in the AHC will be taxable according to their status on any gains, reflecting any growth in the value of the investment portfolio. Where proceeds on disposal of investment assets are returned, the transaction will similarly result in a potential tax charge for the investor. The government therefore proposes that AHCs be able to obtain relief for gains on disposals of investment assets. However, in order to preserve the tax base in respect of UK property, the relief should not apply to disposals of UK land or any assets such as shares that derive 75% or more of their value from UK land (UK property rich assets).  In this context, it will be important to ensure that the use of an AHC to hold such investments does not result in a double layer of taxation and that the position of tax exempt investors in the AHC can properly be accommodated.

The document suggests that this relief could be designed as an overall exemption for gains or could operate via several reliefs or exemptions, to ensure that amounts not yet returned to investors were easily identifiable. This might involve a combination of a roll-over relief for gains in respect of amounts reinvested in new investment assets and relief for gains returned to investors. If gains are reinvested a number of times, it would be necessary to identify the cumulative gain so that, on any ultimate return to investors, where those investors are UK resident, the full amount can be treated as a gain in their hands.

The government is also considering whether and if so to what extent an AHC should be exempt from the duty to deduct a sum representing income tax on payments of interest to investors. In particular, the government accepts that in the case of foreign investors the movement of their investment income through the UK via a UK AHC should not necessarily lead to the imposition of UK tax on the investor, any more than flows of investment income should be subject to tax in the AHC. In the case of UK investors, any tax should be paid via their self-assessment tax return. However, the government is clearly concerned by possible tax avoidance in this context and is intent on exploring the position further.

The consultation response addresses a number of other tax issues. For example, respondents to the initial consultation raised the issue of the hybrid mismatch rules as a particular concern for funds structured as partnerships and in particular the fact that all investors in a partnership are deemed to be acting together by reason of having delegated the exercise of rights over an investee company to the fund manager. The government has therefore accepted that the UK's hybrid mismatch rules will be disapplied in relation to payments to and by AHCs to the extent needed to meet the policy objectives.

AHC regime: tax for investors

The government proposes that AHC rules should operate so that, for investors within the scope of UK tax:

• amounts deducted from taxable income of an AHC and paid to investors are treated as taxable income in the hands of those investors; and
• amounts returned to investors that are attributable to capital gains realised by an AHC are treated as gains in the hands of those investors.

The starting point would be that UK investors would be taxed on returns as income where the AHC has received a deduction for the payment. For this purpose, regime rules may need to specify what kind of income an investor has received. For example, if an AHC receives interest income and obtains relief against that income for a payment that might be classed as a distribution, regime rules could specify that the relevant amount should be treated as interest in the hands of a UK investor.

However, the government proposes that amounts returned to investors that are attributable to capital gains realised by an AHC should be treated as capital gains in the hands of investors. The issue here is how to achieve this aim in practice, given that there are several different transactions which an AHC might use to return gains to investors. It might repurchase its own shares from investors at a premium, repurchase debt from investors at a premium or make distributions. In any of these cases, special rules would be needed as part of an AHC regime to classify an appropriate amount as a gain in the hands of a UK investor. The consultation puts forward a number of potential approaches to this issue for further consultation, but, given the potential for avoidance, also makes it clear that anti-avoidance rules would be needed. Clearly this is an area that may lead to complex rules, tracking gains through the fund structure particularly when coupled with some form of rollover/reinvestment relief at AHC level.

Amongst a range of other potential tax changes being considered by the government in this context, it intends to explore providing a stamp duty exemption where an AHC repurchases its own shares in order to return capital to investors. More generally, the government will explore whether there is scope for broader exemption from stamp duty and SDRT on some or all transfers of shares and loan capital in an AHC.

More broadly, the government requests views on any other issues that should be considered in design of a regime for AHCs. These could include the tax treatment of investors who invest via a UK AHC as well as tax treatment of the AHC itself. The government would in particular like to receive evidence on the extent to which any such issue could affect take-up of an AHC regime, as well as suggestions for how it could be addressed. In addition, details of the tax treatment of specific examples of existing, overseas companies fulfilling the role of an AHC are requested, in order to test the full effects of the proposed regime and of draft legislation.

AHC regime: real estate funds

The government is clear that AHCs should not be used to obtain tax benefits on investment in UK real estate. One option to achieve this would be to specify that an AHC should not own any UK land or UK property rich assets. However, the government is also seeking feedback on whether this would be an appropriate solution, or whether there are situations where investors would want to use an AHC or ordinary company owned by an AHC to invest in UK property, for example as part of a multi-jurisdictional fund of the kind described below. If an AHC were allowed to invest in UK property, regime rules would need to ensure that the additional deductions and reliefs available to an AHC, such as relief for interest payments on results dependent instruments could not directly be used against income and gains on UK property and could not indirectly enable greater relief against such income and gains than would be available to an ordinary company.

The government is however giving consideration to whether the AHC regime could be suitable for multi-jurisdictional real estate funds, which hold property in multiple countries. Gains realised by AHCs in these structures will obtain relief under general rules for capital gains realised by an AHC. However, where such AHCs receive rental income from an overseas property business, this presents some specific questions.

In many cases, an overseas jurisdiction will have taxing rights over local property. For this reason, whereas most funds are structured to minimise tax liabilities before income and gains reach the ultimate investor, real estate fund structures will use holding companies or other special purpose vehicles (SPVs) to handle local tax obligations. Beyond these obligations, the fund will aim to minimise further tax liabilities within the structure before income and gains reach the investors themselves. This can result in a structure where a master holding company owns investment properties through a number of SPVs. The structure may also involve a number of intermediate holding companies that sit between the master holding company and SPVs and are used to borrow money from third party lenders.

SPVs used in these structures will often be located in the same jurisdiction as the properties they are used to hold, but there are circumstances where an SPV will instead be located in the same jurisdiction as the master holding company. The government therefore asks for further feedback on situations where a UK AHC might be used to own and receive overseas property income directly with a potential exemption from UK tax on overseas property income.

UK REITs regime changes

Although the government does not intend the AHC regime for use for holding UK property, feedback to the original consultation noted a number of areas where the REIT regime could be reformed, to remove unnecessary barriers. Whilst a comprehensive review of the REIT rules is intended to form part of the wider funds review, the government is now considering a number of changes to the existing regime that could be made alongside the introduction of the AHC rules and that would have immediate benefits in making the UK a more competitive location for holding real estate assets. On this basis, the government is now consulting further on these potential changes at the same time as the introduction of the AHC regime.

The particular areas which are part of the immediate review include:

• The listing requirement (though the government is not minded to repeal this aspect).
• Institutional investors and the close company requirement. The rules on the close company requirement were relaxed in 2012, so that a close company could enter the REIT regime where it is close only because it has an institutional investor as a participator. The government is now considering whether the range of investors in this category can be expanded and also reviewing the approach to foreign REIT equivalents.  However, the government is also reviewing the existing list of institutional investors, to see whether any further conditions, such as a requirement for diverse ownership, may be appropriate for certain categories of institutional investor.
• Holders of excessive rights rule. This rule gives rise to a tax charge on a REIT that makes property income distributions to a shareholder which is a company or other body corporate with a holding of 10% and greater. The government recognises that this leads to certain investors in REITs needing to fragment their shareholdings, creating complicated and costly structures solely to remain under the 10% limit, even where those investors are entitled to receive gross property income distributions. The government will consider relaxing this rule so that it would apply only on distributions to entities that are not entitled to receive property income distributions gross.
• The balance of business test. This test requires that 75% of a REIT's assets and income derive from property investment assets. Responses have made it clear that many see the test as burdensome and potentially unfair in its operation, for example where an anomalous or unexpected transaction or event arises in one or more years. The government will consider how the test can be reformed to provide greater certainty.

The government will take forward a further review of the REIT regime in a call for input for the wider funds review which will be published shortly, along with a request for responses on any other REIT regime reforms that the government ought to consider.

Comments

This second consultation will run until 23 February 2021 and responses should be submitted by email to ukfundsreview@hmtreasury.gov.uk.

Draft legislation will be published during 2021, allowing for a period of technical consultation ahead of its inclusion in the Finance Bill.

Generally, the measures proposed are welcome, although as ever, the devil will be in the detail.  The key challenge for government in formulating any new AHC regime will be to create a set of rules that provides the necessary certainty of treatment to asset managers and investors so that they are prepared to make use of UK AHCs, whilst addressing government's concerns around avoidance.  Having a complicated list of conditions that will need to be monitored on an ongoing basis in order for the AHC regime to apply may not be competitive by reference to other jurisdictions in which AHCs have more commonly been located. 

In addition, the issue of VAT is a key one which should be addressed as part of any future regime, ensuring that unnecessary VAT costs be mitigated where portfolio management or investment advisory services are provided to the AHC, whilst also enabling the asset manager providing such services still to recover relevant input VAT which it incurs on its costs.  It is to be hoped that as part of the parallel review of VAT and fund management services, which is expected to commence in earnest in early 2021, a holistic approach can be taken to ensure that these issues are addressed, with a view to securing the success of the new UK AHC regime.