Getting the tax right for the future UK funds regime - HMT seeks views

The government has released a call for input as part of its ongoing review of the UK funds regime in the post-Brexit environment. This consultation signals HM Treasury's aim to support the UK's role as an attractive location for asset management and fund establishment.

Responses to the consultation should be submitted by email to ukfundsreview@hmtreasury.gov.uk by 20 April 2021.

Simmons & Simmons will be responding to the Call for Input.   

Background

Last year's Spring budget promised a review of the UK's existing funds regime. This latest Call for Input, released on 26 January 2021, sits alongside an earlier consultation on the tax treatment of UK based asset-holding companies (AHCs) in alternative fund structures, to which the government responded in December 2020 and which is subject to further detailed consultation at present, with legislation expected to follow this Summer. See our thoughts on HM Treasury's December response to the AHCs consultation here.

The primary aim of this latest, wider consultation is to ensure that the UK remains an attractive location for the establishment, management and administration of funds in light of the UK's new relationship with the EU. It is also clear that the government will be looking to support investors to make a wider range of more efficient investments in an effort to rebuild the asset management industry following the COVID-19 pandemic.

The hope is therefore that changes made to the existing regime could grow the existing asset management industry (and that of related service providers), support job growth across the UK and enable investors to meet their goals.

The consultation is split into three parts. The first section raises queries regarding the UK's existing approach to funds taxation. The second considers the UK's approach to funds regulation. The final section invites suggestions as to how best to conduct a wider reform of the regime.

This article considers the first and final of those three sections. Our views on the funds regulations issues can be found here.

The UK's approach to funds taxation

The Call for Input begins by recognising that tax neutrality is a fundamental element of the UK's taxation of funds. This has been a longstanding theme on the part of industry, and it is positive that this is front and centre of the Call for Input.  HM Treasury's central intention is to ensure that investors achieve a neutral tax treatment irrespective of whether they invest in an asset directly or via a fund. HM Treasury recognises that the reality is that the existing regime often results in a lack of tax neutrality, for example in the case of multi-asset funds. In particular, certain balanced funds that invest both in equity and debt instruments are not always entitled to tax deductions for distributions at fund level and tax leakage may therefore arise at the fund level. The consultation calls for suggestions as to how such balanced funds can be taxed in a way that is less distortive.

The Call for Input raises questions concerning the Tax-Elected Fund (TEF) regime, which was originally introduced to facilitate onshore multi-asset funds, and the government is keen to understand why the uptake of TEFs has been so limited.  Anecdotally, the inability for certain investment platforms to manage the additional investor reporting requirements that arise with TEFs, together with the perceived complexity of the regime itself compared to that in other jurisdictions which adopt a more straightforward tax exemption model, have held back the launch of UK TEFs, and the experience with those funds will hopefully inform the broader reforms to UK funds taxation discussed in the Call for Input.

The Call for Input raises concerns that the existing Real Estate Investment Trust (REITs) rules are unnecessarily complex. There have been suggestions that certain REIT rules no longer serve their intended purpose or facilitate the full range of uses to which UK REITs are now put.  The proposals in relation to REITs should be considered alongside those in the latest AHCs consultation - our understanding is that those latter "snagging" changes may be addressed first, with the matters covered in the Call for Input representing a longer term approach to reform.

The government is also keen to explore certain indirect tax issues applicable to funds. Namely, there is concern that the existence of VAT on fund management services can incentivise funds managers to establish funds outside of the UK. HM Treasury is looking to take initial responses to this issue at this stage, in anticipation of potentially releasing a separate formal consultation at a later date.  The question of VAT will be critical to the success of any UK funds regime, both in terms of avoiding any irrecoverable VAT cost at fund level on management fees, but also in ensuring that the position of asset managers is not adversely affected by their incurring significant amounts of irrecoverable VAT that would not arise if they provided management services to a fund established outside the UK.

The Call for Input notes that the use of UK-domiciled limited partnership funds (LPs) has declined in recent years. As a result, HM Treasury is keen to explore the main barriers to the use of UK-domiciled LPs and Private Fund Limited Partnerships, or PFLPs, and how tax changes might address these issues.

The government is also considering whether it ought to take specific action to guard the benefits of the UK's existing tax treaty network, or alternatively to enhance it in the context of the UK's new relationship with the EU.

A wider reform of the existing regime

It is arguable that the most engaging section of the request for input considers the opportunities for wider reform.

The memorandum ponders the introduction of a range of new fund vehicles in light of increasing investor demand. This includes a reference to the Long-Term Asset Fund (or LTAF), which was previously recommended by the UK Funds Regime Working Group. The intention is that LTAFs will allow investors to access illiquid infrastructure or venture capital assets. In particular, it has been suggested that this review will facilitate the investment of capital into long-term investments which support the UK's target of achieving net zero emissions by 2050. The consultation also suggests that certain UK professional investors would benefit from a new, flexible and tax-efficient unauthorised fund entity. The reforms are part of a general intention to appeal to Alternative Investment Funds (AIFs) targeting international markets.

The memorandum signals a concerted effort to develop fund administration "hubs" in an effort to generate more jobs outside of London. HM Treasury are also keen to discuss how to improve the popularity of Investment Trust Companies (ITCs). The memorandum queries whether requiring asset managers to justify their choice of fund structure on application may result in an increased uptake in ITCs.

The fund industry has also made the government aware of the benefits of permitting authorised funds to distribute sums directly out of capital. FCA rules currently prohibit such a distribution. It has been suggested that permitting direct capital distributions would allow fund managers to develop new, competitive products such as "bond ladders" for the retirement income and drawdown market.

Comment

Beneath these ambitious proposals lies a large amount of granular detail. The Call for Input is an opportunity for practitioners and the fund industry to achieve more than simply papering over the existing areas of the UK tax regime which give rise to friction. This may be an opportunity instead for a wider "root and branch" overhaul of the existing system resulting in tangible improvements.

The success of that overhaul will depend largely on whether genuine tax neutrality can be achieved while also driving an increased use of UK onshore funds through adoption of a taxing regime that is simple to understand, certain in terms of its application and competitive alongside that of key EU and non-EU fund domiciles.