Offshore Funds

Two tier limit problem | Definition of offshore fund | Loss on disposal | Approved Investment trusts companies- disposals of investments in non distributing offshore funds

The UK's offshore fund regime taxes UK investors on their gains arising from disposals of investments in offshore funds as though those gains were income unless the offshore fund pays a certain minimum distribution and meets other conditions. In this case the fund qualifies as a "distributing fund" and UK investors are subject to tax on capital gains on any disposal rather than tax on income treatment. The aim of the legislation is to prevent UK taxpayers rolling up income offshore and converting it into a capital gain on disposal by either taxing the gain as income or forcing the fund to distribute the bulk of its income in order to qualify as a distributing fund. Most UK retail investors would prefer to invest in a distributing fund.

Two tier limit problem
There are various conditions for a fund to qualify as a distributing fund, not least the need to distribute the bulk of its income each year. However another condition is that a distributing fund may only invest in another offshore fund where very broadly that other fund is also a distributing fund, but that second tier fund may not invest in another offshore fund even if that third fund could meet the conditions to be a distributing fund. This two tier limit problem has been causing problems for fund of fund structures that wish to attract UK investors.

The effect of the change now announced is that there is effectively no limit to the number of tiers provided that each tier is or could be a distributing fund.

Our view
In our view this will be helpful to offshore fund of funds seeking to market their products to UK investors.

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Definition of offshore fund
The offshore funds regime applies where a UK investor disposes of a material interest in an offshore fund which does not qualify as a distributing fund. The definition of material interest includes the requirement that the investor can reasonably expect to realise the investment within a reasonable period, taken to mean within 7 years. Offshore funds which are companies only come within the definition of an offshore fund if they meet the FSA's definition of an open-ended investment company (OEIC). This also includes a condition that an investor is able to realise the investment within a reasonable time, but this is generally taken by the FSA to mean within 6 months.

Our view
The intended effect of the change appears to be that a reasonable period would mean within 7 years for both purposes, however the interaction between specific changes and the existing law is confusing come practitioners who are in discussion with HMRC as to whether these amendments will achieve that objective.

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Loss on disposal

Where a loss arises on the disposal of an offshore fund which is not a distributing fund it has always been considered to be a capital loss rather than an income loss despite the fact any gain would be taxed as income.

The change announced in the budget makes that position clear.

Our view
Again, it is useful to have the position clarified.

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Approved Investment trusts companies- disposals of investments in non distributing offshore funds

Investment trust companies that meet certain conditions are approved by HMRC and broadly pay tax on their income but are exempt from tax on their capital gains. One of the conditions is that the majority of their income is derived from shares and securities, known as eligible income (the income test).

Until 2005, the prevailing practice was to treat the gains made by an approved investment trust company on the disposal of an investment in a non distributing offshore fund as eligible income. HMRC more recently changed their view and a change of interpretation was published in Tax Bulletin 79 (October 2005). That change of interpretation was originally to have applied from 1 January 2006 but because it could have adversely affected some investment trust companies it was delayed.

The effect of the change now announced is that gains made by an approved investment trust company on the disposal of an investment in a non distributing offshore fund will be ignored for the purposes of the income test. Thus although such gains will no longer count as income derived from shares and securities neither will it be possible for these gains to cause an investment trust company to fail the income test and thus the company's approved status will not be threatened by this issue.

Theses gains will remain taxable as income in the hands of the investment trust company.

Our view
In our view it was always rather odd (although helpful) to have the gain treated as eligible income and this solution is probably more technically correct. Although investment trust companies will no longer be able to use the gain to increase eligible income neither will the gain cause an investment trust company to fail the income test. This solution was negotiated with HMRC by the Association of Investment Companies (AIC) and in our view is a fair and sensible one.

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