Review of the UK funds regime: tax aspects

On 10 February 2022, HM Treasury (HMT) published its much anticipated Summary of responses to its January 2021 Call for Input, Review of the UK Funds Regime. The publication summarises the responses that the government received and how it intends to take forward reforms in relation to the UK funds regime. The Simmons & Simmons response to that Call for Input can be found here.

From a tax perspective, the government will seek to take forward proposals to make the taxation of funds simpler and more efficient, including changes to the genuine diversity of ownership (GDO) requirement, further enhancements to the REIT regime following on from the initial changes announced last year and further consideration of solutions to deal with multi-asset funds, including the possibility of (elective) tax exemption.

The government will also shortly publish its long-awaited consultation on the VAT treatment of fund management, albeit that, disappointingly, zero-rating has been ruled out for fiscal reasons.

Our review of the key regulatory issues contained in the summary of responses can be read in our separate article found here.

Background

At Budget 2020, the government announced a wide-ranging review of the UK’s funds regime, covering both tax and regulation, and in January 2021, published a formal Call for Input. The overarching objective of the review is to identify options which will make the UK a more attractive location to set up, manage and administer funds. This objective underpinned two key initiatives that the government has already taken forward as part of the review, a new tax regime for qualifying asset holding companies (QAHCs) in fund structures, which will come into effect from April 2022, and facilitating the introduction of an illiquid Long-term Asset Fund structure.

HM Treasury has now published its summary of responses received to that process, setting out the next steps the government intends to take.

Overall, respondents to the Call for Input identified three priority areas for reform. These encompassed the VAT treatment of fund management fees, simplification of the funds tax regime and strengthening the double tax treaty network, including a focus on accessing relief for UK UCITS following Brexit and discontinuation of the availability of the Interest and Royalties Directive and the Parent Subsidiary Directive.

VAT

From a tax perspective, the top priority item identified by respondents was the review of the VAT treatment of fund management, specifically to ensure that the treatment of fund management in the UK is competitive, uncertainties and complexities are addressed and importantly that the case for zero-rating is considered. This was a position echoed in client surveys that we have undertaken, given the potential VAT disadvantages faced by a UK based manager of a UK domiciled fund.

The response document confirms that the government will shortly publish a long-awaited consultation on the VAT treatment of fund management fees which it recognises is a crucial element in making the UK’s fund regime internationally competitive. However, disappointingly given its importance to the competitiveness of the UK funds market, the response document rules out the possibility that the forthcoming consultation will consider the possible introduction of a VAT zero-rate for fund management fees. The government considers that the cost to the Exchequer of such a change would be very significant and cannot be prioritised in the current fiscal context. Instead, the consultation will examine other, as yet not identified, options to improve and simplify the VAT regime for fund management. Although positioned as simplification of the current regime, whatever is proposed will likely provide less clarity than zero-rating, and this may inhibit the UK’s desire to be seen as a jurisdiction in which to domicile investment funds, particularly where those funds are managed domestically.

Multi-asset / balanced funds and tax exemption

The Call for Input recognised that multi-asset funds can be tax inefficient due to the tax paid on income from interest bearing investments and derivative contracts. The Call for Input put forward a number of possible solutions for consideration. Having analysed responses, the government intends to continue to work to address the tax inefficiencies in multi-asset funds. In particular, the government will further evaluate the case for a deemed deduction for distributions and other sources of income.

The other area for consideration is a tax exemption for funds. However, overall, there was no consensus on whether tax exemption would be beneficial – or at least that it would benefit all funds. Whilst recognising that this may increase the tax efficiency of funds and reduce complexity of the tax rules, this would need to be weighed against the potentially significant downside in the loss of treaty benefits for tax exempt funds.

In the case of authorised funds, the government will explore with stakeholders the case for an elective tax exemption. In the case of unauthorised funds, the government recognises that any decision on whether to take forward tax exemption will depend on the range of vehicles that will be available. As such, further consideration of this issue would depend on other proposals in the review, including the proposal for new unauthorised fund structures which would be tax transparent.

REITs

The Call for Input saw strong support for the UK REIT regime to be made more attractive. As a result, the government has announced that it will establish a new workstream as part of the UK funds regime review to evaluate the options for further reform. The workstream will determine which specific proposals will be taken forwards, such as removing the requirement for larger REITs to be subject to both the corporate interest restriction rules and the interest cover test, revising (but not removing) the three year development test, removing the three property requirement, removing tax inefficiencies in holding non-UK property and broadening the definition of qualifying assets. The government will also consider whether any of these changes will be made to other relevant fund vehicles, such as PAIFs.

The government will consider whether some of the reforms that may be taken forward as part of this workstream, including in relation to the interaction between REITs and QAHCs, can be included in the next Finance Bill. However, it notes that more fundamental changes may run to a longer timetable.

Tax treaty issues

Responses to the government Call for Input on treaty issues stressed the importance of the UK’s treaty network and highlighted a number of issues. These included lack of future access to the Interest and Royalties Directive and the Parent Subsidiary Directive following Brexit. Respondents suggested that replacement bilateral agreements should be prioritised in this context. Some respondents also stated that a solution should be sought quickly to allow UK UCITS to continue to demonstrate comparability with EU UCITS.

Many respondents stated that the UK should seek certainty of treatment for specific UK fund types, and therefore more clarity around the availability of treaty benefits. This was raised in the context of a mismatch between funds treated as opaque or transparent. Respondents suggested this should be explicitly agreed in amendments to existing tax treaties, when negotiating new treaties, or by Memoranda of Understanding (MoU) or Competent Authority Agreements (CAA).

The government will take on board these responses and will seek certainty and clarity for funds as part of its ongoing treaty negotiation programme. The response document also notes the potential incompatibility between the need to ensure treaty benefits and proposals for tax exemption for funds.

Limited partnership funds

The Call for Input sought to understand any barriers to the use of limited partnership funds (LP funds) in the UK and invited suggestions for improvements. Respondents identified a number of tax barriers, including administrative complexity around partnership reporting rules and the tax implications of the stamp duty and SDLT rules applying to transfers of interests in LPs and property investment LPs.

The response document offers general support for the LP fund model, recognising its importance and confirming that the government intends to continue to work to ensure that it remains efficient for investors. However, none of the reforms suggested (such as an optional election for English LPs to have separate legal personality) were identified as priority items and, therefore, the government intends to consider these issues further before taking forward any specific measures. In the meantime, the government welcomes any additional representations.

Finally, the response document notes that there may be advantages in the creation of a bespoke tax regime for LP funds. However, this is again not regarded as a high priority item and so the government does not intend to progress this further at this time.

Long term asset funds (LTAFs)

The Call for Input also looked at the tax rules for the new LTAFs. The response document confirms that now that the regulatory detail for LTAFs is finalised, the government will conduct further discussions in relation to the taxation of these funds. On an interim basis, regulations came into force in December 2021 that extended the UK taxation regime for authorised investment funds to OEIC and AUT LTAFs, generally where such LTAFs met a modified GDO requirement. However, this approach does not deal with all aspects relevant to the taxation of LTAFs and it is encouraging that further discussions will be taking place.

New unauthorised fund structure

A particular issue raised with the government by the asset management sector was the gap in the range of authorised fund structures offered in the UK, and the lack of an option for a flexible, tax efficient, unauthorised fund aimed only at professional investors and that can invest in alternative asset classes. It was noted that for such a structure to be successful, the tax regime would need to be simple and stable and offer equivalent investor benefits to those offered by overseas alternative funds.

However, it had been noted that a VAT zero-rate would be necessary for unauthorised LP funds and unauthorised corporate structures to be commercially attractive. Given the government’s decision not to consider a VAT zero-rate for fund management at this stage, the government will not proceed further with these proposals in the short term. The case will be considered again following the forthcoming consultation on VAT.

However, stakeholders argued that an unauthorised contractual scheme that invests in real estate would be commercially attractive within the current VAT rules. Accordingly, the government intends to conduct further work to explore the options to include unauthorised contractual schemes in the UK’s funds offering. From a tax perspective, it is expected that the tax rules for these schemes would largely replicate the tax rules for co-ownership authorised contractual schemes (CoACS).

Comments

The result of the Call for Input is that the government will now take forward a number of a number of areas of work including, from a tax perspective:

• A review of the genuine diversity of ownership (GDO) condition;
• Further consideration of options to improve the tax efficiency of UK authorised funds, and in particular multi-asset funds;
• A workstream focusing on further reforms to REITs, which will also consider the interaction of REITs with the new QAHC regime;
• Further work to explore options for the introduction of a new unauthorised contractual scheme fund structure; and
• A consultation on options to simplify the VAT treatment of fund management fees.

In addition, the government welcomes further representations and engagement from stakeholders both on the proposals that are not being taken forward in the short term and also any new ideas affecting the UK funds regime. Further engagement should be via UKfundsreview@hmtreasury.gov.uk.