REV BN 07: Reform Of Taxation Of Collective Investment Schemes

Who is likely to be affected?

1. Providers of, and investors in, Authorised Investment Funds (AIFs), i.e. Authorised Unit Trusts (AUTs) and Authorised Open-ended Investment Companies (OEICs). Some of the changes affect all unit trusts, one affects only Qualified Investor Schemes (QIS), and one affects investors in a void PEP, ISA or CTF
account.

General description of the measures

2. The measures include some minor changes to the tax rules for potentially chargeable capital gains arising to:

  • certain unauthorised unit trusts (UUTs) where the fund manager holds units in the fund temporarily;
  • certain UUTs with life assurance companies as unit holders; and
  • investors in accumulation units in a unit trust or accumulation shares in an OEIC

3. Other changes simplify the deduction at source rules for interest paid on accounts no longer within the PEP/ISA rules (void accounts), clarify the tax arrangements for AUTs that issue multiple classes of units and correct two crossreferences in the offshore funds legislation relating to loan relationships and permanent establishments.

4. The package includes powers to make regulations to reform the tax treatment of AIFs and their investors. The main changes will:

  • allow funds to make both interest and dividend payments in a distribution period;
  • extend the circumstances in which interest distributions can be made gross; and
  • provide for different tax rules for investors with a significant stake in funds that are QIS

Operative date

5. In the main, Budget Day 2005, apart from the reforms to be provided in regulations. The operative date for these will be set in the regulations, which will be published in draft for discussion later in the year.

Current law

6. The current regime subjects AIF income to corporation tax at a rate equal to the lower rate of income tax (currently 20%) and exempts their chargeable gains from tax. Management expenses are allowable in arriving at the amount distributable to investors. Subject to meeting a daily investment test (bond fund
test), distributions are either yearly interest or dividends. Interest distributions are deducted to arrive at the fund’s tax liability.

7. Individuals generally receive interest distributions net of lower rate tax, which can be set against tax due, or reclaimed in the same way as tax on bank interest. Unit holders within the charge to corporation tax and non-residents generally receive them gross. Dividend distributions are treated in the same way as ordinary dividends, except that for corporation tax purposes dividends are split between a part attributable to UK dividends and that attributable to other income.

8. If an AIF is held within a PEP/ISA or CTF, interest distributions are generally paid gross. If the account is void, e.g. because the investor dies, interest is payable net of tax. If that does not happen, the AIF manager must account for that tax.

Proposed Revisions

9. It is proposed to change the chargeable gains rules as follows to:

  • give statutory effect to Extra Statutory Concession D17 - exemption from tax on chargeable gains where the manager temporarily holds units in the capacity of manager;
  • allow a life assurance company/friendly society to hold units in a UUT without the UUT losing chargeable gains exemption if the units are referable to a category of the company’s business where chargeable gains are exempt from corporation tax; and
  • give effect to an Inland Revenue practice allowing amounts reinvested in accumulation units/shares as a deduction on disposal of the units or shares

10. The first two changes will apply from 2005/06, the third will apply in relation to disposals of accumulation units/shares on or after today (16 March 2005).

11. Administrative arrangements when a PEP, ISA or CTF account is void are being simplified. From 6 April 2005 responsibility to account for income tax will move to the investor, or the executors where the investor has died.

12. Since 1 April 2004, when the FSA introduced its new rulebook (COLL), AUTs can use multiple classes of units in the same way as OEICs can issue multiple share classes. Non-discrimination rules similar to those in the OEIC rules are being introduced for AUTs that issue more than one class of unit.

13. Finance Bill 2005 will include powers to change the regime in regulations to:

  • define and consolidate the existing tax rules in regulations;
  • allow changes in response to future FSA changes, or to counter avoidance;
  • change the existing distribution rules; and
  • permit different tax treatment to be applied to different unit/share holders in funds that are QIS

14. Further discussions with interested parties are planned before publishing draft regulations. This will include discussions on design issues, start dates and will take account of the time funds may need to adapt their systems. Among other things, any regulations under these powers will deal with:

Distributions: AIFs can invest in a mix of assets including equities and bonds but the ‘bond fund’ rules prevent them from making distributions fully reflecting that mix. The daily 'bond fund' test will therefore be removed and funds will be able to make interest and dividend distributions in the same period in proportion to the interest and other income received. Funds will be able to elect to distribute profits only as dividends. The rules determining who can receive interest distributions gross will be aligned with the gross payment rules for bank interest but this will not affect deductibility of such distributions when calculating an AIF’s income chargeable to corporation tax.

Substantial ownership rule: The AIF regime provides tax benefits to investors who pool their investments, handing over management to independent fund managers. The QIS regime allows a new degree of flexibility in investment strategy. As access to a QIS can be limited, this flexibility offers greater scope for potential exploitation of the AIF tax regime. To counter this the Finance Bill will include a power to make regulations to tax unit/share holders differently if they own a substantial portion of a QIS. We will also consider the case for a purposive anti-avoidance test for QIS. For other investment funds work will continue on the suitability of either a purposive test or other potential measures. For the QIS rule the investor will need to take units/shares owned by connected parties and associates into account when deciding what proportion of the fund they own – similar to the control test for close companies. Certain kinds of investor such as pension funds, charities, companies carrying on life insurance and nominees acting on behalf of investors will be excluded from this rule.

This rule for QIS will apply to the investor, so the tax treatment of the QIS will remain as for other AIFs. However, where an investor owns a substantial portion of a QIS, any annual increase in the value of their units/shares will be chargeable as income under self-assessment. Unrealised gains at the time the rule starts will be held over and treated as chargeable gains when the units are sold.

Property: AIFs can now invest up to 100% in property. Furthermore, HM Treasury and Inland Revenue today published “UK Real Estate Investment Trusts: a discussion paper” to consider reform to the taxation of the property investment market in the UK. Many of the issues in that paper are relevant to AIFs and regulations to deal with the tax treatment of property-owning AIFs will be drafted once the Government's position on UK-REITs has been finalised.

Further advice

15. If you have any questions about these changes, please contact Michael Swan on 020 7147 2608 or Stephanie Allistone on 020 7147 2560. Information about Budget measures is available on the Inland Revenue website

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