Finance Act 2007 (FA 2007) announced a change in the definition of an ‘offshore fund’ for the purposes of section 756A Income and Corporation Taxes Act 1988 (ICTA). The change is introduced by section 57 FA 2007.
It is intended to put beyond doubt that an open-ended company is not prevented from being an offshore fund in which an investor may have a material interest for the purposes of sections 756A and 759 ICTA purely by virtue of failing the “reasonable period” test in section 236 Financial Services and Markets Act 2000 (“FSMA”).
It has been suggested that this FSMA test may result in companies in which investors are able to realise their interests in under seven years being excluded from the definition of a collective investment scheme at section 235 FSMA, and thereby being outside the scope of the offshore funds regime (OFR); whereas section 759 ICTA encompasses interests that can reasonably be expected to be realised at some time during the seven years from acquisition. Section 57 achieves its aim by removing the reference to “reasonable period” in section 236 FSMA when that section is used in the context of the offshore funds regime.
Section 57 does not seek to return the compass of the offshore funds regime to the pre Finance Act 1995 position.
Some advisers and fund managers have raised concerns that this may bring some offshore companies within the rules that were previously not considered to be ‘open-ended’ for the purposes of either FSA regulation or the offshore fund regime.
The offshore funds regime applies only to an entity defined as a collective investment scheme within section 235 of FSMA. In considering whether that is the case, the Economic Secretary’s statement that the definition of a collective investment scheme in FSMA is intended to cover companies that look to a reasonable investor like open-ended investment companies can helpfully be considered.
This view is also supported by the statement made by the Minister during the debate on the relaxation of the definition of an offshore fund that was introduced in 1995 by section 134 FA 1995 (when there was no reference to “reasonable period” in the Financial Services Act definition of open-ended companies):
“If, however, evidence emerged that tax planners were attempting to abuse the relaxation by creating vehicles that did not fall within the Financial Services Act 1986 definition of collective investment schemes but that could in some way be used to roll up income, the Government would not hesitate to withdraw it.”
From a tax perspective the presumption ought therefore to be that a company with fixed capital is outside the offshore fund definition unless there are special conditions to suggest the contrary.
Advisers and fund managers who have contacted HMRC and HM Treasury since the measure was first announced have said they would find it helpful if HMRC could set out its views on this issue and, therefore, how various types of offshore entities and their investors might be affected by section 57. The following “frequently asked questions” are based on examples brought to our attention by those who have contacted us and
HMRC is happy to discuss the detail of other cases with fund managers to provide certainty.
Background to the evolution of the meaning of ‘offshore fund’ since 1984 when the regime was introduced and more detail on the meaning of ‘collective investment scheme’ and ‘reasonable period’ in the context of both tax and FSA regulation are in the Appendix and the end of this note.
To-date, most of the examples of overseas companies and/or their investors thought by advisers and fund managers to be affected by section 57 are not in fact affected by the clause. However, we are aware that certain open-ended investment companies not previously within the definition of offshore fund may now be within that definition as a result of section 57.
1. Are investors in a ‘limited life’ closed ended investment company who buy shares less than seven years before the end of the company’s life treated differently from those who bought earlier?
Here the concern is that investors in a company with, say, a ten-year life who buy shares three years or more after the company is set up would be affected by the offshore income gain rules whereas an investor who bought at the outset (when the company did have more than seven years left to run) would not be.
The section 236 FSMA 2000 definition, as modified by section 57 FA 2007, applies to the company as a whole and not to the status in the context of an individual investor in that company. If, applying that modified definition, the company is not an open-ended investment company when its shares are first offered, it does not become one seven years before the winding up date.
2. What is the position of an investment company which has some classes of shares that are redeemable and others that are not?
As with FAQ 1, we need to look at the company as a whole. The company cannot be ‘open-ended’ for investors in one class of shares but not in respect of investors in another class of shares.
The overall balance of the company must be looked at to determine whether or not the company is an open-ended investment company. In looking at the company as a whole, HMRC may however disregard the existence of a small tranche of non-redeemable shares if its whole or main purpose is to create a class of investors with no expectation of realisation within a reasonable period.
3. Is an investment company that offers early redemption by reference to an index open-ended?
Here we are looking at the type of company that offers to redeem shares issued for £100 in say three years time at £100 x F1002010 /F1002007 where F1002007 is the FTSE 100 index at the 2007 date of issue and F1002010 is the FTSE 100 index at the 2010 redemption date.
HMRC would not regard such a company as meeting the ‘satisfaction’ test in the section 236 FSMA definition of ‘open-ended investment company’. That test’ requires the reasonable investor to expect to receive an amount calculated wholly or mainly by reference to the net asset value (NAV) of the fund’s property. Where the return at the three-year redemption point is by reference to the movement in an index, then it is not calculated by reference to NAV. The company will not therefore be open-ended and consequently is not caught by the offshore funds regime.
4. Is it different if redemption is index-linked with no access to out-performance?
Looking at the same type of company as in FAQ 3, the concern here is whether the view would be different if the company invested only in instruments designed to produce exactly the promised return.
This would depend on what happened if, at the three-year point, the fund’s investments had performed better or worse than the index.
The company may for example restrict redemption proceeds if the provider of one of the instruments has defaulted but limit the pay-out to £100 x F1002010 /F1002007 even if one of the instruments does in fact out-perform the index. Where there has been default or where the instruments deliver exactly the promised return, the redemption proceeds will be equal to NAV. But if the redeeming investor cannot benefit from any out-performance of the index, then the investor cannot expect the redemption to be calculated by reference to NAV, even though in most cases it is expected to be the same.
HMRC would not regard a company which offered early redemption by reference to an index, which did not allow the investor access to out-performance, as being an open-ended investment company.
It would not, therefore, be within the offshore funds regime.
5. What about a company that offers a defined return with a lower limit on redemption?
Here we are looking at a company which offers shares that will be redeemed in say five years time by reference to changes in the price of a notional portfolio of, for example, precious metals but with guaranteed minimum redemption proceeds equal to the subscription price.
As with FAQs 3 and 4, even though in practice, the investor is likely to obtain their share of the NAV at redemption, this may not be the case if prices of precious metals fall, or if the instruments acquired by the company to generate the return out-perform the value of the notional portfolio.
HMRC would not regard such a company as being an open-ended investment company as defined in section 236 FSMA, as modified by section 57 for the purposes of section 756A ICTA. It would not therefore be within the offshore funds regime.
6. Is a company that has a conditional redemption clause that could be triggered within seven years of establishment an open-ended investment company?
Some companies include in their prospectus an intention for the directors to seek to redeem a class of shares or to wind up the company in say three to seven years time if the fund’s investments meet certain performance criteria.
HMRC would not regard such an intention to redeem or wind up as amounting to a reasonable expectation by an investor that they can redeem their investment. This is because it is conditional on the performance of the investment assets, the actions of the directors and obtaining the assent of the majority of shareholders. The company would not therefore be an open-ended investment company as defined in section 236 FSMA, as modified by section 57 for the purposes of section 756A ICTA because the ‘satisfaction test’ is not met. It would not therefore be within the offshore funds regime.
7. Is a company that offers a window for redemption open-ended and therefore potentially within the offshore funds regime?
If the company includes in its prospectus the intention that shares will be redeemed within a set period, dependent only on action taken by the directors, then following the introduction of section 57 the length of the redemption window is unlikely to affect whether or not the company is open-ended but may affect the application of the offshore fund regime to investors if the company is, in fact, open-ended and therefore within the offshore funds regime.
If the fund is open-ended the length of the window for redemption will determine if shares in the company amount to a ‘material interest’ for the purposes of section 759 ICTA.
If the redemption period is say three to seven years from the date the company issues the shares, then the shares are likely to be a material interest in the company, as the investor can reasonably expect to redeem their investment within a seven year period.
If the redemption period is four to eight years from issue, then the investor does not have an expectation of redemption within seven years. In that case, the shares would not be a material interest for section 759 ICTA purposes.
8. What is the position for a ‘limited life’ investment company which plans to deliver capital growth but has less than a seven-year life?
This type of company would typically be set up to offer a return based on the performance of various indices, similar to FAQs 3 and 5. On winding up, after say five years, investors would receive their share of NAV after costs of liquidation. This type of fund may be an open-ended investment company as defined in section 236 FSMA, as modified by section 57 for the purposes of section 756A ICTA unless it is a closed-ended fund acting in the ordinary way that a reasonable investor would expect a closed-ended fund to behave. Limited life (even if this is less than 7 years) or upcoming liquidation by themselves would not lead to a closed-ended investment company becoming open-ended.
If it is an open-ended company and therefore within the offshore funds regime the shares would also constitute a material interest in the company, as an investor could reasonably expect to realise their investment at or close to NAV within seven years.
If the fund is designed to provide capital growth and its investments are similarly structured, it is likely that the company could qualify as a ‘distributing fund’ as an offshore fund that receives no income can nonetheless meet the distribution test. The offshore income gain rules would not therefore apply on disposal of shares during the life of the company or on winding up and any gain or loss on the shares would be taxable under the chargeable gains rules.
There are companies that are designed to produce a total return, for example, an equity-based fund where redemption proceeds will reflect dividends as well as growth in share prices over the period. HMRC’s view is that it is the kind of fund that aims to roll-up of income, free of UK income tax and is the type of collective investment scheme at which the offshore funds legislation is targeted. Unless the company pursued a distribution policy that satisfied the tests in Schedule 27 ICTA, investors would be subject to the offshore income gain rules when they dispose of their shares in the company.
Concern has been expressed that section 57 FA 2007 changes the status of existing offshore companies, thereby bringing them and their investors into the offshore funds regime with retrospective effect. It is suggested that a company which would not have been within the offshore fund regime prior to 19 July 2007 will become an offshore fund from that date. It is further suggested that an investor who sold shares in that company on 18 July 2007 would be taxable under the chargeable gain rules while an investor selling shares on 19 July 2007 would be subject to the offshore income gain rules unless the company certified as ‘distributing’.
HMRC’s view is that there is no retrospection in these circumstances. This is because to fall within the offshore income gain rules a UK investor must be disposing of a “material interest” in an overseas company that comes within the offshore funds regime. “Material interest” is defined in section 759(2) ICTA 1988 and exists only where, at the time the interest is acquired, it could reasonably be expected that at some time during the period of seven years the investor would be able to realise the value of the interest. Therefore if, at the time of acquisition, company was not within the offshore fund regime, either with or without the changes being proposed by section 57, then subsequent events cannot bring the investor within the offshore fund regime. Any gains made on disposal of the investment will therefore continue to be taxed under the chargeable gains rules.
Following publication of Budget Note 29, concern had also been expressed that one unintended effect of the new legislation could be to cause funds that are currently certified as distributing funds to lose that status, as a result of inadvertently holding interests in companies that were not considered to be offshore funds prior to the change made by the clause. This might arise if more than five per cent of the certified fund’s assets consist of interests in such companies, so that the test at section 760(3)(a) ICTA is failed. To resolve this issue, the Government introduced an amendment ensuring that the section 57 change shall not apply for the purposes of defining “offshore funds” as the term appears in section 760(3)(a) ICTA; i.e. that the FSMA definition of a collective investment scheme (unmodified by section 57) should continue to be applied for the purposes of the 5 per cent test in section 760(3)(a) ICTA.
