Child Trust Fund Bulletin 5b July 2005

Partial Regulatory Impact Assessment (RIA)

Proposal to amend the ISA, PEP and CTF regulations to allow all Collective Investment Schemes aimed at retail investors and authorised by the Financial Services Authority under Chapter 5 of the new Collective Schemes Sourcebook to qualify for the ISA.

Purpose and intended effect of the measure

The policy objectives

1. To amend the Individual Savings Account Regulations 1998 [the ‘ISA regulations’] with the Individual Savings Account (Amendment) Regulations XXXX; the Personal Equity Plan Regulations 1989 with the Personal Equity Plan (Amendment) Regulations XXXX; and the Child Trust Fund Regulations [‘the CTF Regulations’] with the Child Trust Fund (Amendment) Regulations XXXX. Without changes to the above Regulations some ISA providers will no longer be able to provide ISAs because of changes taking place at the Financial Services Authority in February 2007

2. Changes at the FSA aim to shift the emphasis of FSA regulation on to management principles rather than reliance on specific types of investment product. The proposed changes to the ISA, PEP and CTF regulations intend to simplify ISA, PEP and CTF investment decisions for savers, reduce burdens for business and ensure that regulation of suitable retail investment products remains with the FSA.

3. The aim is to follow the FSA proposals as far as they are compatible with the ISA principle of easy access to savings, and the CTF aim to provide savers with flexibility to transfer funds. The proposals will allow all schemes the FSA approve as being suitable for retail investors to qualify for the ISA, PEP or CTF, provided savers are given reasonable access to their funds through schemes not exercising their rights to impose ‘limited redemption’ on units.

Background and introduction

4. Collective Investment Schemes can currently be authorised by the FSA under one of two collective investment sourcebooks – the “Collective Investment Sourcebook” known as the ‘CIS sourcebook’ and the “New Collective Investment Scheme Sourcebook” known as the ‘COLL Sourcebook’.

5. From February 2007 the FSA CIS Sourcebook will cease to operate and any scheme that is authorised under the CIS sourcebook will have to convert and seek authorisation under the COLL Sourcebook rules to continue to be authorised. The COLL sourcebook will only authorise two types of retail investment scheme so from February 2007 the Financial Services Authority (FSA) will only authorise either:

  • an EU compatible ‘undertaking for collective investment in transferable securities’ scheme, known as a UCITS scheme; or
  • a non-UCITS retail scheme, which are all schemes that are available to retail investors that do not fall in to the very specific EU rules on UCITS and are marketed in the UK.

6. The rules for the COLL UCITS scheme are almost identical to the CIS UCITS scheme and both already qualify in the ISA and PEP savings regimes and will be brought in to the CTF. Currently non-UCITS retail schemes would not qualify for the ISA, PEP or CTF scheme.

Rationale for government intervention

7. COLL non-UCITS schemes are very similar in nature to UCITS scheme. They are subject to very similar management and risk management requirements, to protect the investor and provide for similar types of mixed investment. However non-UCITS retail scheme rules allow in a slightly wider class of investment product, most notably investment in real property, i.e. land and buildings, and allows a slightly broader range of investment in other collective investment schemes. The latter makes these schemes slightly more attractive, and far less restrictive an option for CIS authorised Fund of Fund schemes (schemes that allow investment in other collective investment schemes) to convert to a non UCITS retail scheme.

8. The current exclusion of non-UCITS retail schemes could exclude some schemes currently held in an ISA, PEP or CTF from those savings regimes in future, unless they convert in to a COLL UCITS. This would result in increased burdens and costs to those providers. This was not the intention of the FSA change.

9. These FSA changes highlighted three key points:

  • The FSA is responsible for regulating financial products and it is difficult to justify excluding schemes, that the FSA have authorised as suitable for retail investors, from ISAs, PEPs and the CTF.
  • HMRC aims to minimise compliance burdens, where possible, but providers claim that excluding non-UCITS retail schemes would place excessive new regulatory burdens on some ISA providers in order to stay in the ISA market.
  • Access and flexibility for savers remain fundamental principles of the ISA and flexibility to transfer funds are key to the CTF.

10. Historically the ISA regulations have excluded investments that were considered ‘unsafe’ either because they were illiquid, such as property, or had the potential to be high risk, such as derivatives.

11. However, since 1997 the investment climate has changed. Changes have already been made to the ISA regulations to allow investment in such products traditionally considered ‘unsafe’ such as:

  • Derivatives in 2003, when we brought in UCITS schemes; and
  • Property as a potential ISA investment when stakeholder medium-term products came into the ISA in 2005.
    Bringing non-UCITS retail schemes into the ISA will provide a level playing field for collective investment schemes, allowing them to invest in such products as property.

Issues

12. However there is a concern that the ability of some non-UCITS retail schemes to make use of the new FSA COLL sourcebook rules on “limited redemption” might reduce saver’s ability to access their savings. The FSA ‘limited redemption’ rules allows non-UCITS retail schemes with substantial investment in real property to restrict an investor’s ability to cash in units to dates specified by the fund. The maximum gap allowed between redemption dates is 6 months. This clearly does not fit with the ISA principle of easy access and may also prevent savers transferring funds in the CTF to another provider within the 30 days allowed for by that scheme.

13. Given that the investment rules and management requirements for non UCITS retail schemes are very similar for those for UCITS schemes it is difficult to sustain their exclusion because:

  • To the investor UCITS schemes that qualify for an ISA can look almost identical to a non-UCITS retail scheme, as both can invest in a similar mix of products.
  • Existing ISA compatible authorised schemes, may choose not to convert to a UCITS by 2007, and become excluded from the ISA even though they have not changed their investment practices; this may be difficult for investors to understand.

14. Existing schemes have also been wary of converting to COLL schemes, as conversion to a non-UCITS retail scheme would mean they cease to qualify for the ISA or CTF. This has had the effect of stifling the market.

15. The FSA support the entry of non-UCITS retail schemes into the ISA. In their view both UCITS and non-UCITS retail schemes have similar protections and aims, and are both suitable for any retail investor.

16. The difference between UCITS and non-UCITS retail scheme rules is largely driven by the EU UCITS directive, which provides compatible rules for all EU states and allows UK UCITS schemes to compete equally with and be marketed alongside UCITS schemes authorised by other EU countries in any EU state.

17. Most EU states also provide rules for a similar range of non-UCITS schemes that they deem suitable for retail investors. Like FSA authorised non-UCITS retail schemes, these are authorised by the relevant authority in that country and can only be marketed in that country. However unlike FSA non-UCITS schemes some other EU countries allow a far wider range of investments to be sold in the retail market, products that the FSA would not deem suitable in retail products in the UK.

18. Bringing non-UCITS schemes into the ISA raise two key issues:

(A) Although non-UCITS retail schemes can be very similar in structure to UCITS schemes because of the additional types of investment possible there is a question around liquidity of certain funds.
(B) Provision of non-UCITS schemes in EU countries opens up the question of EU competition, which requires us to open the ISA, PEP and CTF to similar schemes set up in other EU states.

19. The UCITS directive provides a universal EU definition for appropriate collective schemes that all EU countries follow. There is no similar single EU wide definition for a non-UCITS retail scheme, which makes it impossible to easily define, identify or regulate which EU based non-UCITS schemes would be considered similar to the FSA non-UCITS retail scheme and therefore suitable for access to the ISA, PEP and CTF.

Consultation

20. We have discussed policy alternatives with the FSA and key representative bodies from the industry. They were unanimous in their view that non-UCITS retail schemes should be provided with the same ISA, PEP and CTF treatment as UCITS schemes. With regard to the exclusion of schemes using the FSA’s limited redemption rule providers were keen that any ISA rule did not impose additional burdens on providers or limit development of products. We consulted with providers of existing property funds outside the ISA, PEP and CTF, who are entitled to use the new limited redemption rule. This showed that all schemes open to retail and non-retail investors currently provided easy access because that was what saver’s demanded. These providers confirmed that they were highly unlikely to develop new schemes for retail investors using this new rule. This indicated that imposing a restriction within the ISA, PEP and CTF would have no greater effect on products or providers than the demands of existing savers.

Options

Option 1: Do nothing

21. This would mean that all non-UCITS retail schemes would not qualify as investments for the ISA, PEP and CTF schemes.

22. Although this option would be the easiest route to take with regards to the ISA, PEP and CTF regulations, it would have a large impact upon the financial industry. Fund of Fund schemes currently make up a large proportion of all ISA investments. There are around three to four hundred such schemes out of a total of 1900 authorised investment schemes, and at least 160 of these provide ISA products with in excess of £1 billion in ISA funds invested.

23. Requiring these schemes to convert to COLL UCITS so that they can remain in the ISA imposes new costs on them. Some schemes would have to restructure, even if they do not intend to change their investment practices. All would be required to monitor all of the funds they invest in, not just to track performance but also in order to ensure that they never on any one day hold more than 25% of the total units issued by any particular fund. This means they will need to increase their checks on the schemes they invest in to a daily basis to ensure they remain within the FSA’s UCITS rules. All schemes are open ended and the number of units issued will fluctuate substantially. Funds of Fund schemes are major investors in many such schemes, so the risk of inadvertently exceeding the 25% rule is real. This makes complying with UCITS rules complex and expensive to achieve whereas these additional burdens are not imposed by the non-UCITS retail rules.

Option 2 – Allow Non-UCITS retail schemes into the ISA, PEP and CTF and exclude use of limited redemption.

24. This will allow investors a wider choice of qualifying investments whilst removing the barriers between similar types of investment products and removing the potential burdens to providers at Option 1. It will also retain the concept of 'easy access' to ISA funds and maintains the ability to readily transfer CTF investments between different providers or investments.

25. The reason for the distinction between UCITS and Non UCITS retail schemes now lies solely with the EU Directive. This restricts investments within the UCITS to a range of products and investment limits that EU Member States collectively agreed would be acceptable and can be subjected to similar management criteria across all EU territories. Non UCITS retail schemes are not inherently more risky than UCITS schemes. However, they do have a slightly more relaxed investment criteria but the FSA still consider the risk management rules make these suitable for retail investors.

26. Burdens will arise for schemes converting to the new UCITS or Non UCITS retail rules under the FSA ‘COLL’ sourcebook but allowing both schemes in to the ISA, PEP and CTF means that those burdens arise solely from the FSA requirements.

27. By allowing Non-UCITS retail schemes into ISAs, PEPs and the CTF we will ensure that investors have access to schemes that have some investor protection. It will minimise the risks of innovative offshore schemes being developed to bring property or wider types of investment scheme into ISA, PEP or CTF.

28. Currently around four FSA authorised non-UCITS retail property funds exist, with up to 90 per cent of the fund invested in commercial property. This is seen as a growth investment market, with an increase in numbers of retail investors moving into the market even without ISA status. These funds are seen, and marketed, as providing an alternative to equity products. In practice they will be attractive to savers who are looking for something that lies between a low risk ‘bond fund’ and a higher risk ‘equity fund’.

29. For ISA purposes we were concerned to preserve easy access to savings. All the existing non-UCITS property funds already provide this, as none have chosen to limit an investor’s right to redeem their investment. Providers do not believe that retail investors would find limited redemption attractive, even outside the ISA, except in very specialist funds. No provider that currently has or plans to set up a non-UCITS retail property scheme intends to apply limited redemption and these providers have no issue with this being a restriction of access to the ISA or CTF.

30. Any rule to exclude limited redemption will have to be simple to apply and fair. The UCITS Directive does not require UCITS schemes to trade daily - it requires them to trade at least twice a month – and we should not wish to be more prescriptive for non-UCITS funds. We suggest linking to the same rule for non-UCITS. Although, as with UCITS schemes, in practice we expect most will use daily pricing.

Option 3 – Allow all non-UCITS retail schemes into the ISA, PEP and CTF with no restriction on limited redemption.

31. This option would have the same benefits as option 2 except it would not fit comfortably with the ‘easy-access’ nature of the ISA and it would also prevent CTF savers from easily shifting their investments to new providers.

32. There is no real industry or retail investor demand for such a product at present and this is unlikely to change.

33. Option 2 is the preferred option – it allows for all existing Fund of Fund investment schemes that currently qualify for the Personal Equity Plan and Individual Saving Account schemes to continue doing so, without causing any confusion in the financial market place. It also simplifies choice for investors as it removes the complexity of understanding why one fund can fall into an ISA whilst another potentially similar authorised fund cannot.

Costs and benefits

Business sectors affected

34. Adults residing in the UK do not pay tax on income and growth on ISA, PEP and CTF savings. Around 435 financial providers are currently authorised to act as ISA managers or provide savings or investment products within the ISA regime. These include:

  • Banks, Building Societies and the National Savings and Investments
  • Persons authorised by the Financial Services Authority
  • Insurance companies and
  • Friendly Societies

Individuals can access advice and information on ISA products directly from ISA providers and managers or through Independent Financial Advisors (IFAs).

35. Any of the proposed changes would only affect collective investment scheme managers, who predominantly provide stocks and shares ISA component products. In particular it will affect

- existing ISA providers who sell units in schemes authorised under CIS Fund of Fund and Money Market Schemes who would be required to convert to a UCITS scheme from 2007 as a result of the FSA and existing ISA provisions; and
- new ISA providers hoping to set up a new collective investment scheme

These organisations would be classed as large organisations, as they hold considerable levels of investment funds.

Issues of equity and fairness

36. The impact of the preferred option, and Option 3, would be to increase equity and fairness between similar types of investment products. This would allow any collective investment schemes for retail investors; especially those investing in similar ranges of investment product to all have access to the same ISA, CTF and PEP tax treatment. It would also put FSA authorised Collective Investment Schemes on the same footing as other collective investment products, such as insurance and stakeholder products by allowing investment in property.

37. Option 1 could put Fund of Fund schemes at a disadvantage. They currently make up a large proportion of all ISA investments. Requiring them to convert to a UCITS scheme would impose additional administrative burdens and costs, and they would have to restructure even if they did not intend altering their investment practices. These additional burdens are not imposed if they are able to convert to the non-UCITS retail rules to remain within the ISA, PEP and CTF.

Benefits

38. The preferred option will allow investors a wider choice of investment and it removes the barriers between similar types of investment products, whilst retaining the concept of ‘easy access’ to ISA funds and the ability to readily transfer CTF investments between providers or investments.

39. In addition, it will ensure that investors have access to schemes that have some investor protection, rather than the current alternative of unauthorised property schemes. It will also minimise the risk of innovative offshore schemes being developed to bring property or wider types of investment schemes in to the ISA or CTF.

Policy costs

40. The preferred option will create no new costs for managers provided we have devised a simple way of identifying suitable non-UK schemes. We want to extend the ISA, PEP and CTF rules to those schemes whose rules are similar in nature to the FSA rules for UK Non UCITS retail schemes. Each EU member state has their own rules for such schemes some of, which would not be acceptable against the FSA’s criteria. There will be no additional administrative burdens for Fund of Fund schemes, even though non-UCITS schemes provide similar investor protection to UCITS. Also, there will be no additional burdens for property schemes, as existing non-UCITS retail property schemes do not apply ‘limited redemption’. Due to investor demands these funds provide savers with easy access to their investment.

41. The first option (do nothing) would increase the administrative costs to fund of fund schemes as they would need to convert to a COLL UCITS if they wished to remain in the ISA and PEP scheme. In addition, some fund of fund schemes would need to restructure, which would carry additional costs.

42. The third option would have the same cost impact as the preferred option. However, by allowing limited redemption this option would not fit well with the easy access nature of the ISA and it would also prevent CTF investors from easily shifting their savings to new providers. In addition, there is no real investor or industry demand for such a product at present.

Implementation (compliance) costs

43. The implementation costs of option 2 and 3 are negligible compared to the administrative costs of option 1, which would require fund of fund schemes converting to a COLL UCITS.

Exchequer effect/distributional impacts

44. The costs to the Exchequer of allowing non-UCITS retail schemes into the ISA and CTF should be negligible (less than £2 million a year). This impact arises from

  • the tax treatment given to property funds, which could under the preferred option get access to the ISA, and
  • the potential increase in ISA savers, attracted to the new products, who are not investing the maximum in their equity ISA.

There is no Exchequer impact for the CTF as annual investment limits are far lower.

Small Business impacts

45. There should be no impact on small businesses as those providing collective investment schemes do not fall within this classification. Independent Financial Advisers, who may be categorised as small business, will not be affected by the change, as this merely adds to the products allowed within the ISA, PEP or CTF.

46. The burden of identifying whether a product satisfies the ISA requirements, including the ‘cash like’ test already applied to collective investment products will be the responsibility of the ISA and PEP manager and the product provider. The provider will be responsible for ensuring that the information they provide on the product is sufficient to inform investors, IFAs, and ISA managers when a product qualifies for the PEP and ISA and for which component.

47. This is no different from the current position, as advisers are required to keep up to date on changes to investment products.

Other costs and benefits (public & private sector)

48. The preferred option should simplify and increase the fairness of the ISA, PEP and CTF investment rules, which had become more complex with the introduction of stakeholder products and the exclusion of certain types of collective investment schemes. This also makes clear that regulation of financial products for retail investors sits with the FSA and should reduce any burdens on business from complying with separate ISA and FSA rules.

Unintended consequences

49. None identified.

Other impacts

50. None identified.

Devolution

51. No issues identified.

Human Rights

52. The policy should have the same coverage and effect as the current ISA, PEP and CTF schemes, so there will be no human rights impacts from these changes.

E-policy

53. None identified.

Environmental impacts and Rural proofing

54. None identified.

Competition assessment

55. The competition filter has been applied and no competition issues arise as the measure seeks to maintain the status quo whereby all collective investment schemes currently qualifying for the ISA, PEP and CTF continue to do so.

Securing compliance

56. None of the options, as proposed, would increase compliance burdens within HMRC as in each case HMRC would rely on FSA regulation to identify qualifying and non-qualifying investments. The restriction in Option 2, excluding schemes using ‘limited redemption’, will form another criteria used within the existing HMRC audit process.

57. With option 1 the compliance burdens would fall on Fund of Funds schemes if they wished to remain as qualifying investments for the ISA, PEP and CTF schemes but this would fall out of the FSA requirements.

58. As part of the normal process for notifying providers changes to the ISA, PEP and CTF regulations we also intend to issue revised guidance notes on the eligibility criteria

Monitoring and evaluation

59. This partial RIA invites comments, particularly on the compliance costs aspects of option 1. The analysis and recommendations will be updated to reflect any such comments prior to implementation.

60. In the longer term, the recommended policy change will be monitored and reviewed to ensure that it is having the desired effect and has not introduced any unintended side effects. This evaluation will take place as part of the ongoing analysis of the regular statistics provided by managers of ISA, PEP and CTF products and through on going informal discussion with ISA managers and representative bodies.

61. The preferred option is expected to have an ongoing positive effect on the compliance burden, through simplification. It is not expected to introduce any one-off costs. HMRC will monitor and confirm these assessments by continued discussion with the industry on the impact of the ISA, PEP and CTF rules and as part of the forthcoming ISA review.

62. HMRC will publish statistics on ISA and PEP take up, as now, on a quarterly basis and CTF information as arranged and will consider how best to publish outcomes of ongoing informal discussions and evaluation in due course.

Summary and recommendation

63. The policy change will bring UK non-UCITS retail schemes into the ISA and CTF. This will give investors and schemes greater flexibility and freedom while FSA controls still provide investors with protection.

64. However, to maintain the easy access nature of the ISA and need for transfers within CTF property schemes that applied ‘limited redemption’ should be excluded. Current information on such schemes and the proposals discussed the Exchequer costs of allowing such schemes into the ISA are expected to be negligible.

Contact Point
David Ensor
HM Revenue and Customs
Room 56,
100 Parliament Street
LONDON SW1A 2BQ
Tel: 020 7147 2838
Fax: 020 7147 2742
Email: David Ensor