Global Tax Alert - UK Budget, Spring 2020Consultation on tax treatment of UK intermediate holding companies in alternative fund structures
The government announced in the Budget that it recognises the importance of the UK’s fund industry and will undertake a review of the UK’s funds regime during 2020. This will cover direct and indirect tax, as well as relevant areas of regulation, with a view to considering the case for policy changes with the clear aim of making the UK more attractive to the alternative funds industry. As an opening step, the government announced that it will enter into a consultation on the attractiveness of the UK as a location for intermediate entities through which alternative funds hold fund assets. The consultation document can be found here. Below we set out the key highlights from the consultation document.
The government will also conduct a review of VAT charged on fund management fees, which is yet to be published. Luxembourg already has a wide VAT exemption, and as a result of Brexit (depending on the terms of any free trade agreement negotiated with the EU) the UK may be able to make changes which are not on all fours with the EU Principal VAT Directive, and in particular widen the scope of the VAT exemption.
The government understands from engagement with industry and its advisors that, despite the general attractiveness of the UK tax system for holding company structures, there remain barriers to the establishment of intermediate fund entities in the UK. The focus of the consultation is on intermediate asset holding companies (AHC). The government recognises the fiscal benefits to the Exchequer of funds establishing UK AHC, and this includes tax on a UK AHC’s margin (e.g. on back-to-back loans) and employment income, and taxing supporting industries (such as lawyers and accountants).
The consultation is, in the main, limited to alternative funds (otherwise referred to as non-CIV funds) that are typically closed-ended funds and which pool investor capital for the purpose of generating investment returns, but are not subject to investor-protection regulation in the same way as other collective investment funds. The investors are generally sophisticated investors, such as pension funds, insurance companies and sovereign wealth funds. The funds commonly pool investor capital through a limited partnership, with the limited partners being the investors in the fund and the general partner being the investment manager. The pooled capital is then invested in corporate equity, debt or real estate through one or more AHC. The consultation’s focus is therefore on debt, real estate and private equity funds.
The government is prepared to make legislative changes in order to improve the UK corporation tax regime for AHCs, but is not prepared to make changes that take significant amounts of existing UK taxable income and or gains out of the scope of taxation. In addition, changes must be consistent with the principles of the UK tax system, otherwise this could encourage abuse. Any legislative changes must also fully adhere to international tax standards such as the OECD’s BEPS standards and global standards on fair tax competition as governed by the OECD’s Forum on Harmful Tax Practices.
The consultation will run until 20 May 2020.
In order to make UK AHC more attractive to alternative funds, the government is considering the following changes:
Debt funds invest in debt securities or originate loans through an AHC. The government understands that AHCs used by debt funds are generally located in jurisdictions that ensure taxation on a simple financing margin that corresponds to the basic function that the AHC performs, while investment income (interest and fees, pull to par gains) is repatriated back to the fund and its investors. Luxembourg is one such jurisdiction. Under UK corporation tax rules, there are difficulties with a debt fund using back-to-back lending arrangements that seek to match the amounts on notes issued to the fund from third-party investments, as there are tax rules that restrict tax deductions on interest dependent on the results of a company’s business (so-called results dependent interest arrangements, which can be treated as distributions).
One proposed solution is to introduce a bespoke securitisation tax regime equivalent to those found in other jurisdictions (one example is the Irish s.110 vehicle), which ensures that an AHC in a debt fund is only taxed on the margin. Alternatively, the government could relax some of the existing UK securitisation regime conditions (e.g. requirements for the securitisation vehicle to issue notes with an aggregate value of GBP10 million, and the permitted activities and financial assets conditions of the securitisation vehicle); however, the government has expressed reservations with the latter option given the “vital importance of regime stability for users of existing securitisation arrangements.” However, the government remains open to further discussion on this issue.
Real estate funds
The government acknowledges that there are challenges under UK corporation tax rules for UK AHCs to repatriate capital back to investors tax-free. The UK has a participation exemption on gains (the substantial shareholding exemption), which, since 2016, also includes the qualifying institutional investor (QII) test, which provides a full exemption on gains realised by an AHC held by the fund (held directly, or indirectly pursuant to the tracing rules), to the extent that qualifying institutional investors hold in aggregate 80% of the interests in the AHC, through their investment in the fund (and a pro-rata exemption depending on the percentage holding of qualifying institutional investors, where they hold in aggregate between 25% and 80% interests in the AHC). UK AHCs face challenges when relying on the QII test for a full or partial exemption on gains; for example, where there is a mixed investor profile of both exempt and non-exempt investors as this gives rise to difficulties to ascertain the QII percentage, with the added uncertainty that the percentage could change over the fund’s term.
Proposals submitted by stakeholders include:
- expanding the QII remit, such that other investors would be considered qualifying institutional investors for the purpose of the test;
- creating a broader SSE exemption through removing the trading conditions at investee level, although the UK government is keen to ensure that disposals of UK property-rich companies remain within the scope of UK tax (including the recent NRCGT rules); and
- relaxing some of the REIT rules (e.g. the requirement that a UK REIT’s shares must be listed on a recognised stock exchange), which could allow a UK REIT to be an AHC, introducing a private (unlisted) REIT regime to the UK for the first time.
The government recognises the difficulties of retaining the character of capital gains realised by an AHC on the disposal of its shares in target companies, when those gains are repatriated up to fund investors. The issue is partly a function of UK company law (which as compared to other jurisdictions such as Luxembourg makes share buybacks more challenging), and also UK tax rules which treat the repurchase of share capital as an income distribution for UK participators in the fund, including carried interest holders.
The government would like to better understand the extent to which the above affects decisions taken by the fund industry to establish UK AHCs. The challenges to capital repatriation may also affect other asset classes (i.e. debt funds and real estate funds).
General tax challenges
Withholding tax: the government acknowledges that although there are exemptions to UK withholding tax levied on interest payments paid by AHCs to non-UK corporate and individual lenders (e.g. treaty relief, quoted eurobond exemption and private placement rules), the administrative burden that this causes represents a potential barrier for funds when evaluating whether the UK is a suitable jurisdiction for incorporating an AHC. The government is interested in views as to whether the UK withholding tax rules for corporate interest should be relaxed, if this would make it more likely for funds to incorporate a UK AHC funded with debt.
Hybrid mismatch rules: stakeholders have suggested that the hybrid mismatch rules can have an unintended and disproportionate impact on the funds sector, reducing the attractiveness of the UK as a location for AHCs. This includes the acting together provisions, and impact of the rules on exempt investors. Stakeholders are encouraged to provide evidence on these issues, and proposed approaches on how to overcome any such hurdles.
DLA Piper comment
The government’s review of the alternative funds industry, which seeks to make the UK tax regime more favourable for the alternative fund industry, is to be welcomed. The government’s attention to the alternative funds industry reflects the immense rise of the fund industry over the last few decades, and which has seen the UK lag behind other European jurisdictions that have become dominant in establishing and supporting such funds (e.g. Luxembourg and Ireland).
Reducing tax hurdles will make it easier for UK fund managers to remain in the UK, and will likely encourage investment into the UK to be made through UK fund vehicle entities. At the time of Brexit, the government is right to be also considering the VAT rules on fund management, as the UK’s VAT exemption is narrow, as compared to some European jurisdictions (in particular Luxembourg).
The government is also right to be considering the funds industry holistically from a tax perspective, as there are some complex issues, both at the fund level (such as VAT leakage on management services) and at the intermediate company level, which is the focus of this consultation. Other tax issues for the government to consider include the UK carry rules (DIMF, IBCI, and employment tax rules), which are unnecessarily complex. UK tax rules that restrict the use of carried forward losses can also adversely affect a UK general partner that may only receive a return on exit.
In addition, it remains to be seen whether any changes made to the UK corporation tax regime will be limited to funds or will also apply to other investment structures. In implementing any legislative changes, the consultation proposes making either a series of discrete changes to the UK tax code, or creating a specific set of tax rules for companies within investment fund structures.
Finally, the government is right to recognise hurdles to the UK funds industry, although challenges arising from Brexit (such as passporting rights) will depend to an extent on negotiations with other Member States.
DLA Piper’s UK Tax team will be making representations to government, and if there are any views you would like us to put forward or discuss, please do not hesitate to get in touch.