Highlights of DLA Piper’s submissions to HM Treasury

Eligibility criteria

The consultation sets out that AHCs must be held (directly or indirectly) by Funds which are collective investment schemes or investment trusts, holding independently managed investment assets, and the manager should be subject to regulatory oversight. The consultation also considers a minimum amount of capital raised for investment by the AHC.

As part of our submission to HMT, we highlighted that if a minimum amount of capital test is used, consideration should be given to the fact that the Fund manager will draw down cash from the investors’ commitments as and when an investment opportunity presents itself. Accordingly, a minimum amount of capital raised, should be by reference to the amount of total investor commitments or to the amount of Fund investments once all the commitments have been drawn down by the Fund.

We also understand that HMT is considering a test looking at the proportionate holding in the underlying investment. Consideration would need to be given to credit funds which make loans to third party borrowers, as opposed to holding shares. We see no reason for loans to third party borrowers to be subject to a minimum amount of loan to value (LTV) ratio.

Activities of the AHC

The consultation sets out that the AHC must not earn trading profits, which we agree should not be the case, subject to the caveats below.

We highlighted in our submission that consideration should be given to credit funds which may use an AHC differently from a real estate or private equity fund, in which the AHC holds shares in subsidiary portfolio or subsidiary real estate companies. In a credit fund, it is common for the Fund entity (eg a limited partnership) to incorporate a limited company (Finco) that makes loans directly to third party borrowers. Under the UK loan relationship rules, these loans would likely be held for the purpose of a trade, and they would be taxed as trading credits. The AHC regime should accommodate activities of a Finco. In addition, although this should not ordinarily amount to a trade, in many circumstances, the AHC will act as the entity acquiring shares / assets (i.e. a Bidco). The new rules must permit the AHC to carry on such activities.

Tax deductions

Under current UK tax rules, interest paid on results dependent debt (e.g. profit participating loans (PPLs)) is generally not tax deductible. Under the proposal set out in the consultation, these rules would be switched off under the AHC bespoke regime, and therefore the AHC would have the flexibility to use PPLs in order to pay interest up to the investors, and the AHC would pay corporation tax on a margin under transfer pricing (TP) principles (assuming that the PPL and interest rate are on arms’ length terms).

HMT has also proposed an even more flexible approach that would provide for tax deductions at the level of the AHC, for repatriation of profits to the Fund LP, other than dividends (subject to TP rules in order that the AHC pays tax on the margin). Alternatively, the AHC would always achieve full tax deductions, regardless of the method of repatriation to investors (including dividends), and the AHC would be taxed on the margin, under TP principles. Under the latter approach, in order to limit abuse, we would suggest that distributions paid up to investors which achieved a tax deduction at the level of the AHC should be taxed as income in the hands of the investors (i.e. as opposed to returns of capital).

Capital gains

The approach taken in the consultation, is that a UK AHC should be exempt from capital gains tax, but amounts repatriated to UK investors that are attributable to capital gains realised by the AHC should be taxable in the hands of the UK investors, notwithstanding if paid out as a dividend. In effect, the exemption from AHC’s gains, is in fact a deferral of capital gains tax (i.e. a proportion of AHC’s gains are attributed to UK investors in the Fund when the gains are paid out by the AHC to the investors in the Fund. As a result, the consultation addresses issues that arise with respect to the AHC reinvesting gains and appropriate levels of deductions, in order to correctly calculate and identify the amount of gain that UK investors should be taxed on. HMT considers that the tax treatment of investors should be no different than had they invested into the Fund’s assets directly.

We disagree with this approach. The government’s proposed deferral regime for gains for UK investors, can create additional complexity, as compared to the participation exemption in other regimes such as Luxembourg which provides for a broad exemption on gains.

Furthermore, and more fundamentally, we strongly urge HMT to reconsider its approach from a policy perspective. The UK government should seek to create a level playing field between UK and overseas investors, and instead of a deferral regime on capital gains, we propose a comprehensive participation exemption for capital gains tax (and not a deferral with respect to UK investors). Otherwise, a Fund manager seeking to target UK investors will prefer (to continue) using a Luxembourg Fund and AHC in order for UK investors in the Fund to benefit from the Luxembourg participation regime.

Furthermore, Fund managers are typically required to have ‘skin in the game’ and will therefore co-invest into the Fund, on broadly similar terms to other investors. UK Fund managers may continue to prefer using a Luxembourg AHC which provides for a comprehensive participation exemption on gains, as opposed to using a UK AHC which taxes the manager on capital gains on his/her coinvest profits (e.g. on receipt of dividends by a UK company).

Our preferred approach is that should there be comprehensive participation exemption on capital gains tax at the level of the AHC. A repatriation of capital by the AHC to the Fund (e.g. a share buyback in the shares of the AHC), would give rise to a capital gains tax charge in the hands of UK investors, subject to appropriate reliefs. In the alternative, if a distribution was made by the AHC, the investors would be subject to tax on receipt of income under the normal rules, subject to reliefs.

We understand that HMT are also concerned that in particular individual UK investors could benefit from the AHC rolling up its income, and converting its income to capital using e.g. a share buyback (this could be a concern for example if the bespoke AHC regime would give a full deduction, other than tax on the margin, at the level of the AHC, irrespective of the method of repatriation to investors – see above). In order to counter such abuse, HMT is considering using an overlay of existing rules such as the offshore funds rules in order to calculate the appropriate amount of income, or in the alternative using for example the transactions in securities legislation to ensure that UK individual investors are taxed on an appropriate amount in the form of income.

We can understand HMT’s concern here, but at the same time, the new AHC regime should allow for express safe harbours such as where the Fund pays out all of its income to investors by way of interest income to the extent that this gives rise to a tax deduction at the AHC level. There should also be provisions to allow the AHC to recycle interest income (whilst being able to tax the interest received), otherwise this could jeopardise the ‘beneficial ownership’ requirement when relying on double tax treaty relief on payments of interest to the AHC.

Stamp duty

Broadly, the UK imposes a 0.5% stamp duty on acquisition of UK shares, including share buybacks. The consultation proposes a stamp duty exemption with respect to the AHC repurchasing its own shares, when repatriating capital to investors. Repurchase of shares is a common approach taken in other jurisdictions (such as repurchasing of Alphabet shares in Luxembourg, which is not subject to stamp duty in Luxembourg), and the UK should ensure that repurchase of shares does not give rise to a UK stamp duty liability.

Income / capital in the hands of AHC and investors

The consultation considers whether repatriation of certain profits in the hands of investors (in particular individual investors) should be treated as capital and not income. Under the UK loan relationship rules, profits on loans received by the AHC, including loan premium (e.g. due to the improved credit worthiness of the borrower) are generally taxed as income profits under the UK loan relationship rules. Furthermore, premium repatriated up to non-corporate investors (e.g. individuals) is typically subject to tax on income under the deeply discounted securities rules. By contrast, in other regimes such as Luxembourg, premium on distressed debt is taxed as capital, and the AHC can achieve deductions on its premium received by using certain financial instruments (eg partial redemption of PECs and CPECs). A bespoke AHC regime should allow such profits to be taxed as capital in the AHC and at the level of the investor.

Withholding tax

As mentioned, HMT is proposing that the bespoke AHC regime should provide for an exemption on WHT on UK source interest. HMT is however concerned with abuse whereby investors could invest in the Fund through entities resident in tax havens (and thereby would not be taxed on income on receipt in the recipient jurisdiction).

In order to limit abuse, our favoured approach here would be to create a “blacklist” of countries in offshore jurisdictions, whereby interest payments by the UK AHC to entities resident in a blacklist jurisdiction would be subject to WHT on UK source interest. HMT can draw on comparisons found in other EU jurisdictions that have adopted WHT on interest payments to entities resident on the EU blacklist, and the Netherlands has in addition introduced its own blacklist, and which includes all low tax paying jurisdictions which has a corporation tax rate below 9%. Adopting a similar blacklist regime in the UK would be a simple factual test, and easy for Fund managers to administer. A purpose test could be used in addition, such that if investors have genuine commercial reasons for investing through a blacklist jurisdiction, they would not suffer WHT on UK source interest payments by the AHC. We do not propose a standalone purpose test, which would require the Fund manager to diligence their investors, something that would be time intensive for Funds with large numbers of investors.