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This article explains the changes to the UK tax regime applying to offshore funds following changes effected in December 2009.

Background

The offshore fund tax regime was first introduced for UK investors in 1984. Its main aim was to ensure that UK tax residents were unable to accumulate income in an offshore fund to avoid paying income tax so that they would only pay tax on the capital gains made from the fund on the eventual disposal.

The original UK tax regime introduced in 1984, defined two categories of offshore funds for UK taxation:

'Distributor Funds' where either at least 85% of the income of the fund (or at least 85% of the UK equivalent profit of the fund if higher) was distributed (or paid out to investors) and all distributions (whether capital or income) were subject to capital gains tax.

'Non-Distributor Funds' meant any fund where less than 85% of the fund was distributed as income. All income and capital for non-distributor funds was subject to income tax.

The distributor funds therefore had the preferred capital gains tax treatment and became a popular choice with investors.

What is an offshore fund?

The Income and Corporation Taxes Act (ICTA) 1988 first attempted to define an offshore fund for tax purposes within its definition of a material interest in an offshore fund (Section 759 (1)). This gave scope for the recognition of further regulatory definitions of assets that could qualify. The most recent definition of an offshore fund was included in the Finance Act 2008 and is more characteristics based.

In summary, an offshore fund may be defined as a non-UK collective investment scheme* subject to certain exceptions. The full legal definition of offshore fund can be found is Section 756A of the Finance Act 2008 .

* A “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income, as defined in Section 235 of the Financial Services and Markets Act 2000.

The current tax regime

Since 22 December 2009, distributor and non-distributor funds were replaced with 'reporting funds' and 'non-reporting funds'. This new regime provides that preferential tax treatment will apply to the offshore fund if its income is reported to UK investors in such a way that UK investors are taxed on their share of the ‘reported income’ (regardless of whether that income is distributed or accumulated).

Reporting funds are offshore funds where:

  • An application has been made and approved by HMRC of reporting fund status.
  • The fund manager has agreed to an undertaking:

 - to meet certain conditions in respect of fund reporting to HMRC and any UK investors for each accounting period; and 
 - to provide other information to HMRC on their reasonable request.

Unlike distributor funds, where the fund manager has to apply for distributor status each year, once reporting status has been granted for a reporting fund, the status remains while the fund complies with the undertaking.

A UK investor’s share of the reported income (based on the share of investment in the fund) will be assessable as income for income tax (or corporation tax for companies) whether that income is distributed or not, but all further disposals made by the UK investor will be assessed as capital for capital gains tax (or corporation tax for companies).

Example

Jane is a UK resident. She purchases 100,000 units in X Equity Fund, a Guernsey open-ended investment company, on 1 May 2011 for £2.50 per unit (£250,000).

The fund’s aim is to provide a mix of income and capital growth. It has a policy of distributing 25% of its income to investors and accumulating the rest. The fund prepares its accounts to 31 December each year, and makes distributions on 31 March. It sends a report to each of its investors electronically on 1 May each year (containing the information required by its undertaking including details of actual distributions and the ‘excess’ of reported income per unit over the sums actually distributed). The fund is not a bond fund.

Jane received the following distribution and notification of the 'excess of the reported income' in the form of accumulated income for the 2012/13 tax year:

Period ending

Sum distributed (Reported income)

Date distributed

Income accumulated (Reported income)

Date reported

31/12/2012

£2,100

31/03/2013

£6,300

01/05/2012

         


She will pay income tax on both the distributed income (£2,100) and the ‘excess’ income accumulated within the fund (£6,300) as this represents her share of the reported income.

The current offshore fund tax regulations are contained in two statutory instruments The Offshore Funds (Tax) Regulations 2009 S.I. No 3001] and [The Offshore Fund (Tax) (Amendment) Regulations 2009 S.I. No. 3139 effective from the 1st and 22nd December 2009 respectively.

New regime versus old regime

So what are the benefits and considerations of reporting funds compared to distributor funds and non-reporting funds compared to non-distributor funds?

Reporting Funds

Non-Reporting Funds

Benefits

Considerations

Benefits

Considerations

No fixed distributed income amount

Income tax is payable on reported income whether this is distributed or not

The tax treatment remains the same as non-distributor funds

Previous distributor funds may choose to become non-reporting funds

All disposals are subject to Capital Gains Tax

All reported income is subject to income tax

One tax regime for all income and capital

All disposals are subject to income tax

Offset against tax paid on reported income from future disposals of the same income

More onerous accounting/ paperwork required as to what tax previously paid

Paperwork remains the same

 

A facility for advanced election for reporting fund status - greater certainty of tax treatment

Requirement to submit annual reports remains

No requirement to obtain tax status - automatically non reporting unless elected

 

Consideration of only one layer of funds for reporting purposes

 

 

 

Better guidance on reporting breaches

 

 

 

Comparison of tax on Offshore Bonds and Offshore Funds held by a UK investor

We can also consider how investing in an offshore bond compares with investing directly into offshore funds.

 

Offshore Bond

Reporting Funds

Non-Reporting Funds

Annual tax return?

No

Yes

Possible

Tax based on

Capital returns when arising or end of policy year for part surrenders (Income tax)

Reported income (income tax) and capital gains on disposals (CGT)

Income distributed and gains on disposal (Income tax)

Rates of Income Tax

Up to 45%

Up to 52.5%*

Up to 52.5%*

Rates of Capital Gains Tax

Not applicable

28%/18%**

Not applicable


*Up to 52.5% for dividend income (42.5% + 10% tax credit) and Up to 45% for other income (and gains where relevant).
**28% rate applies to higher rate and additional rate taxpayers, trustees of UK resident trusts.

This article has highlighted the different types of offshore funds and how they are taxed. It is essential when considering what type of investment is appropriate, to include the tax treatment and reporting obligations of each investment. Of course, this is only one aspect and other areas, such as investment aims of the client, their attitude to risk and their other financial planning needs must also be considered.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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