In this article:
- Background to offshore investment funds and their tax treatment
- Reporting Fund Status
- Compliance requirements for offshore reporting funds
- The application process
- Ongoing requirements
- Transitional arrangements
The UK has a large number of authorised investment funds and these are common investment choices for UK tax residents. As with holdings in equity stocks, capital gains tax is payable on realised gains (i.e. a gain made when the investment is sold) on these securities. Capital gains are currently taxed at 20%.
The rules however are different for investments in offshore investment funds. UK funds have certain tax obligations with HMRC; whereas offshore funds aren’t subject to the same rules. HMRC’s position is as a result of the fact that they can’t always be certain whether a gain is of an income or capital nature.
The result of this is that any capital gains on offshore investment funds are taxable to UK investors as income rather than capital gains. This makes a big difference as the higher rate for income tax is 40% compared with 20% for capital gains.
Reporting Fund Status
For the reason above, many offshore funds with UK investors apply for ‘Offshore Reporting Fund’ status with HMRC. This confirms that the fund will comply with certain rules to essentially bring it in line with the rules for UK funds.
Funds which have this status can be treated as if they are onshore UK funds for UK tax payers. Any realised gains are therefore taxed as capital gains rather than income.
Compliance requirements for offshore reporting funds
The offshore fund must comply with a number of rules, including the requirement to have an independent audit.
A key requirement of UK funds is they have to pay out any excess income at least annually to investors. Funds generate income from their holdings in underlying securities and have expenses such as the annal management charge and depositary fee. Any net income has to be distributed and this is taxed as income for UK investors.
As offshore funds don’t have to make distributions in accordance with UK rules, this creates a mismatch between the offshore and UK requirements. As a result offshore reporting funds have to make a ‘deemed distribution’ for the purposes of retaining reporting fund status.
This deemed distribution starts with the calculation of ‘Reportable Income’ each year. This is a calculation aimed at mirroring what a distribution would have been had the fund been a UK onshore fund. The reportable income per share class is calculated and UK investors receive a report of this ‘deemed distribution’ which is used for their tax return.
UK investors have to pay income tax on the deemed distribution, even where they haven’t received any actual distribution from the fund. However the tax effect of this is generally small, compared to the savings made by treating the holding in the fund in line with capital gains tax rules.
In order to apply for reporting fund status, funds have to make an application to HMRC and send certain documents to them.
Applications must be made:
- the latter of 3 months after shares are available to UK investors, and
- end of the financial period for which the fund is to be treated as a reporting fund.
UK funds are prepared in accordance with UK GAAP or International Financial Reporting Standards. Offshore funds using other country accounting standards have to explain to HMRC on the application how they will convert the figures to be compliant.
Once approved the fund classes will appear on a public list maintained by HMRC of all offshore reporting funds.
Each year a submission is required within 6 months of the year-end with a calculation of reportable income and other disclosures to HMRC. This is needed to maintain offshore reporting fund status. UK investors must receive a report of their reportable income per share as they require this for their tax return.
The exception to this is a fund issuing Series classes. For funds which issue these, they have to confirm certain items to HMRC on their initial application. As long as the fund complies in this way, it can add the additional series classes to the annual submission each year without the need to undertake a fresh application each time.
For share classes which are converted from non-reporting to reporting fund classes, there are implications for UK investors. As non-reporting funds are subject to income tax and reporting funds are subject to capital gains tax, transitional rules are required.
UK investors holding an investment in a fund which converts from non-reporting to reporting have two options in this event:
- They can make an election to make a deemed disposal of their non-reporting fund shares. The effect of this is they have to pay income tax on any gains to date. If they haven’t actually sold their holding, then this could mean finding cash to pay tax on a gain which they haven’t yet crystalised in cash terms. However if they do this, any gains made after the election are subject to capital gains rather than income – so there are long-term benefits.
- If no election is made then there is no tax to pay at the point of conversion. However when the UK investor ultimately sells their shares in the fund, all the gain is subject to income tax rather than capital gains tax, even though the fund is now a reporting fund. So long-term, this option is less attractive.
The transitional rules are not particularly generous so if a fund has UK investors it is much better to have offshore reporting fund status from the start, rather than obtaining further down the line.
CAN WE HELP?
Shipleys helps a large number of offshore funds with both initial applications and ongoing reporting requirements. Please get in touch with our specialist Finance Services team if you would like further information or assistance.
Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary. If you would like advice or further information, please speak to your usual Shipleys contact.
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