Investment Funds 2024 Comparisons

The UK is regarded as one of the leading global asset management centres, with an investment funds industry covering both traditional and alternative asset classes. Due to having considerable experience and infrastructure, the UK is one of the most prominent jurisdictions for fund formations and has developed a sophisticated market, offering a range of both closed-ended and open-ended types of funds. The asset management industry is of vital importance to the UK's economy.

Within the UK market, alternative investment funds (AIFs) – as defined in the EU Alternative Investment Fund Managers Directive (AIFMD) and replicated in the UK's post-Brexit alternative investment fund manager (AIFM) legislation (UK AIFM Regime) – include private closed-ended funds, often structured as English or Scottish limited partnerships, which are commonly used for funds that focus on illiquid asset strategies (eg, private equity, venture capital, real estate, alternative credit and infrastructure funds). Listed closed-ended funds available for sale to the general public are also common, and are used for both liquid and illiquid asset strategies. The vehicles most often used are investment trust companies (ITCs) and, in the case of funds that intend to invest in real estate, real estate investment trusts (REITs).

Retail funds tend to be open-ended vehicles, which can be – from a regulatory perspective – either an undertaking for collective investment in transferable securities (UCITS) fund or a non-UCITS retail scheme (NURS). One of the key advantages of a UCITS fund is that it can be marketed to investors throughout the EU without the need for additional, local authorisation in each country, known as the UCITS marketing passport. Following Brexit, UK UCITS can no longer make use of this passport. A NURS provides a similar level of investor protection to that of a UCITS and allows the manager more flexibility in terms of the investments the fund can make.

In addition to the UCITS and NURS, there is also a more lightly regulated regime for institutional and certain other qualified investors: the qualified investor scheme (QIS).

The UK provides for a large number of open-ended vehicles that fall within these two categories, including authorised unit trusts (AUTs), open-ended investment companies (OEICs) and authorised contractual schemes (ACSs). Different authorisations apply, depending on the investments to be made. For example, OEICs that invest in real estate may be structured as property authorised investment funds (PAIFs), provided the relevant conditions are met, and OEICs that invest in unauthorised funds need to be authorised as funds of alternative investment funds (FAIFs).

An FCA-authorised manager must comply with the applicable FCA rules, which have been supplemented by the requirements of the UK AIFM Regime. A key requirement is that the manager must maintain a minimum amount of capital. The amount of capital is likely to be greater if the manager operates under the UK AIFM Regime or the EU MiFID. Other requirements applicable to the typical manager in this structure include:

• prudential requirements, including relating to its governance, the remuneration of key staff, and internal systems and controls;
• FCA approvals of personnel in key positions;
• requirements relating to the conduct of the manager's business, including relating to disclosures to investors and the regulator; and
• anti-money laundering checks, including due diligence checks on new investors.

The FCA-authorised manager must comply with the rules set out above and, to the extent that the UK AIFM Regime applies, must also ensure that certain requirements are met by the fund, such as:

• the appointment of a depositary to have custody of certain assets and/or verify title to privately held assets;
• adherence to organisational controls (relating to risk management, compliance and valuation, for example) and conduct of business rules (relating to due diligence, execution of orders and reporting, for example); and
• compliance with rules relating to companies in which the fund has a substantial stake.

The fund finance market in the UK is sophisticated and well developed, particularly for closed-ended private funds. The market includes a range of lenders, from banks to specialist debt funds, which offer finance solutions to funds and their GPs/managers. The most common product is a capital call facility, allowing the fund to draw money from the lender in anticipation of making a capital call from the fund's investors. The main advantage of this type of facility is that it will allow quick and efficient access to capital.

The fund documents (eg, the limited partnership agreement) will normally require at least ten business days' notice to be given to the investors prior to the date of any capital call, whereas the lender under a capital call facility will allow the money to be drawn on shorter notice. This type of arrangement therefore gives the GP/manager greater certainty of funding, particularly when the fund needs capital for investment purposes. It also allows the GP/manager to smooth out when capital calls are made to investors because the fund is able to make use of the facility for irregular cash requirements, such as fees and expenses.

Other types of fund finance have been developed in addition to capital call facilities, including:

• net asset value (NAV) facilities secured on the underlying assets of the fund;
• fund finance arrangements to unlock liquidity for investors; and
• facilities targeted at GPs/managers to assist team members to participate in any “GP commitment” requirements.

Despite the developments in the market, the general principle for closed-ended private funds in the UK is that investors will not want the fund to be leveraged. This is particularly the case for a private equity fund because the investment strategy of the fund itself normally includes leveraged buyouts, so investors will not want a double layer of leverage (ie, at both the fund level and the investment level). Therefore, the limited partnership agreement in a closed-ended private fund will normally impose restrictions on the amount of leverage that may be incurred by the fund (for example, the lower of 20% of commitments made by investors and the amount of uncalled commitments), and any borrowing incurred must be on a “short-term” basis.

Furthermore, under the AIFMD, any fund that incurs leverage (short-term borrowing is excluded for these purposes) is subject to additional disclosure requirements, and the AIFM is required to observe a higher degree of regulation. As a consequence, it is important for common forms of fund finance (eg, capital call facilities) to adhere to both the investor-imposed and regulatory-imposed requirements.

It would be usual for the lender of a capital call facility to take some form of security. A common approach would be for the lender to have the right to require the GP/manager to drawdown from investors to pay any outstanding indebtedness under the facility. It is even possible for the lender to step into the shoes of the GP/manager and issue drawdown notices directly to the investors. For this to be possible, the lender must be assigned the right to issue these drawdown notices under the limited partnership agreement of the closed-ended private fund. This can give rise to negotiation with investors as to whether they are required to counter-sign security documents. A possible compromise is that the investor signs an acknowledgment that the right to drawdown has been assigned to the lender without the investor being a direct party to the security arrangements. An additional issue is whether the fund or investors are required to provide information to lenders. As a general rule, investors will not want to provide non-public information.

General

Different tax regimes apply to the different forms of UK investment fund. These are complex, and a detailed summary of them is beyond the scope of this chapter, but a high-level overview of some of the key direct tax features of common UK fund structures (at both fund and investor level) is set out here for AIFs and under 3.6 Tax Regime. Please note that the features described are necessarily general and may not apply in certain cases – eg, depending on the assets held by the fund or the circumstances of particular investors.

As a general point, the tax structuring preference of an investor will depend on its particular identity and the asset class or classes in which the fund invests. Many funds will have a wide mix of different types of investors (eg, UK resident corporates – such as life assurance companies – and individuals, sovereign wealth funds and pension funds). Fund managers will then usually look to structure the fund so as to be tax efficient for the investor base as a whole rather than a particular investor or class of investor (unless, of course, a particular investor or class is especially important or has been specifically targeted).

A key issue for all investors will typically be tax neutrality when investing through a fund (wherever that fund is established) – ie, they will not want that investment to leave them in a worse tax position than they would be in if they directly held the underlying assets instead. Investors will also commonly not want to be subject to tax filing obligations in new jurisdictions solely because of their investment in the fund, or, if that is not possible, they will commonly want to be made aware of the relevant filing obligations by the fund manager. Another factor for investors when investing in funds (wherever the funds are located) is a wish to minimise withholding taxes on their returns from the fund, due, if nothing else, to the administrative and cashflow cost.

From a UK tax perspective, a further important issue will be whether the fund would be considered to be trading. This can be relevant at both fund and investor level, as the tax privileges for certain UK fund types and investor classes do not extend to trading profits (eg, UK-registered pension schemes are generally exempt from tax on their investment income and capital profits but this exemption does not apply to trading profits). This can have an impact on the chosen structure. Similar concerns can arise for investors in other jurisdictions.

Private Closed-Ended Funds Structured as English Limited Partnerships

Tax position of the fund and investors

As mentioned in 2.1.1 Fund Structures, the typical structure of a UK private equity or venture capital fund is the English limited partnership. These are transparent for UK direct tax purposes, which means that each limited partner is subject to tax on the income and gains allocated to it under the limited partnership agreement (whether they are distributed or not), rather than the limited partnership itself being taxable on its income and gains.

The taxation of investors on their share of the limited partnership's income and gains depends on the nature of the underlying return that the partnership has received (eg, capital gain, interest, rent or dividend) and the investor's own tax status.

English limited partnerships typically make payments to limited partners in the form of repayment of the loan element of the limited partners' partnership contribution and distribution of partnership profits. No UK withholding taxes should apply to such payments.

Listed Closed-Ended Funds – ITCs

Tax position of the fund

Companies with ITC status are subject to UK corporation tax, but (if certain conditions are met) are exempt from tax on capital gains and on profits of a capital nature from their derivative contracts and their creditor loan relationships. ITCs are also able to benefit from an elective interest streaming regime, which allows them to treat certain dividends to investors as interest distributions, enabling the ITC to claim a corporation tax deduction in respect of the interest distribution (if certain conditions are met). As a UK company, an ITC can also potentially benefit from the general UK company exemption from tax on dividends and other distributions received.

No withholding tax should apply to dividends paid to investors by ITCs, including interest distributions if the ITC enters into the elective interest streaming regime mentioned above.

Tax position of the investor

Investors in an ITC will be taxed on distributions (other than interest distributions) from an ITC in the same way as dividends from normal companies. Therefore, UK tax resident individuals will be subject to income tax, at rates of up to 39.35%, and corporation taxpayers can potentially benefit from the general UK company exemption from tax on dividends.

Interest distributions are, broadly, treated as interest receipts, so UK resident individuals will be subject to income tax (at rates of up to 45%), and corporation taxpayers will treat such distributions as if they were interest receipts under a loan relationship under the corporate loan relationship rules.

Listed Closed-Ended Funds – REITs

Tax position of the fund

A REIT is tax opaque but, if certain conditions are met, benefits from an exemption from UK tax on profits and gains from its property rental business (PRB). Conditions with which a REIT must comply include that, broadly, at least 75% of its profits must come from its PRB, at least 75% of the total value of its assets must relate to its PRB, and it must distribute at least 90% of its PRB income within 12 months of the end of the accounting period in which it arose. There is no requirement for a REIT to distribute capital gains. Other detailed REIT conditions apply in the tax legislation, which also need to be considered.

Distributions by REITs in respect of the profits and gains of their PRB are known as property income distributions (PIDs) and should be paid subject to withholding tax at the basic rate (20%), unless an exemption applies (eg, if the REIT has a reasonable belief that the person beneficially entitled to the payment is a company that is resident in the UK for corporation tax purposes).

REITs are subject to corporation tax in the usual way on any non-PRB profits (eg, trading profits). These can be paid out as dividends, without withholding tax.

Tax position of the investor

For corporation tax and income taxpayers, PIDs are generally treated as UK property income (ie, they are not treated as normal company distributions), so UK resident individuals are subject to income tax on them (at rates of up to 45%), and credit should be given for any tax withheld on payment of the PID by the REIT. Corporation taxpayers will treat them as taxable income. Depending on its particular circumstances, a non-resident investor may be able to reclaim under a double tax treaty all or part of any tax withheld from PIDs paid to it.

Other distributions of profits by REITs are taxed as dividends in the normal way. Therefore, UK tax resident individuals will be subject to income tax at rates of up to 39.35%, and corporation taxpayers can potentially benefit from the general UK company exemption from tax on dividends.

The FCA Handbook sets out stringent requirements as to the operation of authorised retail funds, including that a depositary must be appointed. The fund must also establish and apply remuneration practices and policies, and publish its remuneration policy.

There are also restrictions on authorised retail funds in relation to borrowing and the types of investments such funds can make. NURS have greater flexibility, with differing borrowing and investment restrictions, and are popular for real estate investment through the PAIF structure.

UCITS funds are subject to prescriptive rules on borrowings, as prescribed under the UCITS Directive.

A UCITS is permitted to borrow money for use by the fund, provided it will be repaid out of the scheme property and does not conflict with any restrictions on borrowing that may have been included in the fund’s Instrument of Incorporation. This borrowing is permitted purely on a temporary and infrequent basis, and must not exceed 10% of the total value of the fund’s assets on any day. Prior consent for any borrowing must be obtained from the depositary, or for periods of borrowing that may exceed three months.

The same 10% borrowing limit applies for NURS, but there is no restriction on the length of time for which a NURS may borrow. QISs have the ability to borrow up to 100% of the fund's NAV. Where derivatives are used, a QIS must ensure that its total exposure to derivatives does not exceed its NAV.

General

See 2.6 Tax Regime (General).

OEICs (Other than PAIFs) and AUTs

Tax position of the fund

OEICs and AUTs are subject to UK corporation tax, but are exempt from tax on chargeable gains from the disposal of assets (provided that the gains do not represent profit on trading transactions). Furthermore, if these funds satisfy the “genuine diversity of ownership” condition (GDO), then certain capital profits from investment transactions should be treated as exempt capital gains. For the GDO to be met, the fund must be sufficiently widely marketed. An LTAF can also be treated as meeting the GDO if at least 70% of its shares or units are held by certain institutional investors (or by the manager of the fund in its capacity as manager). Failure to meet the GDO has wider consequences for QISs and LTAFs, such that, broadly, they are taxed under normal corporation tax rules rather than the (more generous) ones that typically apply to authorised funds.

OEICs and AUTs can also potentially benefit from the general exemption from corporation tax on dividends.

OEICs and AUTs must allocate for distribution as dividends or interest the total amount available for income allocation. An OEIC or AUT can only show an amount as available for distribution as interest if it meets the qualifying investments test (such funds are often called “bond funds”). It meets this test, broadly, if the market value of investments that produce interest (or a return similar to interest) exceeds 60% of the market value of the fund’s total investments. If this test is met, the distribution is generally allowable as a deductible expense for the fund for corporation tax purposes.

The net effect of the tax deduction is that bond funds should typically have little to no tax leakage at the level of the OEIC/AUT. If the qualifying investments test is not met, then all of the income available for distribution must be classed as dividends (and there would be no corresponding deduction for such payments by the fund to the extent interest is included in such distribution). Whether or not any corporation tax will be payable for a fund that does not meet the definition of a bond fund therefore depends on the level of interest income and deductible management expenses. Any corporation tax paid by an OEIC or AUT is not creditable for investors.

No withholding tax should apply to distributions paid to investors by OEICs or AUTs.

Because their income profits are taxable at the basic rate of income tax, OEICs and AUTs are “subject to tax” for double tax treaty purposes. As such, they can benefit from the UK’s extensive network of double tax treaties, which can help reduce withholding taxes in other jurisdictions and assist in claiming credit for foreign taxes incurred on foreign sources of income.

It is possible for OEICs and AUTs to elect to be treated as “tax elected funds”, which would modify the tax treatment relating to OEICs and AUTs from that discussed above. However, in practice, the uptake of this regime has been low, so it is not discussed further here. The regime is most appropriate for funds with a mis of debt and equity investments that do not qualify for bond fund treatment.

Tax position of the investor

UK tax resident individuals will be taxed on dividend distributions in the same way as for dividends they receive from normal companies. Therefore, UK tax resident individuals will be subject to income tax, at rates of up to 39.35%.

However, for UK corporation taxpayers, the normal dividend distribution rules do not apply (ie, that dividends received from a UK corporate are usually tax exempt in the hands of a UK corporate taxpayer). Instead, special anti-avoidance rules need to be considered (called the corporate streaming rules), which are designed to prevent corporate investors using OEIC or AUT structures to convert interest-type income into exempt dividend income. The rules are complicated, but in general terms dividend distributions are streamed into franked and unfranked parts following a formula set out in the legislation. In effect, the aim is to tax corporate investors as if they had invested in the underlying assets of the OEIC or AUT directly.

Interest distributions are, broadly, treated as interest receipts, so UK resident individuals will be subject to income tax (at rates of up to 45%).

Corporation taxpayers are required to treat their units in bond funds as creditor loan relationships for the purposes of the corporation tax rules relating to corporate debt.

PAIFs

Tax position of the fund

As mentioned above, OEICs that invest in real estate can be structured as PAIFs (provided the necessary conditions are met). PAIFs are subject to a significantly modified version of the OEIC tax regime described above. An important extra benefit of the PAIF status is that, broadly, a PAIF (unlike a normal OEIC) is exempt from corporation tax on the net income of its property investment business.

Special streaming rules apply to PAIFs. Broadly, the total amount available for income allocation by a PAIF must be split into three pools comprising property income distributions, interest distributions and dividend distributions. Interest distributions should be deductible expenses for the PAIF when calculating the net income of the non-tax exempt part of its business.

Payments of property income distributions are subject to withholding tax (currently at 20%), unless an exemption applies (for example, if the PAIF has a reasonable belief that the person beneficially entitled to the payment is a UK tax resident company). Depending on its particular circumstances, a non-UK resident investor may be able to reclaim under a double tax treaty all or part of any tax withheld from property income distributions paid to it. No withholding tax should apply to payments of interest or dividend distributions.

Tax position of the investor

In relation to PAIFs, broadly, for recipients, property income distributions are taxed as profits of a UK property business, so UK resident individuals are subject to income tax on them (at rates of up to 45%), and credit should be given for tax withheld on payment of the PID. Corporation taxpayers will treat them as taxable income.

Interest distributions are, broadly, treated as interest receipts, so UK resident individuals will be subject to income tax (at rates of up to 45%), and corporation taxpayers will treat them as taxable income under the loan relationship rules.

Dividend distributions are taxed as dividends on shares in the normal way. Therefore, UK tax resident individuals will be subject to income tax, at rates of up to 39.35%, and corporation taxpayers can potentially benefit from the general UK company exemption from tax on dividends.

ACSs

Tax position of the fund

ACSs can take the form of either co-ownership schemes (CoACSs) or limited partnerships. However, the tax discussion in this chapter is confined to CoACSs, which is the more common ACS structure.

A CoACS is not subject to tax in the UK as it is not a body corporate and has no legal personality.

Distributions to investors from CoACSs should generally not be subject to withholding tax (although withholding may be required if a CoACS has UK property income and non-UK resident investors).

Tax position of the investor

From the perspective of a UK investor, CoACSs are transparent with respect to income from a tax perspective but are treated as opaque with respect to the taxation of capital gains.

For the purposes of tax on income, investors in a CoACS are therefore treated as if they directly received the income arising from its assets. Accordingly, the tax treatment of an investor in relation to such income will depend on the investor's own tax position.

For capital gains purposes, an investor's interest in the underlying assets of the CoACS is disregarded and instead its holding of units in the scheme is treated as an asset. This simplifies the computation of the participant’s chargeable gains or losses as they are regarded as having a single asset rather than many separate assets, and they can only incur a chargeable gain or loss on a disposal of their interest in the fund. The rules for computing chargeable gains and losses generally operate in the normal way, as they would for shares and securities.

Following the end of the Brexit transition period, the UK government has placed considerable emphasis on the potential opportunities it sees to create what it hopes will be a more competitive financial services sector post-Brexit, while preserving high regulatory standards tailored to the UK's needs. There were substantive developments in this area in 2022 and 2023.

In April 2022, the UK introduced a competitive new tax regime for qualifying asset holding companies (the UK QAHC Regime). The QAHC Regime is an elective tax-privileged regime available to certain UK resident asset holding companies that are owned by funds or institutional investment structures in order to hold investment assets. The main focus of the regime is on alternative fund structures, which are typically closed-ended, non-retail funds that hold assets across a range of private market investment strategies – chiefly credit, private equity and real estate investments. The QAHC Regime is designed to improve the competitiveness of the UK as a location for asset holding companies by better enabling the tax-efficient flow of income and gains from the underlying investments back through the fund structure to investors so that, for UK tax purposes, investors are broadly taxed as if they had directly invested in the underlying assets with the QAHC paying tax only on a small transfer-priced margin to reflect the activities that it performs. For non-UK fund structures, a UK QAHC has the advantage that substance (which is becoming increasingly important) can easily be achieved where the investment management team is in the UK.

In broad terms, in order to qualify as a QAHC a company needs to be at least 70% owned by:

• qualifying investment funds – ie, funds that:
1. are widely held;
2. are closely held but held by certain categories of institutional investors (such as most pension funds); or
3. meet a diversity of ownership condition; or
• certain institutional investors directly.

There is also a requirement that the QAHC does not carry out trading activities.

On 27 April 2023, the UK government published a consultation seeking views on the potential introduction, scope and design of a tax regime for a new type of unauthorised contractual scheme fund structure, referred to as a reserved investor fund (contractual scheme) (RIF). As an unauthorised contractual scheme, the RIF would be a collective investment scheme under the FSMA. Under the UK’s regulatory regime, the manager of an AIF – in this instance a RIF – must be authorised by the FCA as a full-scope UK AIFM or a small-authorised UK AIFM, or must be registered with the FCA as a small-registered UK AIFM. The consultation closed on 9 June 2023.

On 29 June 2023, the Financial Services and Markets Act 2023 (FSMA 2023) was enacted. Among other things, the FSMA 2023 is intended to implement the findings of HM Treasury’s Future Regulatory Framework (FRF) Review. Launched in light of Brexit, the FRF Review was described by UK Finance as “a once in a generation assessment of the legislative framework in which the financial services regulators operate”. The changes implemented by the FSMA 2023 will involve the revocation of the huge body of EU law that the UK essentially inherited when it left the EU, to be replaced by domestic rules. The provisions will come into force over several years on dates appointed by HM Treasury in statutory instruments.

Reform proposals designed to re-energise capital markets were also published in 2022. In July 2022, HM Treasury published the outcome of the UK Secondary Capital Raising Review, which followed on from the 2021 Lord Hill review recommendations and subsequent call for evidence and looked at ways in which to improve the secondary fundraising process for UK listed companies so that it is cheaper, quicker and more efficient. As of November 2023, the government has accepted all the recommendations addressed to it and is considering how to take the proposals forward.

In December 2022, the UK Chancellor of the Exchequer announced a series of wide-ranging reforms to the financial services sector in the UK, to take effect over the next few years (referred to as the Edinburgh Reforms), which include the legislation and regulation relevant to alternative funds, retail funds and their managers. Key measures announced include the repeal of the UK PRIIPs Regime; draft legislation was proposed on 22 November 2023.

Finally, on 26 October 2023, certain proposed amendments to the LP Act 1907 were published, by way of the Economic Crime and Corporate Transparency Act 2023 (ECCTA 2023). ECCTA 2023 implements a number of changes to the legislation on limited partnerships and creates new offences and penalties, including criminal sanctions, against the partners of limited partnerships in certain circumstances. The key changes include:

• requiring more information about the partners to be filed, including on individual limited partners (although it will not all be publicly available), and controls on who can file the information by requiring certain filings to be made by an authorised corporate service provider (which is subject to anti-money laundering regulations);
• requiring limited partnerships, both new and existing, to have a firmer connection to the part of the UK in which they are registered (by having to maintain its registered office there, as distinct from its principal place of business);
• requiring all UK limited partnerships (not just Scottish limited partnerships) to file confirmation statements confirming that the information held about them on the register is correct; and
• enabling the deregistration of a limited partnership in certain circumstances.