Contributed By Travers Smith LLP
As mentioned above, there are a variety of different UK fund structures available. Various different tax regimes apply to them. These are complex, and a detailed summary of them is outside the scope of this chapter, but a high-level overview of some of the key direct tax features of common UK fund structures (both at fund and investor level) are set out below. Please note that the features described below are necessarily general and may not apply in certain cases, for example depending on the assets held by the fund or the circumstances of particular investors.
1) Overview of tax status of common UK fund structures
a) Private closed-ended funds structured as English limited partnerships
As mentioned above, 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. This means that each limited partner is subject to tax on the income and gains allocated to it under the limited partnership agreement (whether or not they are distributed).
English limited partnerships typically make payments to limited partners in the form of repayment of the loan element of the limited partners' partnership contributions and distribution of partnership profits. No UK withholdings taxes should apply to these payments.
b) Listed closed-ended funds
Companies with ITC status are subject to UK corporation tax, but (provided certain conditions are met) are exempt from tax on capital gains and 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 an ITC to treat certain dividends to investors as interest distributions, enabling the ITC to claim a corporation tax deduction in respect of the interest distribution (provided certain conditions are met). One of the conditions for ITC status is that, broadly, it must not retain in respect of an accounting period more than 15% of its income for that period. As a UK company, an ITC can also potentially benefit from the general UK company exemptions from tax on dividends.
No withholding tax should apply to dividends paid to investors by ITCs, including, if the ITC enters into the elective interest streaming regime mentioned above, interest distributions.
A REIT is tax opaque but, provided certain conditions are met, benefits from an exemption from UK tax on profits and gains from its property rental business. Conditions with which a REIT must comply include that, broadly, at least 75% of its profits must come from its property rental business, at least 75% of the total value of its assets must be from assets relating to its property rental business, and it must distribute at least 90% of its property rental business profits.
Distributions by REITs in respect of the profits and gains of their property rental business are known as property income distributions (PIDs) and should be paid subject to withholding tax, unless an exemption applies (for example, if the REIT has a reasonable belief that the person beneficially entitled to the payment is subject to UK corporation tax).
Withholding tax should not apply to other distributions of profit paid by REITs.
c) Open-ended funds
OEICs and AUTs are subject to UK corporation tax, but are exempt from tax on chargeable gains from disposal of assets. Furthermore, if these funds are marketed sufficiently widely (so that they satisfy the “genuine diversity of ownership” condition), then certain capital profits from investment transactions should be treated as exempt capital gains. 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 (these funds are often called “bond funds”). It meets this test, broadly, if the market value of investments which 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. If the qualifying investments test is not met, then all of the income available for distribution must be classed as dividends.
No withholding tax should apply to distributions paid to investors by OEICs or AUTs.
It is possible for OEICs and AUTs to elect to be treated as "tax elected funds". This would modify the tax treatment relating to OEICs and AUTs from that discussed in this Chapter. However, the uptake of this regime has in practice been low and so it is not discussed further here.
As mentioned above, OEICs which 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 PAIF status is that, broadly, a PAIF 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 of property income distributions, interest distributions and dividend distributions. Interest distributions may 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 subject to UK corporation tax). No withholding tax should apply to payments of interest distributions or dividend distributions.
As mentioned above, 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, the more common ACS structure. CoACSs are transparent for the purposes of taxation of income and are not subject to taxation of chargeable gains. 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-resident investors).
d) Carried interest
Carried interest in relation to a private closed-ended fund structured as an English limited partnership is typically held via a separate limited partnership which becomes a limited partner in the main fund limited partnership. The UK tax treatment of carried interest is complicated, but the basic starting position is that once the hurdle has been reached and the carried interest kicks-in, carried interest participants pay tax depending on the nature of the profits allocated to them (eg, dividend, interest, gain or return of capital). However, there is a minimum special tax rate of 28% that applies to all carried interest returns regardless of their nature. In addition, various rules can apply which can result in carried interest being taxed as trading or employment income (at rates of up to 45% plus national insurance contributions) eg, under the "income based carried interest" rules, broadly, carried interest returns can be taxed wholly or partly as trading income if the fund's average holding period of its underlying investments is less than 40 months.
2) Overview of tax position of investors in common UK fund structures
a) Private closed-ended funds structured as English limited partnerships
As mentioned above, a UK limited partnership is transparent for UK direct tax purposes. Each investor is treated as owning their share of the partnership's assets, and is subject to tax on the income or gains allocated to it under the limited partnership agreement, whether or not distributed. The taxation of returns depends on the nature of the underlying partnership profit (and the investor's own tax status).
b) Listed closed-ended funds
Investors in an ITC will be taxed on distributions (other than interest distributions) from it in the same way as for normal companies. Therefore, UK tax resident individuals will be subject to income tax (at rates of up to 38.1%) and corporation taxpayers can potentially benefit from the general UK company exemption from tax on dividends. Interest distribution 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 a receipt of taxable income.
For corporation tax and income tax payers, PIDs are generally treated as UK property income. UK resident individuals are therefore 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.
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 38.1%) and corporation taxpayers can potentially benefit from the general UK company exemption from tax on dividends.
c) Open-ended funds
UK tax resident individuals will be taxed on dividend distributions in the same way as for normal companies. Therefore, UK tax resident individuals will be subject to income tax (at rates of up to 38.1%). The position for UK corporation taxpayers that receive dividend distributions is complex and is not considered further here.
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 should treat them as taxable income.
In relation to PAIFs, broadly, for recipients, property income distributions are taxed as profits of a UK property business. UK resident individuals are therefore 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. 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 38.1%) and corporation taxpayers can potentially benefit from the general UK company exemption from tax on dividends.
For income tax purposes, a CoACS is transparent and investors are treated as if they directly received the income arising from its assets. Accordingly, the tax treatment of an investor in relation to this income will depend on the investor's own tax position.
For capital gains purpose, 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.
The UK has one of the world's largest networks of double tax treaties. Whether or not a fund itself can benefit from protection against taxation under the terms of a treaty will depend on various factors, including the terms of the treaty itself and the particular circumstances of the fund. Tax opaque funds may be able to benefit from this protection (for example, an ITC may be able to rely on the terms of a double tax treaty to reduce or eliminate overseas withholding tax which would otherwise apply to dividends or interest it receives).
In relation to certain tax transparent funds, it may be possible for investors to benefit from treaty protection in relation to amounts received by the fund. Whether this protection is available will depend on a number of factors, including, the terms of the relevant treaty and the particular circumstances of the fund and relevant investor.
Generally, the UK does not tax non-resident investors on gains made from investments in UK funds or dividends received from these funds, other than in certain circumstances where the fund invests in UK real estate. In cases where the UK does potentially tax non-resident investors, it may be possible for an investor to rely on the provisions of a double tax treaty to reduce or eliminate this taxation, for example, in relation to withholding tax on a PID paid by a REIT. Whether or not relief is available will depend on a number of factors, including, the terms of the relevant treaty and the particular circumstances of the relevant investor.
The UK has entered into a Model 1 Intergovernmental Agreement with the US, which implements FATCA in the UK. Compliant UK funds will not be subject to, nor will they have to operate, any FATCA withholding taxes. The OECD Common Reporting Standard (CRS) and the EU Directive on administrative co-operation in the field of taxation (DAC) have also been implemented into UK law. Relevant UK funds have to carry out due diligence and reporting on their investors under both regimes (FATCA and CRS/DAC), and will then have to report information about these investors to the UK tax authority.
The tax structuring preference of an investor will depend on its particular circumstances and the asset class or classes in which the fund invests. Funds will commonly have a wide mix of different types of investors (eg, UK-resident corporates and individuals, sovereign wealth funds and pension funds) and fund managers will 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 a particular investor or class is particularly important).
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 if they directly held the underlying assets. 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 that is typically important for investors when investing in funds (wherever the funds are located), is a wish to minimise withholding taxes on their returns from the fund.
From a UK perspective, an important issue will be whether the fund would be considered to be trading. This can be relevant both at fund and investor level, as, for certain UK fund types and investor classes, their tax privileges 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).