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Standing Committee Debates

Draft Authorised Investment Funds
(Tax) Regulations 2006

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First Standing Committee
on Delegated Legislation

The Committee consisted of the following Members:


Mr. Mike Weir

†Austin, Mr. Ian (Dudley, North) (Lab)
Burt, Lorely (Solihull) (LD)
†Cable, Dr. Vincent (Twickenham) (LD)
†Engel, Natascha (North-East Derbyshire) (Lab)
†Hall, Mr. Mike (Weaver Vale) (Lab)
†Keen, Alan (Feltham and Heston) (Lab/Co-op)
†Lewis, Mr. Ivan (Economic Secretary to the Treasury)
Raynsford, Mr. Nick (Greenwich and Woolwich) (Lab)
†Reed, Mr. Andy (Loughborough) (Lab/Co-op)
†Selous, Andrew (South-West Bedfordshire) (Con)
†Simon, Mr. Siôn (Birmingham, Erdington) (Lab)
Stanley, Sir John (Tonbridge and Malling) (Con)
†Tami, Mark (Alyn and Deeside) (Lab)
†Vara, Mr. Shailesh (North-West Cambridgeshire) (Con)
†Villiers, Mrs. Theresa (Chipping Barnet) (Con)
†Walker, Mr. Charles (Broxbourne) (Con)
†Watson, Mr. Tom (Lord Commissioner of Her Majesty’s Treasury)
Frank Cranmer, Mark Oxborough, Committee Clerks
† attended the Committee

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Wednesday 15 March 2006

[Mr. Mike Weir in the Chair]

Draft Authorised Investment Funds
(Tax) Regulations 2006

2.30 pm

The Economic Secretary to the Treasury (Mr. Ivan Lewis): I beg to move,

    That the Committee has considered the draft Authorised Investment Funds (Tax) Regulations 2006.

It is a real pleasure to serve under your chairmanship, Mr. Weir—a pleasure that I have not had in the past. As a former Education Minister, I am not sure whether I am happier being here talking about authorised investment than in the Chamber talking about education reforms.

The regulations are important. People have been waiting for a considerable time to see the direction of travel of the policy, so I hope that the debate will clarify exactly where the Government want to go on these issues. Authorised investment funds are unit trusts and open-ended investment companies that are authorised and regulated by the Financial Services Authority. The draft regulations before us for the approval of the Committee set out the detailed tax arrangements for the funds. The aims are to consolidate and to streamline existing rules, and to introduce changes to respond to the FSA’s major changes to the regulatory rules for the funds.

The existing tax rules are in a disparate mix of primary legislation and regulations which have arisen as a result of organic growth and modification of legislative, regulatory and market changes over 40 years. That has made the tax rules unwieldy and difficult to navigate and use, and more changes are needed to accommodate the new FSA regulatory regime for authorised funds, which is known as COLL. We are therefore taking the opportunity provided by the latest need for change to simplify and consolidate the detail of the tax regime for authorised investment funds into a single set of regulations.

We believe that the consolidation will benefit investors and fund providers as well as those who have to deal with their tax liabilities. I stress that the regulations address the detail of the operation of the tax rules. The main taxing and relieving provisions remain under primary legislation and were subject to extensive debate during the passage of the second Finance Act 2005 through Parliament.

The aims behind the regulations fall into three broad categories: first, to consolidate and update the mixture of regimes for taxing authorised investment funds and their investors; secondly, to enable gross payment of interest distributions to United Kingdom resident non-taxpayers; and, thirdly, to provide special rules for taxing certain investors in the new qualified
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investor schemes—QISs. In line with the Government’s policy to tackle tax avoidance, we have also taken the opportunity provided by the introduction of the regulations to make it clear that avoidance that seeks to gain an unintended tax benefit by attempting to insert an authorised fund into a group of companies does not work. We are taking such action in response to disclosures made by scheme arrangers under the avoidance disclosure rules that were introduced in 2004.

The first main aim of the regulations is consolidation. I am sure that members of the Committee will agree that that is a positive development consistent with the Government’s aim to deregulate and simplify. It also provides an easier framework for everyone to understand, and investment managers have generally welcomed it. The second aim is to extend the categories of investors who can receive interest distributions gross. That will allow UK investors who are not liable for income tax to receive their interest distributions without deduction of tax and will remove the need for the investors to make claims each year for repayment of tax.

Investors have been asking for such measures for some time and it puts them on the same footing as non-resident investors in funds who have always been able to receive the payments gross. It also aligns the treatment of fund interest distributions with bank and building society interest. Investors will be familiar with the process for claiming gross payment, as it will be similar to the popular and successful facility that has been in place for some years for bank interest.

Funds already have to make payment gross to non-resident investors, so they will be familiar with the processes involved, too. To allow fund managers time to overhaul and update their systems to accommodate the extension, the start date for gross payment to UK non-resident taxpayers is 6 April 2007.

The other main aim of the regulations is to provide special rules for the taxation of certain investors in QISs. The introduction of QIS was one of the significant changes made by the FSA when it introduced COLL. A QIS is an authorised fund that can be marketed only to sophisticated and institutional investors. It enjoys a lighter regulatory touch than retail funds. QIS fund managers are allowed more freedom over types of assets, investment strategies and borrowing. The tax rules that apply to the fund and to investors in QISs are in general the same as those that apply to all authorised funds, but a QIS can more easily be tailored to the investment needs of a small number of investors than can a widely marketed retail fund, and participation can be restricted to those for whom it was set up. Therefore, a QIS can, in effect, be a semi-private money box.

To guard against that, as part of these regulations we are setting out the detailed operation of the special tax rules for investors who hold 10 per cent. or more of a QIS. Those rules affect the taxation of neither the fund itself, nor of other investors in the same QIS who hold less than 10 per cent. of the fund. The reasons and the need for that kind of special rule were debated
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extensively during the passage of the Finance Act that introduced the explicit power to make these regulations.

The regulations reflect the outcome of extensive consultation, both during and after the passage of that Finance Act, on the detail of the investors to whom the special rules should apply. As such, they provide a robust and well-targeted set of rules that applies a tax treatment similar to the mark-to-market method that already applies to institutional investors in authorised funds. To help the industry and its tax advisers, guidance on the application of the 10 per cent. rule will be published soon.

Let me reassure Members by explaining what the regulations do not do. They make no special provision for taxing income from property held by authorised funds. That is because the Government are committed to considering that in parallel with real estate investment trusts—REITs—which are the proposed new tax regime applying to closed-ended property investment vehicles. Although draft clauses to set up a regime for UK REITs have been published for consultation, it would be premature to introduce rules now for authorised funds that invest in property ahead of finalising the rules for UK REITs. However, that would not necessarily mean waiting for another Finance Bill. If it is decided that it would be beneficial to provide a different tax treatment for property-holding authorised funds and their investors, that could be provided in regulations outside the normal Finance Bill timetable.

That leads me to my final point on the benefits of using regulations to set out the detail of the tax rules for authorised funds. The Government recognise that in an industry as dynamic and innovative as fund management there will always be new developments. Some of that will require changes in the tax regime, and being able to do that in regulations will allow us to respond quickly and flexibly to new issues as they arise.

I thank all those who have been working with officials since early last year and who have commented on the draft regulations published for consultation in December. That constructive dialogue with the industry has been of great assistance in ensuring that the regulations achieve their aims, and do so in a way that keeps to a minimum additional burdens on investors, industry and Her Majesty’s Revenue and Customs.

2.38 pm

Mrs. Theresa Villiers (Chipping Barnet) (Con): I agree with the Minister that it is vital to provide a workable and efficient tax and regulatory framework for the United Kingdom’s £2,000 billion asset management industry, and my party supports in principle the overall proposal to consolidate the rules on taxation of authorised investment funds into a single piece of secondary legislation. It is a sensible idea to draw together and restate the diverse sources of rules in a single set, and the provisions that will largely re-enact existing rules do not cause us any significant
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problems. However, I do have concerns about certain regulations that introduce new provisions, and I shall outline what they are.

I am pleased that the Minister talked enthusiastically about the consultation, but it is my understanding that there have been significant problems with it. In particular, the Government allowed market participants just 35 working days over the Christmas holiday period to comment on 110 draft regulations running to some 44 pages. Participants considered that to be a very short period in which to consider such complex and important provisions. Perhaps of even greater concern, it is my understanding that the Government then gave themselves fewer than five days to consider and incorporate the consultation responses before publishing the final draft regulations. Legislating in a hurry often leads to poor-quality results and there are flaws in the regulations that need to be addressed.

I am also concerned about another procedural point. Future regulations and amendments in this area will, I believe, be subject only to a negative resolution process. The Minister will correct me if I am wrong, but my understanding is that they will not even be considered by a Standing Committee, and that they will be subject to annulment only by resolution of the House. I certainly agree that it may not be necessary for a full Standing Committee to consider every possible change proposed in future, but if the Government wish to use the negative resolution process, they have to commit more time than we have seen in respect of these rules to a proper consultation process.

For example, the Government should consider adopting the practice of the Financial Services Authority on financial regulation. That would, for example, initiate a discussion paper, followed by a consultation paper setting out detailed rules. There would be at least three months between the papers for proper discussion with those affected by the important new rules. Again, I emphasise that it is important for the Government to give themselves sufficient time to digest the response to the consultation. If we are to use the negative resolution process in future, I hope that the Minister will be able to give some assurance that there will be an effective consultation process that is not unduly rushed.

I shall focus on the provisions in the regulations on QISs, because that is where the problems are. As we have heard, QISs were introduced to extend the successful investment fund model to more sophisticated investors. The Opposition welcome their introduction by the FSA, and would welcome a clarification of their tax status. That is needed; the take-up of QIS funds has so far been limited, pending that clarification.

The proposal is that, broadly, QISs will be treated the same as other investment funds. However, as the Minister has outlined, measures need to be taken to prevent individuals from using QISs to gain tax advantages meant for funds. The Government say that they do not want high net worth individuals to be able to turn their investment portfolio into what would
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effectively be a QIS, and that approach is perfectly sensible. I agree with what the Minister is trying to do, although I have a problem with how he suggests in the regulations that we should go about doing that.

A simple way to have solved the problem would have been to require an arm’s-length relationship between the management of a QIS fund and a single investor in it. Arguably, that would be a more targeted and accurate way to deal with the problem than introducing the 10 per cent. rule, whereby those with what is defined as a substantial holding are subject to an additional tax charge on their investment in the fund.

My concern is that the rules on that 10 per cent. principle are complicated and confusing. That lack of clarity is of particular concern because of the severity of the penalty that we are discussing—an annual income tax charge on the increase in the capital value of the holding. That is a serious tax penalty, so we must make sure that it is applied in clear circumstances so that taxpayers know exactly when the charge is applicable.

The 10 per cent. rule can cause a problem when the fund is set up. At that stage, the managers of a fund may have to underwrite a significant proportion of it before they are able to sell it on to customers. That means that the managers are highly likely to have more than the 10 per cent. threshold; a single investor may well have more than 10 per cent. until they sell on to other investors. The time available for the introductory, seeding period has been extended from the six months that the Government initially envisaged to 12 months, through regulation 62. That is a welcome improvement, but I fear that the period is still too short for many funds, particularly in an area of financial innovation, to gain sufficient credibility to sell on 90 per cent. of the investment to customers.

There is a similar problem with winding up. Whereas the Treasury chose to extend the six-month seeding period to 12 months, it has not done the same in the regulations for the period allowed for winding-up QIS funds. The FSA requires a number of steps to be taken when winding up a fund. I understand that it is simply not possible to complete those steps in the six months that the draft regulations provide for. We have a significant clash between regulatory rules and tax rules, which could leave managers who are trying to wind up QIS funds in a difficult position.

In regulation 53, there is a problem relating to exempt investors. Wisely, the Government have chosen to exempt certain investors from the 10 per cent. rule, and the regulations extend the list of people beyond that in the Government’s initial draft. That extension to the list of exempt parties is welcome, particularly the addition of pension funds, charities and long-term life insurance funds. Otherwise, either those organisations would have been taxed twice or organisations such as charities would have found themselves paying tax, which they are not supposed to do.

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The latest draft has solved a problem relating to managers of funds who run a float, or box as it is known, to assist them in managing and netting customer transactions. That might technically take them over 10 per cent., and it is welcome that the Minister has chosen in his current draft to exclude that situation from the 10 per cent. rule. What remains a problem is that non-UCITS retail funds—an undertaking for collective investment in transferable securities—are not included in the list of exempt parties. That means that it will not be possible to have a QIS relating to non-UCITS retail funds—in other words, funds that do not comply with EU rules—so we shall not be able to include in the new provisions funds of funds or funds that invest in property.

I take the Minister’s point about not wanting to pre-empt the rules of REITs, but I do not see that there is a real, serious distinction between the exempt investors who have been included in the regulations and non-UCITS retail funds. There seems to be no distinction in quality or regulatory or tax purposes. I should be interested to hear why the Minister has chosen not to include non-UCITS retail funds in the list of investors exempt from the 10 per cent. rule. A distinction in treatment is also made between life insurance and general insurance. Again, I should be interested to hear from him why one type of insurance is in the list of excluded investors and another is not.

There are significant problems relating to inadvertent breaches of the 10 per cent. rule—situations in which investors exceed the 10 per cent. limit but are not aware that they have done so, which will not be that uncommon. Ownership of the type of fund that we are talking about is likely to change daily. The proportion held by an investor will also change on a daily basis because of other people buying and selling parts of the fund. Transactions by other investors might end up pushing another investor’s share over the threshold.

A six-month period is now available for investors to divest themselves of 10 per cent. holdings acquired accidentally, and that period is a welcome addition to the draft regulations, but there are still problems. A drafting error seems to have been made in regulation 54(4). That paragraph seems to provide that if an investor breaches the 10 per cent. limit he must dispose of his entire holding within the specified period. I see the justification for requiring the investor to go back below 10 per cent., but I cannot see the rationale for requiring him to get rid of the whole holding. If the rules require the investor’s holding to be less than 10 per cent. to avoid incurring the tax penalty, why does regulation 54(4) require the whole holding to be sold off in cases of inadvertent breach, rather than just a sufficient proportion to bring the investor back under 10 per cent?

The measuring dates for determining the six-month period are also incredibly complex and difficult to understand. Some attempt has been made to clarify those dates, but problems remain. I shall give an example to illustrate. Let us take ABC as a QIS fund with an interim account date of 30 June, and an investor, whom I shall call Mrs. X who buys 5 per cent.
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of ABC QIS fund on 1 January 2007. On 1 April 2007 a large institutional investor comes along and redeems its units in the fund. As a result, Mrs. X’s holding represents 12 per cent. of the fund. Her first measuring date is the date when her 5 per cent. holding went above the 10 per cent. threshold. However, her holding has become substantial through no action of her own. The problem is that she is unlikely to know that it has happened. Indeed, if her holding is in a nominee name, which many are, the management of the QIS is not likely to know that it has happened either.

In accordance with regulation 63, the next relevant measuring date is 30 June which, as I said, is ABC’s interim accounts date. However, it could take up to four months for the fund’s accounts to become available. It generally takes at least a couple of months to finalise them. The FSA says that funds can take up to four months before they produce their interim accounts, and even then they are not sent automatically to their customers. Therefore, in many cases, if not in most, people in Mrs. X’s position would not know until up to four months later that their holding was above the 10 per cent. threshold, which in my case study would be at the end of October.

Mrs. X therefore has only two months to dispose of her entire holding which, according to the third measuring date set out in the regulations, must be by 31 December. If she does not do so, she will have an additional and penal tax charge and she will not necessarily know even then exactly at what point her holding became substantial. She will need to ask the fund manager to do a manual trawl through the register to see exactly when that happened. If she succeeds in disposing of her shares in the fund, she may not get the best price, because she has had to do so in a hurry rather than on the basis of considered investment advice. The ironic thing is that disposing of her holding could push other investors over the 10 per cent. rule, starting the cycle again.

My last point is in relation to gross payments. The Minister took us through the sensible proposals to extend the range of people to whom it is permissible to pay interest payments on a gross basis. However, one must bear it in mind that, given the current way in which the market is set up, investment funds have a choice whether they pay gross or net. If an investor is of the sort where it is permissible to pay gross, the investment fund can choose whether it does that or not. There may be a number of incidences where the holding is so small that it is simply not economic to set up a separate payments system to ensure a gross payment.

The Government have extended the list of people to whom it is permissible to pay gross, but they have redrafted it in such a way as to make it mandatory for the fund to pay gross at the request of the customer. By contrast, the current situation allows the customers, if they are qualified to receive gross payments, to request the fund to pay them gross, but the fund does not have to comply with their request. The mandatory requirement that the fund pays gross on request of a qualified customer could impose an unfair cost burden.

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Even worse, before paying someone gross it is necessary to know their tax status. It has to be known whether they fall into that list of people for whom it is permissible to pay gross. Again, where there are a number of investors behind a nominee, the fund may have no way of knowing their tax position—[Interruption.]

The Chairman: Order. If hon. Members want to have conversations could they please go outside the room to do so? The hon. Lady is entitled to be heard.

Mrs. Villiers: Thank you, Mr. Weir. I emphasise that this is a huge industry for this country and these are important tax issues, but I do not propose to delay the Committee for more than a couple of minutes longer.

The manager will be put in an impossible position: they will be obliged by the rules to pay out gross to the customer, but it will be difficult for them to find out whether the customer in question so qualifies. For the parallel example of bank accounts, where there is a joint account and one customer is permitted to receive payments gross and another is not, the bank is entitled to say, “You’re both going to get your payments net. It’s just too expensive for us to separate the interest and pay one customer on a gross basis and the other on a net basis.” That position, which is currently the case for funds, is the preferable approach. I fear that the drafting of the regulations has inadvertently mandated payment on a gross basis. Therefore, I ask the Minister to look again at the provision.

There are some significant flaws in the rules. I ask the Minister and his Department to think again about them and to take time to redraft them. That is why I oppose the regulations and propose to divide the Committee.

2.56 pm

Dr. Vincent Cable (Twickenham) (LD): The Minister modestly introduced his presentation by saying that he would rather be talking about education than authorised investment trusts. I share with him the feeling that this is a somewhat impenetrable subject. I set up some investment trusts some years ago, but the subject remains pretty impenetrable to me.

I think that I understand the basic rationale behind the provision; it is an attempt to rationalise the system of taxation, at least for one kind of investment vehicle—open-ended trusts, or unit and investment trusts, rather than a different proposition—to potentially deal with abuses that can occur when rich individuals use an investment shelter to escape taxation. The provision would apply to them if they were simply being taxed as individuals. I imagine that that is the underlying rationale behind what we are trying to do.

I received submissions from the investment management industry, which the hon. Member for Chipping Barnet (Mrs. Villiers) also received. She has stuck fairly faithfully to the brief and made the points well. I was a little bit surprised about how big this industry is. The IMA described it as having assets of £2,000 billion under management. It is difficult to get
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my head round that, but I think that total British household assets are only £3 trillion and most of that is property. I am not totally clear where that money comes from, but I guess that the industry is managing quite a lot of overseas assets on account. None the less, it is a big industry, so it is important from the revenue point of view and for the health of the City that the Government get this right.

Since the Conservative spokesman has already talked us through the details of the QISs and the rules, I will not repeat all those points. The one thing that struck me as particularly tricky—the area where there was potential for doing quite a lot of damage—was what would happen if someone were inadvertently caught within the penalty rules for institutions or individuals breaching the 10 per cent. rule, through no fault and intention of their own. That is a problem, because if potential investors know that they can be caught if they go into investment vehicles of this kind, however much forward planning they are engaged in, they will not invest. The pool of funds that such institutions require to operate productively and efficiently is in danger of drying up. It is important that the Government have a good answer to the question of how they deal with people inadvertently breaching the rule. As has been said, that is partly a matter of ensuring that there is an adequate period to allow the adjustment to take place and also a matter of not penalising the total sum, but simply the margin that is in excess of the 10 per cent. Those would seem to be sensible provisions for preventing unnecessary damage and tax penalty. Having made that point, I will not add to the list of detail, which has been adequately given.

I have two general points to make. In framing the rules, the Government are satisfied that there is, in effect, a level playing field between different types of investment vehicles. We are only dealing with one set; investment trusts are another set. Is the Minister confident that the two different sets of investment vehicles are being treated on a comparable basis?

The second general point, which the Conservative spokesman raised, is about consultation. The hon. Lady described the peremptory way in which these complex proposals had been put before the industry. She will know, as she was a Member of the European Parliament, that the British Government often lecture the European Commission and the Committee of European Securities Regulators because of the rapid way in which European financial regulations are pushed through, to the disadvantage of the City, without proper consultation. The proposal is an example of very bad practice in this country and I hope that the Minister will explain why things had to be done so rapidly, given that it is such a fundamental issue for the City.

3.1 pm

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