The Chairman: Before I call the Minister to move the motion, I am told that there will be Divisions in the House on the group of amendments currently being debated there. If that is so, I shall adjourn the Committee for 15 minutes for the first Division, another 15 minutes for the second and so on. Members might wish to bear that in mind, and perhaps finish beforehand.

The Exchequer Secretary to the Treasury (Sarah McCarthy-Fry): I beg to move,

You have offered us a challenge, Mr. Atkinson. How nice it is to welcome you to the Chair, and what a pleasure it is to serve under your chairmanship.

I shall give a brief introduction to the regulations. The tax regime for offshore funds was introduced in 1984, its purpose being to establish the tax treatment of activities that use certain offshore funds to convert income flows into capital gains. Before it was introduced, a United Kingdom investor could roll up income in an offshore fund and, when the investment was realised, be subject to tax only on the capital gain rather than having to pay tax on the accumulated income. In contrast, a combination of regulatory and tax rules meant that UK investors had to pay tax annually on income from UK funds. To level the playing field, the offshore funds regime taxed realisations of offshore fund investments as income rather than as chargeable gains unless a requirement to distribute income and certain other conditions were satisfied and approval was obtained from Her Majesty’s Revenue and Customs.

It is now 25 years since the 1984 order was made, and there have been many developments in the funds industry since. Increasing globalisation has seen investment increasing in offshore funds for commercial reasons rather than simply to avoid paying tax. In the Budget of 2007, it was announced that the Government would consider modernising the offshore funds tax rules to bring them in line with commercial developments. However, in parallel with commercial developments, tax-motivated arrangements to avoid the effect of the regime have also increased. The offshore funds regulations are therefore founded on a new characteristics-based definition.

Following extensive consultation, which started in October 2007, the Government introduced powers for modernising the offshore funds tax regime in the Finance Act 2008. At that time, the Government said that they would consult further with the industry on a new definition for offshore funds. Additional consultation led to the inclusion of a new definition for offshore funds in the Finance Act 2009.

Today’s regulations are in four parts. The first deals with preliminary, general and transitional provisions, as well as interpretation; the second deals with the treatment of participants in non-reporting funds; the third deals with reporting funds and the treatment of participants in such funds; and the fourth deals with consequential amendments to primary legislation. The transitional provisions are dealt with in more detail in schedule 1. Although the scope of the new regime is set out in primary legislation, the operational details are set out in regulation. That should enable the regime to be developed to reflect future commercial and regulatory developments in a reduced time span, as necessary.

The regulations introduce the new regime from 1 December 2009. Part 1 sets out when the new regime will take effect. For the purposes of income tax, the regime will apply from tax year 2009-10 and distributions made on or after 1 December 2009. For corporation tax purposes, the regime applies to accounting periods ending on or after 1 December. Under the new regime, funds that fall within the definition of an offshore fund will be classified as reporting funds or non-reporting funds. An offshore fund will be a non-reporting fund unless it makes a successful application to Her Majesty’s Revenue and Customs to be a reporting fund. The definition in section 40 of the Finance Act 2008 was introduced in the Finance Act 2009.

Umbrella arrangements are arrangements that provide for the separate pooling of the contributions of the participants and the profits and income from which payments are made to them. Under the new regime, each part of the umbrella arrangements is to be treated as a separate arrangement, and the umbrella fund itself is to be disregarded. If there is more than one class of interest in arrangements, each class of interest will be treated as a separate arrangement and considered separately, to determine whether it is an offshore fund. The rules for umbrella arrangements and classes of interest reflect those currently in place for offshore funds.

A non-reporting fund is any offshore fund that does not have reporting fund status for a particular period of account. A fund that has previously been a reporting fund may subsequently become a non-reporting fund, and vice versa. Although a reporting fund has certain obligations to Her Majesty’s Revenue and Customs and its investors, a non-reporting fund has no such obligations for UK tax purposes. Commercially speaking, however, it will need to meet its normal obligations to investors, and UK investors are responsible for ensuring that they make the correct returns in respect of any income or gains received from their investment.

Part 2 of the statutory instrument is concerned solely with the treatment of UK investors in a non-reporting fund. Chapter 1 contains preliminary provisions; chapter 2 deals with charges to tax on participants in non-reporting funds; chapter 3 deals with exceptions from the charge to tax on an offshore income gain; chapter 4 deals with disposals of interest in non-reporting funds; chapter 5 deals with offshore income gains and the computation of such gains; chapter 6 deals with the deduction of offshore income gains in computing chargeable gains; and chapter 7 deals with the conversion of a non-reporting fund into a reporting fund.

The main effect for UK investors who have invested in non-reporting funds as opposed to reporting funds is that on disposal of their interest, they will be liable to income tax on any gains arising. That is known as an offshore income gain unless one of the exceptions listed in chapter 3 applies, in which case any gain will be treated and taxed as a capital gain.

Some offshore funds may be transparent for income purposes. That is when investors are taxed on the income received from interests in the underlying assets rather than the fund itself. It may be worth noting that when an offshore fund is transparent for income purposes and is not itself invested in non-transparent funds, such a fund will be included in the exceptions. That is because the income transparency will mean that any UK investors are taxable on their share of the income of the fund, even if it is rolled up in the fund.

A reporting fund is an offshore fund, within the meaning of the Finance Act 2008, that has applied for and been approved as a reporting fund by HMRC and has not voluntarily left the reporting fund regime or been excluded by HMRC. When a fund meets the conditions and the manager can undertake to report income to UK participants and HMRC, as set out in part 3 of the regulations, the manager of the fund may make an application in writing to HMRC on the fund’s behalf for it to be accepted as a reporting fund. It is also possible for applications to be made on behalf of funds yet to be established. The key feature of the regime is that, in contrast to the current distributing fund rules, there will be no requirement that the fund must physically distribute income to UK investors.

Another aim of the new offshore funds regime is to provide certainty to offshore funds’ investors and managers. In order to achieve certainty, funds will no longer need to wait until the end of the year to determine whether they have distributing status, as they did under the old rules. Under the new reporting regime, funds can make an up-front application for reporting fund status. A fund can apply for reporting fund status up to three months after the start of the period to which the application applies. That provides the fund with some flexibility, while providing potential investors with a degree of certainty as to their tax treatment.

The purpose of the offshore funds rules is to prevent the roll-up of income in offshore funds with any subsequent realisation of the investment being returned to the investor in the form of capital. As with the previous distributing fund rules, the regulations provide that in the case of roll-up of untaxed income, any subsequent realisation will be charged to tax as income rather than to tax on capital gains.

The previous tax rules required the income of the fund to be distributed to UK investors if those investors would be charged a tax on capital gains rather than income on disposal of their interest in the fund. By contrast, the new reporting fund rules require only that fund income is reported, although it may still be distributed in whole or in part as well. There are specific rules within the regulations to ensure that any sums reported to UK investors are charged to tax as income.

Using powers given in the Finance Acts 2008 and 2009, the regulations provide for the repeal of the existing legislation in chapter 5, part 17 of the Income and Corporation Taxes Act 1988. The previous legislation is retained for transitional purposes only. The regulations also contain a number of consequential amendments to parts of the tax Acts that referred to the existing legislation.

Schedule 1 to the regulations contains transitional provisions, which deal with situations that may occur during the transitional period. Under the transitional arrangements, an existing distributing fund has until the end of the first accounting period ending after 1 December 2009, and the succeeding period, before it must convert to a reporting or non-reporting fund.

Mr. Mark Hoban (Fareham) (Con): Will the Minister give an indication of how many funds are currently classified as distributing funds and therefore might make an application to Her Majesty’s Revenue and Customs to become a reporting fund?

Sarah McCarthy-Fry: I have the information here, but not to hand. To save time, I would like to provide it in my closing remarks. Will that help the hon. Gentleman?

Mr. Hoban indicated assent.

Peter Bottomley (Worthing, West) (Con): There is something else of which the Minister might like notice; it may be perfectly obvious, but it is not yet obvious to me. The first paragraph of regulation 3, part 1, says what “offshore fund” means, while the first paragraph of regulation 8, also in part 1, starts:

However, paragraph (1) of regulation 3 is followed by paragraph (2), which says:

and a similar provision follows paragraph (1) of regulation 8. I do not have a word-search machine with me, but it would be useful to know where the expression “material interest in an offshore fund” comes in the regulations, so that we can understand the meaning of that exemption in relation to paragraph (1) of regulations 3 and 8.

Sarah McCarthy-Fry: I thank the hon. Gentleman for making his intervention so early; that will facilitate the necessary inspiration to find the appropriate information, so that I can respond to him in my closing remarks.

The generous transitional period will give existing distributing funds sufficient time to adapt. I hope that I have covered the main points in this technically complex area, and I look forward to hearing from other members of the Committee.

Mr. Hoban: It is a pleasure to serve under your chairmanship again, Mr. Atkinson. You chaired the Finance Bill Committee, but I am not sure whether you were in the Chair when we discussed the changes in this year’s Finance Bill that amended last year’s Finance Act to make these regulations possible. As the Minister said, the original tax regime was aimed at preventing the tax leakage that followed from the end of exchange controls, whereby people could transfer sums of money overseas, invest them and hope that the rolled-up interest in those funds would be treated as capital rather than income. The distributor fund regime was introduced to prevent that tax leakage.

The scheme’s drawback was that UK fund managers needed to produce a set of funds that complied with UK tax law. That may have been accessible then, but as the fund management industry has become much more global and fund managers seek to reduce administrative costs and spread them over a wider pool of investors, it is clearly in the interests of the UK fund management industry for there to be modernisation of the tax regime. However, that modernisation raises some issues, which I want to explore with the Minister.

The first question is about the timing. The first consultation took place in March last year. “Offshore funds: next steps” was the document published then. We had a second consultation in December 2008; the document was entitled “Offshore funds: further steps”. Then it all went rather quiet. We had the changes in the Finance Act 2009 and a promise from the Treasury or HMRC to people in the fund management industry and their advisers that they would see a further draft of these regulations before the summer. Then it was promised to be during the summer, and it was published in its final form in September this year.

These regulations are 62 pages long, including the explanatory note. They are complex and there is quite a lot of concern among those in the fund management industry and their advisers that not enough time has been spent discussing the changes in detail. Why was a further draft of the regulations not published before the summer, as they expected?

As the statutory instrument has evolved, one of the problems has been that issues have been identified and, although some have been addressed, some have not. Of course, we are now at a stage where if the SI happens to go through this afternoon, the law will have been set and we will have to wait for another SI next year to get the fine detail right. A number of people in the financial sector would have liked to have seen a draft early in the summer, so we could get a perfect SI in front of us today, rather than our having the prospect of future changes perhaps being made next year. I would be grateful if the Minister explained why an earlier draft was not published.

Of course, there is an issue, because the SI comes into force on 1 December, which leaves a relatively short period in which to implement the measure. Many financial businesses have complex systems that will need to be altered to accommodate changes in the regime, as the Minister indicated. It is at the discretion of the fund manager whether to opt into the regime in the first year, so there is some leeway. However, given that there is a short gap between publication of this final version and implementation on 1 December, there is some concern that not enough time has been given to enable fund managers to implement the measure properly.

One of the issues that has been flagged up is the number of funds that might take advantage of the new regime, which was why I intervened on the Minister earlier to ask how many distributor funds are already in place. A large number of funds outside the current regime feel that they will qualify for the new regime—for example, a number of hedge funds fall outside the current regime on a voluntary basis. The new regime might be of interest to them and their investors, so they may look to convert. Will the Minister indicate whether Her Majesty’s Revenue and Customs is sufficiently staffed up to enable it to process applications? An application should be dealt with within 28 days of receipt; that could put pressure on HMRC if there was a sudden deluge of applications from funds that do not currently qualify for distributor status.

One of the changes in the legislation is that, under a previous regime, funds qualified by virtue of a regulatory definition; that was very explicit. The modernised regime requires there to be the funds to satisfy, or fall into, various categories. Despite being 62 pages long, the SI is supplemented by guidance—which, again, was not published in its current form until September. There is still some uncertainty among the fund management community about whether their funds would qualify under the guidance. Will the Minister explain where HMRC is at in terms of developing the guidance and state whether a further draft will be published before 1 December?

The Minister talked about income tax transparent funds, in relation to which I give an example of the potential for confusion. I think the Minister may well have addressed the issue in her remarks, but the Finance Act 2009 introduced changes that overlap with these regulations. People are starting to work their way through that sort of interaction, and the deadline that has been used is causing some concern.

The regulations contain a carve-out for certain types of trading activities that are referred to in the industry as “white list” activities. That carve-out relates only to a narrow range of funds, and I have been asked what happens to other funds that fall outside the narrow range specified in the regulations. The Minister referred to the funds that are currently distributor funds opting into the regime. There is one group of funds that cannot opt in: those that have an accumulated loss. People do not invest in funds with a view to establishing a loss. Due to the stock market performance of recent years, many funds may currently be sitting at a loss. As I understand it, they cannot be part of the reporting regime established under this statutory instrument. I should be grateful if the Minister explained why that is so.

The Minister said that one advantage of the scheme is that once somebody applies for reporting status, it will be there indefinitely, giving much more certainty to the fund manager and the investor. That is a welcome move. Will she just comment on an issue, which has been raised, about what happens if a fund manager introduces changes that affect the original information submitted to HMRC when the fund qualified for reporting status? I understand that, in the guidance, there is no materiality threshold and that any change—rather than any material change—must be notified to HMRC. Could that issue be looked at, because it appears that HMRC could be inundated with relatively minor changes because of the absence of the materiality issue?

Although the regime presents a challenge for managers, we should spare a thought for taxpayers, because they will face additional burdens. Under the distributor arrangements, as the Minister said, the fund was required to distribute a minimum of 85 per cent. of its income. For taxpayers, that would be relatively straightforward: they would put that in their tax returns and know how much tax they would have to pay. But under the reporting regime that has been set up through this SI, the fund tells the investor how much income has been earned, but it may not distribute that income to the investor. So an investor who has been taxed on income but has not received the income themselves will have to pay a tax bill without having received any cash from the fund. That creates an additional burden for taxpayers.

I doubt whether the distributor funds were available to widows and orphans, as it were, but as the reporting regime becomes much more part of the fabric of the fund-management industry, a number of funds will move to the reporting status. HMRC will then need to provide more guidance to taxpayers about completing tax returns, because those may be the sorts of funds that are marketed to our constituents, who will be looking for guidance. They will be slightly confused to be charged on income that they have not received.

Given the rather specialised nature of offshore funds in the past, they were not widely sold, but it is likely that they will become available on a more widespread basis, through independent financial advisers and others. Have the Government had any conversations with the Financial Services Authority about what disclosure should be introduced so that people who want to buy a fund that qualifies for reporting status understand what they are investing in? It would be helpful if the Minister clarified that.

I talked about the calculation of income and said that investors will be confused because they may be taxed on fund income despite having received no income from the fund directly. The computation of gains will be a challenge as well, because the taxpayer will need to maintain records of the income that has been imputed to them through the reporting structure and the records of the income that they have actually been paid; the unpaid income will be sitting in the funds and they will need to exclude that from the calculation of capital gains. Does the Minister have any thoughts on how that issue might be communicated to taxpayers who, understandably, do not want to pay fees for accountants or tax advisers? I say that as an accountant. How will HMRC provide guidance to taxpayers, given their increased responsibility?

A further point that has been flagged up to me—I will not go into technicalities—is the way in which equalisation applies to funds. Sophisticated investors can sell their holdings in a shrinking fund and suffer a lower tax bill than investors who stay with the fund until it has shrunk further or been wound up. Investors who are less sophisticated could face a disproportionately higher tax charge because of the actions of sophisticated investors. Has HMRC thought about how it might mitigate the risk for those less sophisticated investors?

Finally, the impact assessment suggests that the regime should not increase the costs to fund managers. However, several representations that I have seen suggest that the requirements to submit more information on a regular basis to HMRC will actually increase administrative costs. That is at odds with the cost-benefit analysis that the Government have provided. Could the Minister give more detail as to how the Government came up with their view that the regulations would not add unnecessarily to the costs of managers?

This is a relatively uncontentious statutory instrument, but there are some important technical issues that we need to get right. Part of that stems from the way in which the consultation has been handled, and the gap between the “Offshore funds: further steps” document published in December last year and the publication of the regulations in September.

Mr. Jeremy Browne (Taunton) (LD): I, too, welcome you to the Chair, Mr. Atkinson. Bearing in mind what you said earlier about the undesirability of breaking the sitting into two parts, I shall briefly raise some questions with the Minister. I hope that she will respond to them in her closing remarks.

I should say, as a backdrop, that I agree with the hon. Member for Fareham that, on the face of it, the proposals appear to be fairly uncontentious and sensible. It is certainly not my intention to try to frustrate the Government’s aims in this regard. However, as the hon. Gentleman also said, the process seems to be rather cumbersome.

It is two years since the publication of the consultation papers following the announcement in the 2007 pre-Budget report, and nearly a year since the December 2008 publication of “Offshore funds: further steps”. Why has it taken so long for us to arrive at the point where we are today? It seems that the Minister or, perhaps more accurately, the Government—the Minister, of course, was not in her post two years ago—have travelled a long and winding road. Why did it need to be that long?

My second question also relates to process. As I understand it, the Government intend to keep the regulations under review. It would be helpful, if this has not been touched on—I do not believe that it has—if the Minister indicated how often they will be reviewed, and what structures are in place to ensure that their success in averting tax avoidance can be accurately measured. In other words, how frequently will the regulations be reviewed, and what is the mechanism for ensuring that reviews have a meaningful outcome?

It is interesting to try to boil this down to the impact that it will have on our constituents. I would like to know from the Minister how many UK investors she or her Department calculate will be affected by the regulations, and how much revenue the Treasury estimates will be raised by increasing tax compliance through the regulations. I know that that will inevitably be an estimate that may have to take account of behavioural change and other considerations; nevertheless, the question is relevant.

Finally, I understand that the regulations will commence on 1 December, which is just over a month away. Has the HMRC offshore funds manual, which I am led to believe will provide guidance on the regulations, been published? More generally, is the Minister confident that HMRC, the Treasury and any other relevant parts of officialdom are sufficiently ready to implement the proposals smoothly on 1 December this year?