Offshore Financial Centres - Treasury Contents


Memorandum from the Association of Investment Companies (AIC)

EXECUTIVE SUMMARY

  1.  Offshore financial centres provide important opportunities for investment companies and their shareholders. They facilitate the delivery of investment strategies that meet evolving UK and international consumer demands but which cannot be delivered with a UK-domicile. Historically, the UK regime has supported the principle of collective investment through investment companies (as this delivers valuable consumer benefits) but it has not yet responded to recent market developments. This has prevented UK-domiciled investment companies from gaining exposure to emerging asset classes without suffering double-taxation and encouraged the sector to look offshore.

  2.  At the same time, increasingly high standards in offshore financial centres have boosted investor confidence. Offshore financial centres also offer greater commercial and administrative flexibility and certainty than the UK- which has also encouraged moves offshore.

  3.  The shares of AIC member investment companies, wherever they choose to be domiciled, are overwhelmingly traded through UK markets. This provides an additional layer of reassurance for those investors who want to maintain exposure to domestic standards.

  4.  Where investment companies are concerned, old-fashioned suspicion of the reasons for "going offshore" is increasingly inappropriate. These domiciles facilitate legitimate commercial opportunities within an appropriate regulatory framework. Many investors are UK residents. Accordingly they pay tax on the returns they receive, as appropriate. The availability of offshore investment companies to UK investors provides no grounds for regulatory or public policy concern. On the contrary, they have served investor needs and enhanced the position of the UK financial services sector.

BACKGROUND

  5.  The AIC represents closed-ended investment companies whose shares are traded through an investment exchange. These companies invest in a diversified portfolio of assets and seek to provide their shareholders with capital growth (when the value of the underlying assets rise this will be reflected in the share price). They can also offer income to investors (where dividends, interest, rent etc. received by the company are paid out to shareholders).

  6.  The AIC has 349 members, including UK-based Investment Trusts, Venture Capital Trusts and 53 offshore investment companies. Most of these are located in UK Crown Dependencies (Guernsey, 39, Jersey, 9). The others are domiciled in UK overseas territories (Bermuda, 2, Cayman, 2) except two (one in Luxembourg and another in the Netherlands). Our offshore members manage just over £14.5 billion in assets in a range of asset classes including equities, property, bonds, private equity and unlisted hedge funds.

  7.  Each offshore investment company is governed by a board of directors (elected by the shareholders), which provides strategic oversight of the company. It ensures, for example, that the portfolio is invested in line with the investment policy agreed by the shareholders. The board also monitors the performance of the external fund manager. (The day-to-day management of the portfolio is sub-contracted to an expert fund manager, who may be replaced if performance is unsatisfactory.)

  8.  Investment companies (onshore and offshore) are a mainstream part of the UK's investment environment. Their shareholders include large institutions (pension funds, insurance companies, unit trusts etc), wealth managers and retail investors. All are attracted by the opportunity to gain diversified exposure to assets at low cost.

  9.  Institutions seeking access to new or specialist asset classes are currently the predominant investors in offshore investment companies. However, the investor profile of the sector may broaden over time to include more retail investors as the investment practices pioneered offshore become more established. The Association of Private Client Investment Managers now suggests that a "balanced" investment portfolio might include 5% in hedge funds and 5% in commercial property (alongside more traditional asset classes). As these can be accessed through offshore investment companies (by buying shares on the stock market) they are increasingly likely to be considered by a wider range of investors in the future.

  10.  The AIC's mission is to help its Members add value for shareholders over the longer term. This includes understanding the needs of boards and working to help them deliver their obligations to shareholders more effectively.

The growth of the offshore investment company sector

  11.  The offshore investment company sector has seen significant growth over the last 10 years—at the same time new UK launches have declined.

  12.  Overall the sector remains overwhelmingly UK based, but Figure 1 (below) illustrates how new investment companies are increasingly favouring offshore jurisdictions. A UK domicile was the primary choice for new investment companies before 2001. Since then, domicile choices have increasingly been offshore. Figure 1 shows Channel Island investment companies with a London listing (the majority of the AIC's offshore members). It omits those not listed in London—which might have selected alternatives such as Euronext or chosen to quote on AIM—and those domiciled in other jurisdictions such as the Cayman Islands or Bermuda. Nevertheless, even this partial picture shows that the UK has been less attractive than alternative financial centres and that, in the current environment at least, UK launches have largely become a thing of the past.[329]


  13.  Offshore centres, particularly the Channel Islands, have won this business by being more responsive to investor and commercial needs.

Meeting consumer demand for broader asset allocation

  14.  The underlying philosophy of taxing collective investment funds is that investors in those funds should receive, in tax terms, the same return as if they had invested directly in the underlying assets. Without this, the attraction of collective investment is substantially reduced. Investors would face double taxation—once inside the fund and then again when they received dividends or sold their investment. The ability to invest without suffering such tax leakage is particularly important for tax-exempt institutions (such as pension funds) and retail investors, who are the main purchasers of investment company shares.

  15.  Many shareholders in offshore investment companies represented by the AIC are UK-resident for tax purposes and pay the appropriate rate of tax on their investment returns. Where they are exempt institutions they do not pay any tax. Where they are taxpayers they will pay at their marginal rate (many retail investors will be higher-rate taxpayers).

  16.  Of course, where investors are not UK resident for tax purposes, they would not pay tax in any event. However, offshore investment companies also extend the reach of the UK's fund management sector so that it covers assets which might otherwise be managed elsewhere. In turn their fees enhance their profit levels and enhance tax revenues in the UK.

  17.  Investment companies are genuine investment propositions seeking to deliver a tax-neutral outcome for savers seeking exposure to certain asset classes. They are not financial vehicles created for other purposes, for example, by companies seeking to move assets off-balance sheet or to facilitate securitisations.

  18.  The UK government recognises the desirability of encouraging tax-neutral collective investment and offers a variety of tax regimes to support this model. These include closed-ended (ie investment company) regimes such as Investment Trusts, Venture Capital Trusts and Real Estate Investment Trusts and open-ended alternatives, Authorised Unit Trusts and Open-Ended Investment Companies. Despite the UK's historic recognition of collective investment, the tax system has not kept up with market developments and evolving demand. This is illustrated by the investment company experience.

  19.  UK-domiciled Investment Trusts can invest without exposing the shareholders to double-taxation in UK equities, which were traditionally the key component of asset allocation for UK investors. By and large, the Investment Trust rules reflect this historical position. They do not allow for investment in new assets demanded by investors. On the other hand, offshore investment companies have been able to offer a much broader range of assets in a tax-neutral manner.

Figure 2

NEW LAUNCHES BY ASSET CLASS—% OF FUNDS RAISED 2001-07


  20.  As shown by Figure 2, the main assets of offshore investment companies have included private equity, property and unquoted hedge funds. These assets cannot generally be held in Investment Trusts because of their tax position. UK dividend income is currently exempt from tax within an Investment Trust. All other forms of income, including overseas dividends, bond interest and rental income are subject to tax within the company. Where exposure to assets producing these income streams is relatively small, and therefore income levels are low, then the tax burden for the Trust may be negated by offsetting allowable expenses (and double tax relief in the case of overseas dividends). However, this is less possible where investment companies are seeking higher levels of income from those sources. In these circumstances, the best outcome for investors may be achieved where the fund is domiciled in a more attractive regime. This responsiveness to investor needs is the primary reason that jurisdictions such as Guernsey and Jersey have been able to compete successfully for investment company business.

  21.  Even where investment companies are exposed to equities (the traditional Investment Trust asset class) there is still a commercial and consumer incentive to locate in an offshore financial centre. The investment companies described (above) as "equity" funds are in receipt of high levels of foreign dividends—around two thirds have remits to invest entirely outside the UK. As foreign dividends may be subject to tax within an Investment Trust these remits can be difficult to deliver with a UK domicile.

  22.  Indeed, the inflexibility of the Investment Trust rules, particularly the unfavourable treatment of income, has even seen existing Investment Trusts (who pay no tax at present) move offshore during the past 12 months. Various reasons account for this. Key among them is likely to be a desire to increase their exposure to securities which provide income, but which cannot be purchased without the shareholders suffering double-taxation onshore.

  23.  Future investment company launches will continue to be offshore where they deliver asset allocations which cannot be provided effectively by Investment Trusts. For example, recent launches have included exposure to debt or infrastructure which the UK-domiciled Investment Trust structure cannot accommodate effectively.

Commercial advantages offered by offshore domicile

  24.  There are certain areas where offshore investment companies do compete with UK-based alternatives. The offshore property sector provides a good example of this. It competes with UK-domiciled Property Investment Funds (PIFs) and Real Estate Investment Trusts (REITs).

  25.  Offshore investment companies (and other closed-ended vehicles) are able to compete with PIFs because of their structural advantages. PIFs are open-ended. This structure is not ideally suited to investing in illiquid assets such as property, as high levels of redemptions (where consumers sell their units in the fund back to the scheme manager for cash) could create a need to sell the fund's underlying assets to meet this demand. As property sales cannot be undertaken quickly the fund may find itself without the cash required to repay its investors. This would be a particular risk when confidence in the underlying assets is falling. Problems of this nature emerged recently in the property fund market and a number of vehicles were temporarily closed to redemptions (which was contrary to consumer expectations, and may have only postponed the problem). This situation also creates issues for investors which remain within the fund if assets are sold quickly (and cheaply) because of liquidity demands rather than the manager's view of their fundamental investment attractions.

  26.  Closed-ended funds, where the shares are traded on a market (not via the scheme manager) avoid these problems. Both UK and offshore investment companies might therefore be favoured by investors with reservations about open-ended alternatives. However, offshore investment companies can still compete on commercial grounds. In comparison with a REIT, the tax position of an offshore domiciled company may be marginally more attractive depending on the investor's own position. It will also have greater commercial flexibility (for example, it will not suffer from the same gearing restrictions as a REIT). The complexity of tax-compliance (and the impact it has on commercial decisions) is also likely to be far greater for a REIT than for an offshore domiciled company.

  27.  The difficulties in achieving compliance with the UK's tax rules should not be underestimated. Some investment strategies involving derivatives, which could theoretically be deployed by Investment Trusts, are avoided solely because of uncertainty on how they would be treated by the UK tax authorities. The likelihood is that they would not create any tax issues—but the company cannot take that risk. A number of companies wishing to use derivatives for investment purposes have therefore taken a prudent view that an offshore domicile will deliver a more tax-neutral outcome and that they can place more reliance on the approach taken in those jurisdictions. The high levels of certainty available offshore is a very important factor (alongside flexibility and simplicity) which have also helped attract investment companies to these jurisdictions.

Standards applying to offshore investment companies

  28.  The term "offshore financial centres" is not clearly defined. One problem with much of the debate about offshore regimes is that they are judged together and little consideration is given to the differences between them.

  29.  The most significant offshore domiciles for investment companies trading on UK markets are the Crown Dependencies (Guernsey, Jersey and the Isle of Man). A recent International Monetary Fund assessment[330] found that their level of compliance with global standards is extremely high. Where securities are concerned, they have fully complied with 81% of global standards, and "broadly" or "partly" implemented the remainder. The same report found similar high standards applying where money laundering is concerned. No areas were un-addressed. Standards are continuing to evolve and the next iteration of the IMF assessment is likely to see further positive developments.

  30.  Other offshore jurisdictions hosting AIC members have also been rated positively (although they have some way to go to catch up with The Crown Dependencies). However, they have also seen significant improvements in recent years, and we would hope to see further developments over time as the regimes become more established.

  31.  As far as securities regulation is concerned, the record of these financial centres rebuts the myth that they offer no regulatory controls. The increasing quality of regulation has helped encourage interest by investors who would not have considered purchasing an offshore investment company ten years ago. This in turn has led many UK fund promoters to consider offshore options when previously they would have favoured the Investment Trust route.

  32.  The value of offshore regulators was demonstrated in the run up to problems in the Split-Capital Investment Trust market (which emerged in 2000) where a number of offshore and onshore investment companies failed and some retail investors lost money on what they thought were safe investments. It was representatives of an offshore regulatory authority—the Guernsey Financial Services Commission—who were among the first to raise concerns with the UK regulators about potential problems. Clearly, offshore centres do try and balance their commercial position with appropriate regulation (as the UK does). However, where regulatory standards differ from those in the UK, they are not necessarily inferior and they should be assessed on their merits.

  33.  Of course, the offshore Investment Companies represented by the AIC also allow investors to rely on various UK-originated standards because their shares are traded on domestic markets. Most of our members are UK-listed. They therefore apply the rules set by the UKLA (which in part flow from European directives). These cover issues such as transparency, liquidity, independence of directors etc. They include requirements to disclose their governance arrangements in comparison with the standards set out in the UK's Combined Code on Corporate Governance. Other of our members are traded on AIM, the UK's leading alternative securities market with standards reflecting the needs of its investor base—primarily institutions.[331]

  34.  We would also note that many offshore AIC members use the AIC Code of Corporate Governance. This has been developed as a means of reporting against the Combined Code, but it also provides value for investors by addressing unique investment company issues. For example, it examines issues boards might consider when dealing with their external fund manager.

Impact on the UK of offshore domiciled investment companies

  35.  Offshore investment companies customarily employ offshore administrators (indeed, it is a requirement of domicile in a number of jurisdictions). However, as discussed above, their shares often list or trade on UK exchanges. They therefore support the UK's financial services infrastructure.

  36.  Arguably most importantly from a UK financial services perspective, they also tend to employ UK-based fund managers as investment advisers (which are UK regulated). This is a useful source of revenue for these firms. Where investment companies have an international shareholder base (some recent launches have raised their capital substantially overseas) they enable managers to extend their market—with knock-on effects for their profits, which are taxed in the UK. Offshore investment companies also help develop experience within the UK's fund management community where they increase opportunities to gain exposure to alternative asset classes.

  37.  The offshore investment company sector benefits investors and managers as well as developing the overall position of the City. It does not undermine the UK's tax-take or its position as a financial centre. In fact, it can help enhance them. The relationship is mutually beneficial and, while we envisage it will evolve over time, should be welcomed by those interested in the potential of financial services to provide ongoing economic benefits for the UK.

19 June 2008








329   The figures exclude VCT launches and secondary issues. Back

330   As cited in "Foreign and Commonwealth Office: Managing Risk in the Overseas Territories". 17th Report of Session 2007-08. House of Commons Committee of Public Accounts. Page 9. Back

331   The one exception among AIC members is a company trading on Euronext, which applies European listing standards, but it intends to take a dual-listing in the UK and will then also apply UK listing standards. Back


 
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