Offshore Financial Centres - Treasury Contents


Memorandum from the Investment Management Association (IMA)

I.  EXECUTIVE SUMMARY

  1.  The Investment Management Association (IMA) represents the UK-based investment management industry. Our members include independent fund managers and the investment arms of retail banks, life insurers and investment banks. They are responsible for the management of £3.4 trillion of funds (based in the UK and elsewhere), including authorised investment funds, institutional funds, and a wide range of investment management services for private and institutional investors. In particular, our members represent 99% of funds under management in authorised investment funds.

  2.  These clients are both sizeable and international. Some £500 billion is managed within "UCITS" and other authorised funds, and a little under £1 trillion is managed for each of pension schemes and insurers. Other institutional funds, including sovereign wealth fund clients, provide almost all the remaining balance. To put this in context, the UK-based investment managers represented by the IMA manage investments which are larger than the world's hedge funds and sovereign wealth funds put together.

  3.  This submission focuses on the use of pooled investment vehicles, where those vehicles are located in offshore centres. The investment management industry makes significant use of offshore locations as domiciles for their pooled vehicles, which commonly means somewhere as un-exotic as Luxembourg, Ireland, the Channel Islands or the Isle of Man. This submission explains why this is the case, and how Government policy, notably in the tax area, can contribute to it.

  4.  When determining where to domicile a pooled investment vehicle, the principal concern is what is optimal for the investors, bearing in mind that the returns earned belong to them—whether they are pension funds, other institutional funds or retail investors. The investment managers represented by the IMA do not invest on their own account but act solely on behalf of their clients whose assets are being invested. They do not wish to be party to or vulnerable to any form of tax evasion or terrorist financing.

  5.  In selecting a domicile for pooled investment vehicles ("funds"), a manager will take into account a number of factors, but the broad objective will be to deliver the best outcome for the client and in the most operationally efficient manner. Given the multinational nature of many investment management businesses—investing in many different jurisdictions for clients from many different countries—it is clearly efficient to concentrate operations in a small number of fund ranges globally rather than to maintain different ranges in every jurisdiction in which they operate. Thus, many investors worldwide will see their money invested in funds outside their own country.

  6.  A number of factors will affect these decisions: the extent and cost of expertise in the domicile; how it fits in with other parts of the manager's business; and the likely impact of regulatory and tax factors on investors' returns.

  7.  Recent years have seen significant growth of offshore funds, notably in Dublin and Luxembourg, but also in other centres such as the Channel Islands and Cayman Islands, at the expense of UK-domiciled funds. A study by KPMG for the IMA,"Taxation and the competitiveness of UK funds", identified tax factors as key drivers of this trend.

  8.  This submission sets out the taxation aspects for this industry, for funds and for investors. There are, in certain circumstances, key fiscal uncertainties or clear disadvantages with using a UK fund as opposed to its offshore counterpart, especially where the same vehicle is intended to be sold to UK and non-UK investors alike. The simple fact is that the best location will tend to be selected. It is not the case that the UK is the default location—the UK must compete with other territories as a fund domicile. In many cases, the balance has been tipping away from the UK for some years and based on recent trends the UK could in the foreseeable future become a net importer of funds.

  9.  This has an impact on UK tax receipts and the current account, because of the professional and administrative activities which are carried out in the fund domicile rather than in the UK. Further work by KPMG for the IMA[376] estimated that for every £1 billion of funds which were in an offshore location rather than the UK, the cost to the Exchequer was £0.7 million in terms of lost direct tax revenues. Overall EU growth in retail funds has run at 1.5 times that of the UK in the last 10 years, but Ireland and Luxembourg have achieved growth rates of 10.7 and 2.6 times that of the UK.

  10.  If the UK were home to those funds domiciled in Luxembourg and Ireland with a UK investment manager, the UK direct tax receipts are estimated by the IMA to be equivalent to £286 million[377] a year.

  11.  It should be emphasised that this is not a call for lower taxes on UK funds (save in one very narrow respect, where we have pointed to the impact of Schedule 19 Stamp Duty Reserve Tax, which in total raises only £90 million) and certainly not on investment management companies. Instead it concerns the perverse impact of tax policies designed without funds specifically in mind. A good example is the unclear distinction between trading and investing for tax purposes, where the uncertainty that investors could face a penal and difficult to justify tax charge is an incentive to locate funds in a jurisdiction where the risk does not exist.

  12.  The IMA is in dialogue with HM Treasury about these matters. But we have been given no assurance from Ministers that they will be solved, while, of course, the UK's competitors do not stand still. Locations such as Luxembourg and Ireland have made very impressive progress in attracting funds, especially aimed at the European retail market. Likewise, the Channel Islands and Isle of Man are able to offer attractive domiciles to certain types of institutional funds.

  13.  In conclusion, the key points that the IMA would wish to make to the Committee are:

    —  There are good business reasons, which benefit both investment management companies and end investors, for locating certain activities offshore.

    —  Some of those factors are the unintended consequences of regulatory or, in particular, tax policies introduced for entirely different reasons.

    —  The IMA believes the Government should pay greater attention to the impact on the competitiveness of the UK as a place to do business when taking decisions on tax matters.

II.  COLLECTIVE INVESTMENT VEHICLES, INVESTMENT MANAGEMENT AND "OFFSHORE FINANCIAL CENTRES"

Background

  14.  This submission comments on the reasons why investment managers may choose to operate "offshore" and on the taxation implications for the Exchequer. The term "offshore" is a widely-used one, and it is important to explain what is meant by its use in the context of investment management.

  15.  The majority of the assets of institutional investors (pension funds, life companies, sovereigns, etc) are held under segregated mandates, where one investor's money is held and invested separately from and not pooled with other investors' money. The investor may be in one country, the investment manager in the UK and the assets located worldwide. It is common for global investment management houses to operate in a number of jurisdictions. It is obvious that a business needs to have staff and offices on the ground in order to handle marketing and client-facing aspects (ie "distribution"). However, it is also common for the contracted investment manager to delegate parts of mandates to group or third party managers who specialise in eg geographical sectors or certain asset classes. Equally, a UK investor may chose to contract with a non-UK investment manager.

  16.  However, this is about an international business model and is not about the use of offshore financial centres as such. Of more relevance to the Committee's deliberations, and therefore the area that this submission focuses on, is the use of pooled investment vehicles, where those vehicles are located in offshore centres.

  17.  To understand why investment managers may chose to locate collective investment vehicles offshore, it is necessary to separate the components of the business, being the industry, the product and the investor, each of which, separately, may be tax payers.

Components of the industry

  18.  The industry comprises those participants involved in "manufacturing" and distributing the product. The product for these purposes is a collective investment vehicle (hereafter referred to as a "fund"), into which investors may put their money. Many of these funds (though not all) will fall into a definition contained in statute, the "Collective Investment Scheme"[378]. A fund is an arrangement whereby investors come (or are brought) together, pool their money and have it managed on their behalf on a discretionary basis by an investment manager, ie the assets being managed are not under the day-to-day control of the investors.

  19.  Funds may be structured as trusts, corporate vehicles, partnerships or contractual vehicles. They may be "UCITS" (undertakings for collective investment in transferable securities), which are the only EU regulated financial product and may be marketed across Europe to retail investors. The Financial Service Authority (the FSA) authorises UK funds (both UCITS and non-UCITS) and recognises EU UCITS and certain other offshore regulated funds (eg Channel Islands and Isle of Man funds) for sale to UK retail investors.

  20.  In the business of collective investment management, use of "offshore financial centres" means making use of a fund that is legally domiciled offshore. The investors remain resident in their home territory. The industry comprises components of activity which could be based in the location of the fund, the location of the investors, the location of the underlying asset into which the fund is investing or, indeed, simply where it is most beneficial to carry out the activity, independent of all these other factors.

  21.  A fund will have an operator. This operator will often be connected to the investment manager, who may, in turn, delegate part or all of the investment function to investment managers in other jurisdictions. In addition, fund administration is typically delegated to specialist third party providers.

  22.  In particular, UK funds authorised by the FSA for sale to retail investors—authorised unit trusts (AUTs) and open-ended investment companies (OEICs)—will have a fund operator who is specifically authorised by the FSA for that purpose. There is, also, an independent party who is responsible for exercising a supervisory role over the fund operator. This party is either the Depositary (for OEICs) or the Trustee (for AUTs). It is a company with specific authorisation by the FSA and its two major roles are custody of the underlying investments and oversight of the fund operator (a quasi-regulatory role).

  23.  Beyond these integral components of the industry, there are the various distribution channels which are used to bring the product (the fund) to the customer (the investor).

Collective investment and investor motivation

  24.  Every investor has different objectives, but common motivations that cause an investor to use a fund rather than invest directly in the underlying assets are:

    —  access to professional investment management;

    —  cost-effective access to asset diversification;

    —  cost-effective access to geographical sector;

    —  access to a wider range of asset classes; and

    —  liquidity (ie open-ended funds enable investors to redeem on request at a price based on the net asset value of the fund).

  25.  It is not only individuals who use funds. The assets of institutional investors are often partly or fully invested in funds. For example, pension schemes are particularly significant users. Smaller institutional portfolios may make segregated management uneconomic or, even, unviable; specialised funds are convenient for those with similar investment goals; market exposure through index tracking or geographical/asset class diversification may be more efficiently achieved by pooling, and so on.

III.  WHY MIGHT USE OF OFFSHORE FUNDS BE ATTRACTIVE FOR THE INVESTMENT MANAGEMENT INDUSTRY?

  26.  In the past, the UK regulatory regime has been viewed as unnecessarily restrictive for funds designed for institutional investors. Also, during the 1990s, after the first EU UCITS Directive had been adopted, the regulatory regimes for UCITS in Luxembourg and Dublin were, too, less restrictive. However, the FSA's fundamental review of its CIS rules in 2003 (which led to the new and widely-welcomed "COLL Sourcebook"), coupled with increasing scrutiny by and discussion in CESR of discrepancies between Member States' transpositions and interpretations of EU legislation, have significantly closed this regulatory gap between EU fund domiciles.

  27.  Unfortunately, though, the UK's fund tax regime is viewed as unattractive by non-UK and certain UK investors. This continues to drive managers to locate new funds offshore and, when consolidating fund ranges, to move existing UK funds offshore.

  28.  UK authorised funds are subject to a regime of taxation at fund level. For most UK investors and for most funds, this system works relatively efficiently, since the tax at fund level effectively operates as a payment on account system for investor tax (although see the reference to Stamp Duty Reserve Tax below). For some investors (generally, UK tax exempt investors such as pension funds and charities), though, UK funds with a significant tax charge at fund level are not efficient.

  29.  In addition, non-UK investors may be deterred by the fact that UK funds suffer tax at the fund level. Generally, most tax systems apply tax on most types of investment income based on the residence of the investor rather than the origin of the income (although some withholding tax may be levied by the source country). For foreign investors in UK funds, the fact that there is a 20% tax charge at the fund level is often a deterrent to investing in a UK fund, even though in practice most funds actually pay little if any tax given tax exemption for UK dividends, tax deduction for interest distributions and the general ability to offset foreign tax and expenses when computing tax. Nevertheless, the 20% headline tax rate gives rise to a negative perception.

  30.  Consequently, UK investment managers who wish to market fund ranges to non-UK customers tend to make use of offshore fund ranges (typically in Luxembourg or Ireland), where there is no tax at fund level. In the interests of economies of scale, once the decision to establish an offshore range has been taken, these funds may be marketed within the UK to avoid the cost of running a second product range purely for UK investors.

  31.  Another issue which managers must consider in deciding whether to domicile a fund outside the UK is that of "trading versus investing". UK authorised funds, although they pay tax on income, do not pay tax on capital gains. This is essential to prevent a double layer of taxation for investors.

  32.  If a manager thinks that there is any risk that the fund might be subject to a challenge by HMRC that it is engaged in a financial trading activity (rather than investing, an activity giving rise to "passive" income and gains), then any gains treated as capital for accounting purposes would potentially be subject to tax at fund level as the profits of a financial trade (ie taxable as income). The risk of a challenge is generally thought to be small, but the cost of such a challenge being successful would be commercially ruinous. For this reason, too, a manager may prefer to domicile a fund outside the UK.

  33.  It should be noted that where a fund is distributed into the UK, the manager will wish it to distribute sufficient income to obtain "distributing fund" status under the Offshore Fund Regime. Such status, which is in practice essential if the fund is to be commercially viable in the UK, avoids what would otherwise be a penal rate of tax for investors on disposal (ie so that UK investors pay 18% CGT on disposal rather than income tax at up to 40%). However, this is a consideration only for UK investors, and offshore funds that do not have to distribute income are more attractive for many non-UK investors.

  34.  As well as paying stamp duty reserve tax (SDRT) on its acquisitions of UK equities, a UK authorised fund has to pay an additional amount of SDRT based on units purchased and redeemed in two-week rolling periods. This raises little tax for the Exchequer (£90 million), but is complex to administer and audit, is dependent on information provided by third parties and, with a headline rate of 0.5%, supports non-UK investors' negative perception of the tax status of UK funds.

  35.  For these reasons, much institutional investment is undertaken via offshore funds. Moreover, these offshore funds are often "transparent" to some degree, for example contractual funds in Luxembourg or Ireland, or Property Unit Trusts in Jersey or Guernsey ("J-PUT/G-PUT"). The term transparent is used to describe an entity that is not itself subject to tax, but instead tax is levied at the level of its participants. Investors in transparent funds are effectively treated for tax purposes as if the underlying assets of the fund were held directly. Transparency enables an institutional investor to claim Double Tax Treaty benefits (such as reduced foreign withholding tax on income) based on the treaty in place between his own home state and the state in which the asset of the fund is located. A tax-exempt, but non-transparent fund would generally preclude such a claim by the investor, and the fund itself, being tax-exempt, would not be able to claim treaty benefits on its own behalf.

  36.  Likewise, a UK investor investing in UK real estate via a J-PUT/G-PUT would be outwith the Non-Resident Landlord Scheme for UK withholding tax, since the UK investor would be regarded as investing directly. In addition, for real estate investment outside the UK, offshore funds may assist in minimising transfer taxes similar to UK Stamp Duty Land Tax, their flexible regulatory regime may allow the use of holding companies to minimise foreign withholding taxes on income, and so forth.

  37.  Where the investment manager is resident in the UK, normal corporate (or potentially income) tax rules apply, and where the investor is resident in the UK, normal investment income (or corporation) tax rules apply, including (possibly) the Offshore Funds regime. In other words, as for "mainstream" offshore funds, the expected application of tax rules to the investment manager and UK investors is not usurped by the fund's domicile.

  38.  It is worth mentioning hedge funds for completeness. The main reason that these are not domiciled in the UK is that they would, it is widely believed, be regarded as engaged in a financial trade.

  39.  While many of these vehicles would be eligible for authorisation by the FSA as "Qualified Investor Schemes" (which cannot be marketed to retail investors), the UK fund tax regime is such that a UK authorised hedge fund would be tax-disadvantaged. So, the UK is not a hedge fund domicile in spite of the presence here of many investment managers of hedge funds. Instead, hedge funds tend to be located in those places where both the regulatory and tax regimes give the most flexibility, such as Bermuda or the Cayman Islands.

IV.  TAXATION IMPLICATIONS: ONSHORE VERSUS OFFSHORE

  40.  In looking at the various participants, the following comments may be made on the respective tax positions:

    Idustry: investment managers are subject to corporate profit taxes and employ staff who are subject to payroll taxes. These taxes are levied generally where the activity occurs (often the same location as corporate residence). The activity of investment management (ie asset allocation and stock selection), even for offshore funds, can quite easily take place in the UK, so is not directly linked to the location of the fund. However, a number of activities (for example, fund administration, depositary/trustee services and the services of professional advisers) tend to occur where the fund is located, and these activities are generally taxed, as for other businesses, in the local environment.

    Product: UK funds are taxable; Irish and Luxembourg funds are not. However, since the UK fund tax is creditable for most UK investors, this is not of itself independent tax revenue, so does not represent an overall saving of tax by any UK investors. As regards institutional funds, if transparent, the fund would not itself be a taxable vehicle, whether onshore or offshore, since the investor would be taxed as if investing directly.

    Investor: UK authorised funds pay out all their income and UK investors are taxed on this income. Offshore funds must basically pay out all or a very high proportion of their income to UK investors or the investors will pay a penal tax rate on disposal of their investment. Therefore, either way, the use of tax-exempt offshore funds does not actually represent a tax saving for retail investors. As noted above, for institutional investors in transparent funds, the investor is taxed as if owning the assets directly, so there is no tax differential. Importantly, UK exempt investors such as pension funds and charities are therefore left in the correct position if invested in offshore funds, whereas they may inappropriately pay tax if invested in a UK fund.

V.  CONCLUSION

  41.  For the investment management industry, an "offshore fund centre" commonly means somewhere as un-exotic as Luxembourg or the Republic of Ireland. Even for non-EU locations such as the Channel Island or the Isle of Man, offshore funds may well be used simply for regulatory reasons (eg to facilitate investment in certain asset classes) or simply for economies of scale (ie to enable the pooling of assets of different types of investor in the one vehicle without compromising their appropriate tax positions).

  42.  While the tax position for the fund itself will vary according to location, the investor is generally taxed similarly regardless of the location of the fund. This is not the case for some UK investors in UK funds, which makes offshore funds more attractive. The industry (the investment manager and other key service providers) will be taxed where the economic activity of the business is actually conducted. Therefore, the issue for the UK Government is not abusive tax behaviour using offshore centres, but the loss of business and employment tax revenues to the UK due to funds, and hence a number of associated business functions, being domiciled offshore.

  43.  A report by IMA/KPMG[379] found that for every £1 billion of funds domiciled offshore (which could have been domiciled in the UK), nearly £1 million a year has been lost to the UK Exchequer. Funds domiciled in Luxembourg and Ireland with UK investment managers already total twice the size of UK funds, and the size of the UK funds market continues to decline relative to these offshore centres. The loss to the UK Exchequer is therefore mounting.

June 2008









376   "The Value to the UK Economy of Authorised Investment Funds", KPMG/IMA, 30 November 2007 Back

377   Luxembourg €224.5 billion + Ireland €311.1 billion (source-local trade associations) x 0.2% average local expenses generated by funds x 36% estimated direct tax rate (CT and employment taxes) x 0.743 €/£ exchange rate. Back

378   As defined in s235 of the Financial Services and Markets Act 2000. Back

379   "The Value to the UK Economy of UK-Domiciled Authorised Investment Funds", KPMG/IMA, 30 November 2007. Back


 
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