Offshore investment funds taxed as income not capital gains
The UK has many authorised investment funds, which are common investment choices for UK tax residents. As with holdings in equity stocks, capital gains tax is payable on realised gains (e.g. a gain made when the investment is sold) on these securities. Capital gains are currently taxed at 24% for higher rate and additional rate taxpayers. The rules, however, are different for investments in offshore investment funds.
UK funds have certain tax obligations with HMRC; whereas offshore funds aren’t subject to the same rules. HMRC’s position is because they can’t always be certain whether a gain is of an income or capital nature. The result of this is that gains realised on disposals of interests held by UK investors in certain offshore investment funds are taxable as income rather than capital gains. This makes a big difference as the rates of income tax are up to 45% compared with up to 24% for capital gains.
Tax on offshore investment funds
Here, we explain the tax treatment of offshore investment funds, and the effect on UK investors when the fund applies for ‘offshore reporting fund’ status.
Specifically, we cover:
- reporting fund status;
- compliance requirements for offshore reporting funds;
- the application process;
- ongoing requirements;
- transitional arrangements.
Reporting fund status
For the reason above, many offshore funds with UK investors apply for ‘offshore reporting fund’ status with HMRC. This confirms that the fund will comply with certain rules to essentially bring it in line with the rules for UK funds.
Funds which have this status can be treated as if they are onshore UK funds for UK taxpayers. Any realised gains by its UK investors are therefore, generally, taxed as capital gains rather than income.
Compliance requirements for offshore reporting funds
The offshore fund must comply with certain rules, including the requirement to have an independent audit.
A key requirement of UK funds is they must pay out any excess income at least annually to investors. Funds generate income from their holdings in underlying securities and have expenses such as the annual management charge and depositary fee. Any net income must be distributed and this is taxed as income for UK investors.
As offshore funds don’t have to make distributions in accordance with UK rules, this creates a mismatch between the offshore and UK requirements. As a result, offshore reporting funds must fulfil requirements set under legislation, including disclosing their ‘reportable income’ to both HMRC and their investors to retain reporting fund status.
‘Reportable income’ each year is broadly a calculation aimed at mirroring what a distribution would have been had the fund been a UK onshore fund. The reportable income per share class is calculated and UK investors receive a report of this ‘reportable income’ which is used for their tax return.
UK investors must pay income tax on their share of the reportable income, even where they haven’t received any actual distribution from the fund or if the distributions they have received from the fund are less than the amount of the reportable income. However, the effect of this ‘dry tax’ charge for the investor may be small, compared to the tax savings that may be made if the future disposal of their holding in the fund would be taxable under capital gains tax rules rather than income tax rules that would apply if the fund did not have non-reporting fund status at all.
Application process
To apply for reporting fund status, funds must make an application to HMRC and send certain documents to them.
Applications must be received by HMRC before the later of:
- three months starting with the first day on which interests in the fund are available to UK investors, and;
- the end of the first financial period of account for which the fund is to be treated as a reporting fund.
UK funds are prepared in accordance with UK GAAP or International Financial Reporting Standards. Offshore funds using other country accounting standards must explain to HMRC on the application how they will be compliant with the requirements in the regulations for offshore funds.
Once approved, the fund classes will appear on a public list maintained by HMRC of all offshore reporting funds which is updated regularly.
Ongoing requirements
Each year, a submission by the offshore fund is required within six months of the end of each period of account with a calculation of its reportable income and other disclosures to HMRC. This is needed to maintain offshore reporting fund status in the UK. The offshore fund must also make available to each of their UK investors a report which enables them to determine their share of reportable income for their tax return.
Subject to limited exceptions, if an offshore fund wishes to add additional classes of interests in the fund, it is required to complete a further application to add these classes to the list reporting fund classes maintained by HMRC.
Transitional arrangements on conversion of offshore funds status
If an offshore fund is converted from a non-reporting fund to a reporting fund, there are implications for its UK investors. As disposals of investments in non-reporting funds by UK investors are subject to income tax and disposals of investments in reporting funds are usually subject to capital gains tax, transitional rules are required.
UK investors holding an investment in an offshore fund which converts from non-reporting to reporting have two options in this event:
- They can make an election for a deemed disposal of their non-reporting fund investment at its market value on the disposal date. This means they must pay income tax on any unrealised gains accrued up to the disposal date. This could mean finding cash to pay tax on gains which they haven’t yet crystallised, as they still hold the investment and have not actually sold them. However, if they do this, any gains made after the election are subject to capital gains tax rather than income tax – so there may be UK tax benefits for any growth in value.
- If no election is made, there is no tax to pay at the point of conversion from a non-reporting fund to a reporting fund. However, when the UK investor ultimately disposes of their investment in the fund, the whole of any gain realised is subject to income tax rather than capital gains tax, even if the fund is a reporting fund at the time of the disposal. Long term, this option may be less attractive from a UK tax perspective.
How we can help
The transitional rules may not be particularly appealing to UK investors. If a fund has or is likely to have UK investors, it is advisable to have offshore reporting fund status from the beginning, rather than obtaining this later. Contact us for further guidance.
