UK investors in closely held offshore funds can be directly liable for tax if the fund makes a gain on an underlying asset even if the gain is reinvested by the fund and not distributed to the investor. There is also the potential for double taxation to arise for the investor as there is only a limited tax credit mechanism in the legislation. Essentially, the gain needs to be paid out by the fund as a dividend or liquidation proceeds within the following 3 years, otherwise the only relief given is that the tax may be deductible against the realisation proceeds of the investor’s interest in the fund. These unfortunate tax consequences derive from anti-avoidance legislation originally aimed at privately held offshore companies (Section 13 Taxation of Chargeable Gains Act 1992). However, the circumstances in which such a tax liability can arise have changed recently, and further changes are proposed in this year’s Finance Bill.
Currently, an investor can only be liable for a tax charge derived from an offshore fund if (broadly speaking) the investor’s allocable interest in the fund represents 10% or more. The good news is that this year’s Finance Bill proposes to extend this threshold to 25% or more. However, as a result of other recent changes to the tax rules relating to offshore funds, these rules now need to be considered on a sub-fund by sub-fund basis, rather than by looking at the fund as a whole. Accordingly, the circumstances in which a holding could exceed the relevant threshold are likely to be more common. For example, it could commonly be the case that a fund or particular sub-fund could be closely controlled when first established, particularly if a sub-fund is targeted largely at members of the manager, directors or employees. While the 25% threshold is much more generous than in the past it should also be noted that connected party holdings must be aggregated in assessing whether the 25% threshold is exceeded.
Fortunately, further exemptions from the above anti-avoidance rules are also proposed in this year’s Finance Bill as follows:
Gains arising from “economically significant” activity carried on outside the UK. This particular exemption may not be of much relevance in a fund context as it requires the provision of goods or services on a commercial basis involving the use of staff, premises, equipment and the addition of economic value commensurate with the size and nature of the activities.
(Gains on disposals where neither the disposal of the asset nor the acquisition or holding of the asset by the fund forms part of a scheme or arrangement to avoid capital gains tax or corporation tax. This exemption should prove far more useful in the context of UK investors’ holdings in bona fide offshore funds which are marketed widely.
Notwithstanding the above proposed exemptions (which will take effect retrospectively from 6th April 2012 assuming the Finance Bill is passed) it will be important to monitor the potential application of the legislation, particularly when significant redemptions occur in any period and to consider, where appropriate, the potential application of the above exemptions in the light of the relevant facts.