Asset Management Tax Alert Unauthorised unit trusts: The end of the race Back in 2001, EY published a paper entitled Cancel the race. This paper compared the tax regime for unauthorised unit trusts (UUTs) to a one lap race. Managers and advisers spend a lot of time calculating and paying income tax over to HMRC and the investors (predominantly UK pension funds and charities) then spend a lot of time preparing and submitting reclaims of this tax. HMRC spends a lot of time reviewing tax returns and collecting tax, and then more time reviewing reclaims and repaying tax to investors. Allin-all a lot of effort is expended to ensure money goes round in a circle and and no tax revenues are generated. The conclusion of our 2001 paper was rather straightforward and obvious; why not cancel the race? For UUTs invested in by tax exempt investors, would it not be less effort for all involved to have the UUT not pay tax and, therefore, negate the need for investors to reclaim tax? Twelve years on from the publication of Cancel the race, The Unauthorised Unit Trusts (Tax) Regulations 2013 (SI 2013/2819) have been published ( the new regulations ). The new regulations provide for a new tax regime for UUTs. The new rules aim to cancel the race for UUTs invested in only by UK tax exempt investors. In addition, HMRC is aware that UUTs have been used in what it considered to be abusive tax avoidance structures and the new regulations aim to prevent this in the future. The new regulations come into force on 6 April 2014. This alert summarises the changes brought about by the new regulations and considers the actions that managers and operators of UUTs may need to take to prepare for the new regime. Exempt versus non-exempt Under the current rules, if for a whole fiscal year, all unitholders of a UUT are exempt from UK capital gains tax (CGT) (for reasons other than residence), the UUT itself will also be exempt from CGT for that fiscal year. Such UUTs are often referred to as exempt UUTs (EUUTs). Other than the exemption from CGT, there is currently no difference in the taxation of EUUTs and non-exempt UUTs (NEUUTs). Going forward, the new regulations specifically define EUUT and NEUUT and provide for a very different tax regime to apply to the two categories.
Exempt unauthorised unit trusts The new regulations provide that a UUT will be an EUUT for a period of account if: its trustees are UK resident throughout the period all of its unitholders are eligible investors, and it is approved by HMRC as an EUUT A unitholder is an eligible investor if they are exempt from UK CGT for reasons other than residence. The first two conditions are no different to the current position. The requirement that an EUUT needs to be approved by HMRC is new. Approval by HMRC as an EUUT A UUT will need to submit an application to HMRC for approval as an EUUT on or before the last day of the first period of account for which approval is sought. An application for EUUT status must contain: a statement specifying the first day of the period for which approval is sought a copy of the current trust deed a copy of the most recent prospectus an explanation of the controls operated to ensure that no ineligible investors are allowed to invest in the UUT, and a statement of whether the fund operates income equalisation arrangements or not. HMRC has 28 days to respond to an application by accepting it, rejecting it or asking for further information. Acceptance of status as an EUUT is conditional on the UUT continuing to meet the following conditions: Appropriate arrangements must be in place to prevent ineligible investors from being allowed to invest in the UUT No period of account can exceed 18 months Financial statements of the EUUT must be prepared for each period of account and must comply with the Statement of Recommended Practice for the Financial Statements of Authorised Funds (issued by the Investment Management Association) ( the SORP ) in relation to determining whether returns are revenue or capital, and Such financial statements must be audited by an independent qualified auditor The operators of the EUUT must, when submitting their self-assessment tax return, include a copy of the audited financial statements and also include a statement that no ineligible investors invested in the EUUT during the period. Taxation of EUUTs EUUTs will continue to be subject to income tax (and exempt from CGT), but the new regulations make a number of modifications: The basis period of taxation for a fiscal year will be the period of account ending in that fiscal year. Currently UUTs pay tax on income received up to 5 April each year, irrespective of to what date their accounts are drawn up. This is obviously a very significant simplification of the compliance burden Interest income will be taxed on the basis of the amount recognised in the audited accounts as revenue. Currently UUTs tax interest income on the basis of the accrued income scheme which is complicated and often leads to income being taxed in a different period to when it is recognised. Again, this change is a significant simplification of the taxation of EUUTs. EUUTs will be deemed to distribute to unitholders the total income available for distribution as shown in the audited accounts. This deemed distribution is treated as being paid on the last day of the period of account and is deductible against the taxable income of the EUUT. If the distribution is more than the income subject to tax, the excess is carried forward and treated as a distribution in the following fiscal year. The deemed distribution is a gross amount and no withholding of income tax is required. This is the most significant change to the current taxation of UUTs where the deemed distribution is treated as an annual payment from which basic rate income tax needs to be withheld. The end result of these amendments is that, in most cases, an EUUT will have no tax to pay and its unitholders will receive a gross return. Generally the income subject to income tax will be the same as Unauthorised unit trusts: The end of the race 2
the income recognised in the audited accounts, and this income is then allowed as a deduction as a deemed distribution resulting in nil taxable income. The new rules are very similar in effect to the bond fund rules for UK authorised investment funds. Potential pitfalls HMRC could have chosen to make EUUTs truly tax exempt but decided not to. The main reason it chose not to was the concern that a tax exempt EUUT would not have access to the UK s double tax treaty network. The fact that an EUUT is still subject to tax means that care does need to be taken when running an EUUT as it is possible for a tax charge to arise. If a tax charge does arise in an EUUT, there is no longer any mechanism by which credit for that tax charge can be passed to the unitholders and, therefore, it will be a real cost to the unitholders. Two specific areas that EUUTs need to be aware are: Expenses. No relief is provided in the income tax rules for deductions for management expenses. Where expenses are debited in the accounts of the EUUT a potential difference therefore arises between the accounting income (and hence distribution) and the taxable income. This is no different to the current position and UUTs avoid issues with this by providing that expenses are deductible out of distributions to unitholders, rather than in arriving at the distribution. EUUTs will, therefore, need to continue to ensure their trust deed and accounts are drawn up appropriately. While the taxation of EUUTs was simplified greatly, it does seem a shame that the opportunity was not taken to simplify the treatment of expenses and this remains a trap for the unwary. Book to tax differences As stated above, where there are no differences between the accounting income and the taxable income then EUUTs are effectively tax exempt vehicles. However, if there are differences between taxable income and accounting income then a tax charge could arise in an EUUT as the deemed deduction may no longer be sufficient to offset against all the taxable income. This will particularly be an issue for EUUTs invested in real estate where there are very specific tax rules to follow that can differ from the accounting treatment (eg capital allowances versus depreciation and the treatment of lease premia). Problems could also arise for EUUTs that are feeders into transparent funds such as private equity LPs where taxable income is calculated by looking through the LP to the underlying returns whereas the accounting treatment is often merely to reflect distributions and fair value movements. Admission of an ineligible investor One of the key changes in the new regulations is to amend the current cliff-edge consequence of admitting an ineligible investor. Currently, where an ineligible investor is admitted to an EUUT, the whole fund loses the exemption from CGT for that fiscal year. This is the case no matter the size of the investment nor the length of time the investor was invested in the fund. In practice, EUUTs that have admitted ineligible investors have often negotiated a practical settlement with HMRC, but there was no statutory basis for this. The new regulations provide that an EUUT that admits an ineligible investor will not be treated as breaching the ineligible investor condition where the ineligible investor disposes of their holding within 28 days of the EUUT becoming aware of their investment (so long as the EUUT could not reasonably be expected to have been aware of the investment at an earlier time). If the ineligible investor is not tax resident in the UK, and if they are treated as receiving a distribution from the EUUT, the EUUT is not able to treat that distribution as deductible and therefore there would more than likely be a tax charge in the EUUT. As this tax charge would impact all investors in the EUUT operators may want to consider obtaining indemnities from investors so that they can recover the tax from the ineligible investor. Despite this welcome change, the cliff edge still exists. The new regulations provide that the 28 day relief can only be relied on twice in a 10 year period. If an ineligible investor is allowed into the fund for a third time in 10 years, the UUT will automatically breach and no longer meet the conditions to be an EUUT for that period of account. In addition, if an ineligible investor is admitted and not removed within 28 days of becoming aware that they are ineligible, the UUT will not meet the conditions of being an EUUT. Unauthorised unit trusts: The end of the race 3
Other changes A number of other helpful changes were also made by the new regulations. These are: Where an EUUT is invested in a non-reporting offshore fund but has sufficient information to calculate the reportable income that would be due to it if the offshore fund was a reporting fund and such amount is included in the EUUT s income available for distribution, the EUUT can treat the offshore fund as a deemed reporting offshore fund and therefore not be subject to tax on any offshore income gains. Where an EUUT s aim is to replicate an index and that index contains non-reporting offshore funds, no tax will arise to the EUUT on the disposal of the non-reporting offshore fund. Where an EUUT carries out certain specified investment transactions, these will always be treated as investments and not trading transactions. The list of specified investment transactions is the same as is available for investment trust companies and covers transactions in most financial assets Transitional rules The new regulations provide for a number of transitional rules: EUUTs will transition into the new regime in either 2013/14 or 2014/15 depending on their accounting date. EUUTs that have an accounting date between the date the new regulations were made (31 October 2013) and 6 April 2014 will transition in 2013/14 and all other EUUTs will transition in 2014/15. In the transitional year, the current tax rules continue to apply but with some modifications: The income subject to tax is the income arising from 6 April to the EUUT s accounting date ending in the year. Any deemed payment or deemed deduction that would otherwise be treated as being made after the accounting date in the transitional year shall be treated as made on the last day of that accounting period. Any income that has been accrued in the EUUT s accounts for the transitional year but would otherwise arise in a later period will be treated as arising in the transitional year. These rules in effect ensure that all income and distributions accounted for in the accounts of the EUUT for the transitional year are taxed or deducted in that year. Non-exempt UUTs Under the new regulations, any UUT that is not approved as an EUUT will be a NEUUT. As stated above, HMRC has indicated that it is aware of UUTs having been used in what it considers to be abusive tax avoidance schemes. During the consultation period HMRC stated that most of these schemes made use of NEUUTs and, therefore, its aim was to prevent this opportunity in the future. The tax treatment of NEUUTs under the new regulations is, therefore, straightforward in that they will be taxed as if they are a UK resident company and the rights of the unitholders were shares in that company. In addition, the NEUUT will not be able to claim small companies relief and therefore will be subject to the full mainstream rate of corporation tax. Given this new treatment, it is unlikely that new NEUUTs will be created in future. Subject to the transitional rules set out below, NEUUTs will come within the charge to corporation tax from 6 April 2014. Transitional rules During the consultation period, HMRC accepted that there are a number of NEUUTs in existence that were set up for bona fide commercial purposes and which have a mixture of eligible and ineligible investors. It was recognised that tax exempt investors in NEUUTs would be disadvantaged by the change in the taxation of NEUUTs (as the investors have no way of recovering the corporation tax suffered by the NEUUT) and that for some funds it may be difficult to restructure the NEUUT to avoid this disadvantage. The new regulations therefore provide that where a NEUUT has both eligible and ineligible investors, the old tax rules will continue to apply to it for as long as it continues to have at least one eligible investor. To qualify for this treatment, the NEUUT must have had both eligible and ineligible investors at all times in the period from 24 May 2012 to 5 April 2014. As soon as a NEUUT no longer has any eligible investors, the new rules will apply and it will come within the charge to corporation tax. Unauthorised unit trusts: The end of the race 4
EY Assurance Tax Transactions Advisory Next steps The new regulations present a fundamental change to the way UUTs are taxed and anyone that runs, manages or administers UUTs needs to be aware of the new rules and start preparing for them. The first step is to identify all your UUTs and decide if they will be EUUTs or NEUUTs under the new regulations. Listed below are some of the questions to ask to ensure you are ready for the new regime. Do your NEUUTs require restructuring or are you able to take advantage of the grandfathering rules? How will the new tax rules impact your EUUTs and do you need to consider restructuring? This is particularly important for property funds, private equity funds and other alternative fund structures given the potential for irrecoverable income tax to arise Do your funds currently prepare audited financial statements? If they do, are they SORP compliant? What changes, if any, do you need to make to your financial statements and fund accounting processes? Are your funds tax returns fully up to date? In particular do you have a full calculation of the trustee s income pool? During the consultation process HMRC stated that they will be paying particular attention to the calculation of trustee s income pool. Ultimately, is a UUT still the best structure for your funds or could your fund be run more efficiently in another legal form such as the new UK tax transparent fund? How EY can help About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC300001 and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London, SE1 2AF. 2013 Ernst & Young LLP. Published in the UK. All Rights Reserved. ED None In line with EY s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. ey.com/uk EY provides tax assurance and advisory services to UUTs. We were heavily involved in the development of the new regulations, working with and providing comments to HMRC throughout the process. Our multi-disciplinary team will be able to help you quickly understand the impact the new regulations will have on your funds and help plan any remedial or restructuring actions that will be needed. To discuss this alert and how EY can help you please contact one of the names listed below or your usual EY contact. Stuart Chalcraft schalcraft@uk.ey.com 020 7951 1190 Alex Seeley aseeley@uk.ey.com 020 7951 6096 Ben Smith bsmith5@uk.ey.com 020 7951 8144 Lynne Sneddon lsneddon@uk.ey.com 0131 777 2339 Unauthorised unit trusts: The end of the race 5