On 27 July, HM Revenue & Customs ("HMRC"), HM Treasury and the Department for Business Innovation and Skills launched a consultation on the modernisation of the tax rules for investment trusts. This was a welcome announcement, since modernisation of the current legislation, which dates back to 1965, is overdue.
It is hoped the consultation will represent a shot in the arm for the investment trust industry. In addition to wider economic factors, it has been argued that inequalities in the tax legislation have prevented investment trusts from competing on a level playing field with authorised funds and with the offshore funds industry.
In fact, the new consultation builds on a process of modernisation which has already begun through a combination of targeted Government initiative, changes in general company taxation and court judgements.
Recent Steps to Modernisation
In September 2009, the Government introduced an optional regime to allow investment trusts to elect to treat dividends paid out of "qualifying income" (broadly, interest income and certain derivatives and contracts for difference) as interest distributions. Dividends treated in this way are deductible for corporation tax purposes (unlike normal dividends), while investors receiving the dividends will be taxed in the same way as if they received an interest payment. Since interest would otherwise be taxed both in the fund and when received by the investor, the new regime removes one of the main sources of inequality between the investment trust and authorised/offshore fund sectors, which do not suffer taxation at the fund level.
Although not targeted specifically at investment trusts, last year's reform of the company distributions legislation removed some of the advantages enjoyed by the offshore funds industry. Under the old regime, dividends received by a company from another UK resident company were exempt from corporation tax, while dividends received from a non-UK resident company were taxed. The new rules now treat dividends from non-resident companies in the same way as those received from UK resident companies. This means that, in the majority of cases, dividends from any source received by a UK resident company, including an investment trust, will be exempt from corporation tax.
The courts have also had their part to play in removing tax inequalities between investment trusts and other authorised funds, notably as a result of the decision of the European Court of Justice in JP Morgan Fleming Claverhouse Investment Trust plc v HMRC. As a result of this case, the UK VAT exemption for management services provided to "special investment funds", which had previously only applied to authorised unit trusts, certain trust-based schemes and open ended investment companies, was extended to cover investment trusts. As most investment trusts do not make significant VAT-able supplies, the VAT incurred on management services represented a real cost. The extension of this exemption was therefore a welcome development and placed investment trusts on a level playing field with authorised funds and offshore funds.
The stated aim of the new regime introduced by the consultation is to facilitate the making of a wider range of investments by investment trusts, to remove areas of uncertainty in the application of the investment trust rules and to reduce the administrative burden faced by investment trusts. The new rules will apply to "closed-ended investment funds" which meet certain conditions. These conditions are broadly in line with the current investment trust qualifying criteria, but have been simplified.
The consultation contains a number of proposals which are to be welcomed:
- The requirement that an investment trust must not have a holding in any one investee company which exceeds 15% by value of the trust's investments is to be replaced by a spread of risk test. This will be based on the Listing Rules and will require the investment trust to maintain a published investment policy. The revised test is intended to eliminate the risk of a company inadvertently losing its investment trust status as a result of a minor breach of the 15% test.
- The income derivation test, under which an investment trust's income must be derived "wholly or mainly" from shares or securities, is to be abolished, allowing investment trusts to invest in a wider range of asset classes.
- In place of the existing requirement to obtain annual approval, an investment trust will make one application in advance to join the regime. Once within the regime, minor and inadvertent breaches of the qualifying conditions will not cause a company to lose its investment trust status, providing these are remedied without delay. Investors will benefit from the greater certainty this provides.
- Mirroring the regime which already applies to authorised investment funds and offshore funds, HMRC will introduce a "white list" of transactions which will be treated as investment, not trading, transactions for tax purposes. Any income from transactions on the white list is to be ring-fenced and will not be 'tainted' by other trading transactions undertaken by the trust.
While these proposals represent a positive move towards deregulation and greater flexibility, other changes announced in the consultation may be less helpful. In particular, proposals to remove the quoted company exemption in determining whether an investment trust falls to be regarded as 'close' and to amend the income retention rules have been criticised and it is hoped will be withdrawn or amended as part of the consultation process.
These changes have helped to remove some of the inequalities between investment trusts and other collective investment vehicles. The proposals announced as part of the consultation represent another positive step, and active engagement in the consultation is to be encouraged to ensure that the rules once enacted are 'fit for purpose'.
The consultation remains open until 19 October 2010, after which draft legislation will be published for comment prior to enactment in next year's Finance Act.
We would be delighted to provide further information to clients on the scope of the consultation and, if required, to assist clients in formulating responses to it.
Head of Tax
0141 303 2497
020 7002 8538
Director, Investment Companies
020 7002 8540
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This briefing is written as a general guide only. It is not intended to contain definitive legal advice which should be sought as appropriate in relation to any particular matter.