Tax Transparent Funds provide a new opportunity to set up innovative fund structures in the UK, with particular attraction for fund managers, insurers and reinsurers, charities and pension funds.

TTFs are a new type of authorised fund, to be introduced by the end of 2012. These structures will implement the Government's proposals to make available a form of authorised tax transparent fund.

The Treasury have announced that they will issue a revised set of proposals by the end of July. This follows a consultation paper issued in January 2012 by the Treasury and a subsequent paper from the FSA setting out some more details of the regulatory framework that will apply to these structures. The FSA's preferred terminology appears to be that of the ACS (Authorised Contractual Scheme), rather than the TTF previously used by the Treasury - we will use TTF in this note.

The Treasury have indicated that the revised proposals will include some significant changes to their original proposals, but this seems an opportune moment to review the current proposals and consider what opportunities they offer, and what issues may need to be addressed.

A TTF can adopt one of two forms:

• A co-ownership structure. This is established by a deed between the operator and the depositary. While legal title to the assets of the TTF is vested in the depositary, the beneficial interest is held by investors as tenants in common or as common property
  
• A limited partnership structure. This is based on the familiar limited partnership under the 1907 Act, often used for unregulated collective investment schemes, but with some useful variations. In particular:
• The depositary becomes the first limited partner, but does not have to contribute capital
  
• Investors who redeem their holdings will not retain a liability for partnership debts
  
• Changes in the composition of the partnership or of partners' interests will not need to be registered with the Registrar of Companies.
  
  

Authorisation process
As with other authorised funds, the FSA must determine an application for a TTF which is a UCITS scheme within 2 months, while NURS and QIS applications have a 6-month time-limit. It appears that a limited partnership must be formed before the application for its application for authorisation as a TTF can be submitted to the FSA.

Changes to these vehicles have a one-month approval period, except that the FSA must deal with an approval to convert a TTF which is a feeder UCITS to a non-feeder UCITS within 15 working days.

Why use a TTF?
The attraction of a TTF lies in its tax treatment. Both forms of TTF are transparent as far as tax on income is concerned; but, for tax on capital gains, the LP structure (as with other LPs) is transparent, while the co-ownership structure is semi-opaque. In relation to overseas taxes that might be imposed on a disposal of fund assets, investors in the TTF will remain liable for those taxes, but, assuming that the overseas jurisdiction recognises the transparency of the TTF, would be able to access the same double tax treaty benefits and exemptions as if they had invested in the underlying assets directly. On that assumption, from the perspective of overseas taxes, a TTF structured on the co-ownership basis would be treated as fully transparent in relation to capital gains; but it would be treated as opaque for the purpose of UK taxation on capital gains, so the investor's UK tax liability for gains only crystallises when they realise their holding.

The most obvious use of a TTF, and the one most heavily promoted by the Treasury, is as the master fund of a master-feeder structure, as permitted since UCITS IV was implemented in July 2011. The Treasury's declared motivation is to promote the UK as a venue for establishing such funds, which are already permitted in Luxembourg, Ireland and the Netherlands in the EU.

However, there are also some other potential uses:

• As a pooling vehicle for tax-exempt investors such as charities and pension funds - in particular, for smaller pension funds where segregated mandates are too expensive. Pooling these assets will create cost and other efficiencies
• As a way for multinational companies to achieve economies of scale, by combining the administration of pension schemes across their group
• As a vehicle which will enable insurance companies to take assets off their balance sheet, thereby mitigating the impact of Solvency II
  
  

It may be an attraction that the Schedule 19 SDRT charge will not apply; and, for charity-only funds, the Treasury have indicated that there may be relief from stamp duty and SDRT on the acquisition of securities by the fund. Anti-abuse provisions are also promised.

It should be noted that TTFs are not confined to UCITS schemes. Using a QIS in particular may open the way to an authorised tax transparent structure for a wide range of assets, as long as the restrictions on eligible investors (which will include financial institutions) and on genuine diversity of ownership are observed.

Co-ownership or LP?
The Treasury view is that the co-ownership scheme is likely to be the preferred option. Under current proposals, it is more flexible than the LP: it can accommodate an umbrella structure, which an LP cannot (though the responses to the Treasury's consultation paper have suggested that this additional flexibility should be allowed for LPs as well). However, the LP structure is the more familiar one for UK funds lawyers and investors and might be more attractive to tax paying investors. For example, if a fund structured as an LP held gilts, an investor within the capital gains regime which disposed of its interest in the fund would be treated as disposing of a fractional interest in the gilts and would be entitled to treat any gain attributable to the gilts as exempt. However, if the fund were a co-ownership structure, our understanding is that an investor which disposed of its interest would be treated as disposing of a single asset - its interest in the fund - and would not be entitled to treat any part of the proceeds as exempt. A similar issue may arise in relation to any relief or exemption which depended on the nature of the asset held, e.g. the substantial shareholdings exemption. Nevertheless, an operator may find it unattractive that they have to act as the general partner of the LP, and therefore risk incurring unlimited liability for its debts.

Setting up a TTF
The Treasury propose to provide relief from Stamp Duty and SDRT on the seeding of a TTF. However, seeding could crystallise a capital gain unless the transferor was exempt from tax on chargeable gains - as would be the case, in a master-feeder structure, if the transferor was an existing UK authorised fund. In the case of seeding from the long term fund of an insurance company, it is proposed that any chargeable gain should fall under s212 CGTA, rather than being chargeable immediately.

Will TTFs work?
The previous attempt to create a vehicle for tax-exempt investors, the tax elected fund (TEF) was not successful, with less than 10 set up. This was, at least in part, due to the tax treatment of authorised funds under double taxation treaties. The Treasury are hopeful that the TTF regime will be accepted internationally as a tax-transparent vehicle, though some commentators believe that the time involved in bringing these vehicles within the treaty network means that the initiative is already too late - particularly as alternatives already exist in other jurisdictions. Nevertheless, fund managers, particularly those who already operate significant UK domiciled funds, may prefer to use a vehicle which is based in the UK, and operates under the auspices of the FSA or its successors.

The costs of operating these vehicles will be an important consideration. Reporting income and, for LPs, capital transactions will be a substantial administrative task, and the Treasury acknowledge that these vehicles may not be economic for direct investment by individuals or smaller corporate investors. However, for pension funds, insurers and charities, who can pool assets of sufficient size, they offer exciting opportunities which merit further exploration.

The consultation period on the Treasury paper closed in March, while the FSA's consultation closed in May. The Treasury have announced that they will issue their draft regulations by the end of July, and the response to the FSA's consultation will follow.

What points are outstanding?
The Treasury consultation did not contain a reference to extending the "white list" of transactions which will be treated for tax purposes as non-trading to the TTF regime, although possibly because this is a point of detail to be addressed in due course. In our view, this will be key from the perspective of both exempt and non-exempt investors, exempt investors wishing certainty that the TTF is not engaging in taxable trading activity and non-exempt investors needing to understand their tax reporting obligations (particularly under the co-ownership structure, where trading profits would need to be reported on an arising basis, while capital gains could be disregarded).

The ability for a tax transparent LP to adopt an umbrella structure is one area where, it is hoped, responses to consultation may lead to a change in the proposals.

Who could benefit from the TTF opportunity?

• Fund managers - an opportunity to set up structures to enable smaller charities or pension funds to pool their investments to achieve cost reductions
• Insurers/reinsurers - a method of taking investment portfolios off their balance sheet, and reducing the impact of Solvency II
• Charities and pension funds - an opportunity to save cost in the management of their investment portfolios

How we can help

We can provide a combination of specialist advisers to help assess the possibilities for using a TTF. Our team includes Nick Rutter, who has advised on the formation of all types of authorised fund, and has pioneered a number of innovative fund structures; Michael Livingston, the head of our Insurance group and an acknowledged expert on Solvency II, Gary Cullen, who heads our Pensions group and advises regularly on the issues currently facing the UK pension industry, and Alastair MacLeod, who specialises in the taxation of investment funds.

Contact us

For further information, please contact:

Nick Rutter
Partner
020 7002 8515
nick.rutter@mms.co.uk

Michael Livingston
Partner
0141 271 5730
michael.livingston@mms.co.uk

Guy Norfolk
Partner
020 7002 8568
guy.norfolk@mms.co.uk

David Young
Partner
0131 228 7179
david.young@mms.co.uk

Gary Cullen
Partner
020 7634 8729 / 0141 271 5779
gary.cullen@mms.co.uk

Alastair MacLeod
Associate
020 7002 8538
alastair.macleod@mms.co.uk

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