Offshore funds

Question proposed, That the schedule be the Twenty-second schedule to the Bill.

I have just a couple of questions about the schedule. The first relates to the clarity of the guidance that has been issued so far on the matter. My second and more substantive concern may seem a curious one for me to raise given my earlier remarks about the way in which the rules on the debt cap and dividend exemption seem to be driven by the EU, and the fact that the Government have assured us that they were robust to challenge. However, it has been suggested that the rules on schedule 22 may not be robust and may be challenged on whether or not they comply with EU rules.

Let me deal with the guidance point first. There is concern that although some guidance has already been issued by HMRC it does not address all the questions raised by industry during the consultation on schedule 22. The grandfathering rules that apply until 1 December 2009 are helpful, but they should address immediate industry uncertainty.

The characteristics-based definition is potentially so wide-ranging that instead of providing greater certainty, it is likely to make the position even more unclear. It is suggested that there may be a range of offshore arrangements that are not, in substance, funds, but that may be subject to the rules. There is concern regarding interpretation around offshore companies’ fixed lives, shared buy-back arrangements and liquidation exit routes as well as special purpose vehicles under partnership. It may be the Government’s intention to ensure that such areas are not caught by schedule 22, but, as they stand, the broad nature of the rules catches those entities.

This schedule introduces into legislation the definition of an offshore fund. It can be

“a mutual fund constituted by a body corporate” or

“a mutual fund under which property is held on trust for the participants where the trustees of the property are not resident in the United Kingdom” or

“a mutual fund constituted by other arrangements that create rights in the nature of co-ownership” where those arrangements are affected by non-UK law. The schedule then sets out some conditions that a mutual fund might need to satisfy to then be defined as an offshore fund. Therefore, some certainty is required. Uncertainty does not only impact on UK investors; it also creates additional complexity and administrative  burdens for the offshore asset management industry, which already has quite a lot to do in getting its funds in shape to meet the rules.

The second issue goes back to the breadth of the funds that might be caught. The offshore funds’ tax regime does not comply with the UK’s obligations under agreements that create the European economic area. Previous legislation linked the definition of offshore funds to the regulatory definition, as in sections 235 and 236 of the Financial Services and Markets Act 2000, and was unlikely in practice to apply to mainstream retail investments. However, the proposed definition set out in schedule 22 appears to bring a far greater range of investments within the definition of an offshore fund—that was the comment I made in the first part of my remarks about trying to have greater clarity. The definition is so broad that the question of the regime’s non-compliance with EC law arises in practice.

I have been given the following example, in which a UK bank offers, as a retail investment,

“a debt security which redeems at any time after a minimum holding period of, say, 12 months by reference to the FTSE 100 (though any chargeable asset, or index of chargeable assets, for capital gains tax purpose would provide the same result).

In the absence of complicating factors, such an investment should be regarded as a capital gains asset for tax purposes, with any gains, made on disposal of the investment subject to tax at 18%. The offshore funds rules will not apply because the mutual fund is constituted by a UK resident company.”

However, if the same debt security is

“issued by a French or a Luxembourg financial institution under the proposed new definition”, that definition is sufficiently broad to cause that identical investment to be subject to different rules, which would result in any gains being treated as income and therefore taxed at the higher rate. Therefore, if the Government introduce their plans for a 50 per cent. tax rate, those gains could be subject to tax at that rate, whereas the same security issued in a UK resident fund would be taxed as capital gains at 18 per cent. There appears, therefore, to be a difference between UK issuers of investments and non-UK issuers of investments, which constitutes discrimination. That, it is argued, then constitutes a restriction in the free movement of capital from UK resident investors to financial institutions resident in other EEA member states, which would be unlawful. I would be grateful if the Minister could comment on whether the Treasury believes that that differential treatment renders the rules in breach of EU law.

Schedule 22 is in two parts. The first part deals with a new definition of an offshore fund for tax purposes and the second part deals with the capital gains tax treatment of participants in certain offshore funds. The hon. Member for Fareham has concentrated on the first part, and, as I think that we agree on the second part, I will not specifically refer to it.

As the hon. Gentleman knows, following extensive consultation last year the Government introduced powers, in the Finance Act 2008, to modernise the offshore funds tax regime. At that time, we said that we would consult further with industry on a new definition for offshore funds, with a view to including that in the Finance Bill 2009.

Additional consultation has led to the inclusion of a new offshore funds tax definition, in part 1. With the new offshore funds tax definition, the Government aim to provide more certainty to UK investors and funds; to achieve, to the extent possible, economic parity with the position of UK investors in UK-authorised funds; and to strengthen existing anti-avoidance rules so that UK investors who choose to invest in offshore funds do so based on a commercial decision, rather than for tax purposes. The new definition uses a characteristics-based approach, which the hon. Gentleman referred to. That aims to counter unintended tax advantage being obtained when offshore arrangements are technically outside the current definition of an offshore fund but are economically the same as such a fund.

I shall now turn briefly to the substance of the schedule, before responding directly to some of the hon. Gentleman’s questions. Paragraph 40A defines the type of body that will be an offshore fund if it meets the characteristics defining a mutual fund. Paragraph 40B sets out three conditions that must be satisfied for a fund to be a mutual fund. There are powers to make regulations to amend the third condition, using the affirmative procedure. In addition, certain closed-ended entities are excluded.

Exclusions apply for those investors in closed-ended entities who can effectively redeem their investment only on the winding-up of the arrangements. Those exclusions are applicable when either the arrangements have no pre-determined termination date or are only generating a capital return and do not give rise to any income, or when all income generated is paid to credit to the investor and is taxed as income. The powers in this part allow for future changes to the legislation by regulations, and the Government will continue to monitor the area for avoidance and will use those powers if it becomes evident that schemes are being devised to convert returns that would otherwise be income into capital gains. The Government will also be prepared to make changes in the future if it is clear that certain arrangements should be excluded from the tax definition.

This part also amends the regulation-making powers introduced by the 2008 Act to repeal the existing offshore tax funds legislation and to ensure that existing investors in arrangements that do not meet the current definition of offshore funds are not adversely impacted by the change. We have made draft regulations available to the Committee, and they set out certain exceptions for UK investors from the tax charge to an offshore gain.

The hon. Gentleman made some points about guidance. As he knows, the guidance has been published by HMRC as a draft for consultation and is based on the offshore funds definition. I confirm that further guidance will be published on the operation of the rules. HMRC is happy to make the guidance clearer, following consultation responses on specific issues.

It is also right to emphasise the Government’s position, which is that we believe that there is no discrimination here with regard to the treatment of schemes and how they comply with EU rules. We intend to treat investors in funds that provide taxable income to investors as authorised UK funds in a similar way to investors in UK-authorised funds. So there is no discrimination.

I am grateful for the Minister’s comments about the compliance with EU law, but does he believe that, in the example that I gave, where a UK bank  officer reads as a retail investment a debt security that redeems at any time after, say, a minimum holding period and that return is subject to the movements of the FTSE, for example, which is not dissimilar to condition C in new section 40B, that return would be treated as income? The industry believes that that would be treated as a capital return and taxed at 18 per cent., not at the investor’s highest rate of income tax.

I do not want to be drawn into commenting on specific examples and giving rulings on them. I want to rest on the fact that we believe that what we are doing is compliant with EU law. Having heard what the hon. Gentleman says with regard to industry’s concerns about the treatment, I will see whether I can clarify matters, whether through correspondence or other routes.

What practical steps do the Government take in relation to the general issue of compliance with EU regulation? Do they go off to somewhere in Europe with the draft Bill and say, “Is this okay? Does it tick the boxes?” Or is it solely opinion from here? What consultation goes on with Europe?

As the hon. Gentleman is aware, extensive financial and legal expertise is available to the Government. When drafting legislation, the experts are aware of EU law that is extant in this and other areas. When drafting legislation we always seek to ensure that it will be EU-compliant.

The policy is to exclude partnerships where they are tax-transparent for both income and capital gains purposes. If we receive representations saying that certain partnerships are included in the definition but should fall outside it the Government will be happy to address that in regulation.

On debt securities issued by EU institutions, debt will not be treated as a participating interest in an offshore fund, unless it gives the right to participate in profits. That point is addressed in the extract of regulations previously provided to the Committee. I am more than happy to provide, in correspondence, further clarification, if it is required, on the specific point raised by the hon. Member for Fareham.

Question put and agreed to.

Schedule 22 accordingly agreed to.

Clauses 45 and 46 ordered to stand part of the Bill.

Schedule 23 agreed to.