The last quarter of 2019 saw ‘nudge-letters’ being issued by HMRC’s ‘Wealthy & Mid-Sized Business Compliance Unit’ to hundreds of UK taxpayers for suspected of non-compliance relating to their investments in offshore funds. Another batch of these letters were issued in July 2020 but these were issued by the HMRC ‘Risk and Intelligence, Offshore Unit’ and seem to be more detailed due to the increased exchange of tax information agreements with other nations as well as the Common Reporting Standard (CRS). The intention of these letters is to prompt voluntary disclosure by taxpayers and ensure that they are reporting the correct amount of income and gains to HMRC.

A sample nudge letter sent by HMRC can be found here.

This increased scrutiny by HMRC is a result of two key reasons 1) incorrect or no reporting by investors of their Excess Reportable Income (ERI) from offshore funds with Reporting Fund Status (RFS) and 2) gains from disposal of investments in non-reporting offshore funds being treated as a capital gain (and being subject to a lower rate of tax) rather than an offshore income gain.

Furthermore, it has also come to HMRC’s attention that some financial institutions (i.e. private banks, wealth managers etc.) are not providing the appropriate income declarations arising from offshore funds to UK investors, thus the investors may be unaware of their filing obligations.  Even when financial institutions have complied with their obligations, by making the ERI information publicly available on their website or emailing it to the relevant investors, it is often difficult to fully ascertain whether the investors have correctly included the provided information in their tax returns.

What is RFS?

The reporting fund regime provides an advantageous tax treatment for investments made by UK investors in offshore funds, a UK investor is subject to income tax on gains realised from investments in non-reporting offshore funds, attracting a tax rate of up to 45%. However, where an offshore fund obtains and maintains RFS, UK investors can have their gains taxed at capital gains tax rates of up to 20% (although this is widely expected to rise), thus providing a significant reduction in the tax liability of the individual.

Obligations of RFS funds

To gain entry into the RFS regime, offshore funds must make an application to HMRC to be included in the list of approved offshore reporting funds. As part of maintaining RFS, funds must prepare annual calculations that need to be submitted to HMRC. This calculation aims to tax undistributed income arising from the fund, called ERI, which is subsequently attributed to the relevant investors. As mentioned, ERI arising to the UK taxpayer is taxable at income tax rates and must be included in the individuals’ self-assessment tax return.

Reporting funds also have the obligation to provide reports to participants (investors) in the fund stating if there is any ERI arising. This report needs to be made publicly available and can be passed on to investors in several ways, but the most common methods used in practice are to either make the report available on the fund’s website or to email it to the relevant investors. Therefore, where this is not sent directly to the UK investors, it is not unusual for some investors to be unaware of any ERI that may have arisen to them.  Therefore, it is important for fund managers / financial institutions to communicate this information to all relevant UK investors even though in reality this may sometimes prove operationally difficult and add to costs. Furthermore, it might be the case that the relevant investors are not familiar with their reporting obligations under the regime and therefore may not always understand what to do with the information provided to them. This can also be the case for their personal tax advisors who may not always be familiar with compliance obligations for investors in offshore reporting funds.

HMRC expect the relevant information to be made available to them and relevant investors within 6 months of the accounting year-end of the relevant fund, however, there is no breach if these obligations are completed within 10 months of year end. Therefore, funds with a December 2019 yearend have latest until October 2020 to submit the relevant documents and make their reports available to investors.

Consequences to the fund

Where RFS funds fail to fulfil their obligations under the reporting fund regime and do not provide the required information within 12 months of the deadline, they receive a notice from HMRC stating that going forward they will no longer benefit from RFS and be treated as a non-reporting offshore fund. This could not only prove disadvantageous to investors but is also bound to have reputational damage on the relevant fund.

Consequences to the individual taxpayer

The failure to declare amounts of ERI on the self-assessment tax return and pay the correct tax liabilities to HMRC could attract punitive rates of penalties and interest on the taxpayer. The amount of penalty that can be charged depends on whether the error was due to careless behaviour, deliberate behaviour or deliberate and concealed behaviour.

Under the recent Failure to Correct rules, any undisclosed income of foreign origin can attract a penalty of up to 200% of tax owed as well as well as an asset-based penalty of up to 10% of the value of the relevant assets plus interest. Adopting a proactive approach in resolving historic non-compliance and taking the initiative to tell HMRC about a potential error may help reduce the overall penalty due.

Final Thoughts

Considering that ERI arises 6 months after a reporting fund’s year-end, it might not be taxable for UK investors until over 2 years later (for example, a fund with a 31 December 2018 year-end has ERI arising on 30 June 2019 and for an individual investor this falls within the tax year ended 5 April 2020, where the tax return is due by 31 January 2021), it is important that records are kept of when any tax liabilities may arise from investments in offshore funds.

With the likelihood of HMRC to continue sending nudge letters to affected UK taxpayers, it is important for investors to understand their filing obligations around their offshore income gains and for all parties to communicate effectively. The investor relations team may be best placed to liaise with UK investors in this regard and ensure they understand their filing obligations. The first step therefore would be to ensure that the staff communicating the information understand the requirements and are aware of the obligations. However, care needs to be taken so as not to give any tax advice when communicating with relevant investors and direct them to the HMRC website or their personal tax advisors where required. The fund prospectus should also be reviewed to ensure that the UK tax section of the prospectus adequately highlights the issue and reporting requirements.

Understanding the obligations under the reporting fund regime can be complex for both fund managers and investors, as such professional advice should be sought where required to ensure compliance.