Original article co-authored with Claire Cummings (solicitor) and published in collaboration with Cummings Pepperdine LLP in November 2022.

Introduction

Anyone who is setting up a fund will be faced with a range of issues to consider. As well as the Jurisdiction of the fund and the fund manager, and the regulatory considerations which come with those decisions, is the overriding issue of tax.

The good news is that correctly setting up a fund which takes investments from UK individual taxpayers can give you an edge over others in your field. This is via the UK’s Reporting Fund Status Regime.

The simple explanation on how to do this is just to create a separate share class (or share classes / series) which only accept investments from UK taxpayers and let HMRC know all about it. But, as ever, there is an art to what might seem a simple route.

And in this note, we tell you about that art and how we can help you find the tax efficient solution for your fund which will give potential UK investors the tax benefits they would like to see.

Offshore funds with UK Reporting Fund Status are significantly more advantageous to UK investors over non reporting funds as Reporting Fund Status enables UK investors to have their gains taxed at capital gains tax rates of up to 20% rather than income tax rates of up to 45%. This 25% differential can be a significant gain to UK individual taxpayers.

The aim of the offshore fund rules is to treat investors in UK and non-UK funds equally from a tax perspective. The UK Reporting Fund Status Regime is optional and, once entered into, determines how UK investors are taxed both annually and on their gains upon eventual disposal.

Non-UK funds that meet the definition of an offshore fund can apply to HMRC to obtain UK Reporting Fund Status (RFS) if they meet certain conditions. Status is granted when the fund makes a successful application for Reporting Fund Status for each share class that has UK investors. Thus, each share class is treated as if it were a fund and calculations are prepared at a share class level.

HM Revenue & Customs (HMRC) publish a list of reporting funds that helps UK investors screen out any non- reporting funds when making investment decisions.

Investors

Law and regulation

The first port of call when considering investors is whether you will be able to sell your fund to them. This is a legal and regulatory matter.

The promotion of hedge funds is restricted by law and they may only be promoted to certain categories of investors as set out under relevant law; as a result they are generally directed at institutional investors, such as pension funds, and sophisticated high net worth individuals and, save with the exception of UCITS funds, are not available to the general public.

In the UK, there are two layers of legislation to consider. The first is the regulation needed for anyone who conducts a specified activity in relation to a specified investment and this is governed by domestic regulation. The second layer is the Alternative Investment Fund Managers Directive, as it has been on shored into the UK post-Brexit.

Tax efficiency and the reporting regime

Also crucial to the structure is how individual investors are taxed, in particular those who pay tax in the UK as they may be able to benefit from the Reporting Fund Status regime.

The stark 25% tax differential between reporting and non-reporting funds for UK individual taxpayers makes funds with UK RFS highly beneficial.

This significant benefit greatly increased the marketability of a fund with Reporting Fund Status in the UK. Any investors who need to confirm a fund’s Reporting Fund Status can check its name on a publicly available list that can be found on the “HMRC Reporting Fund Status List” on this link.

For an investor to benefit from Reporting Fund Status, the fund itself must be within the regime for the entire period the investor has held its investment.

Existing funds seeking Reporting Fund Status for the first time can still benefit if a UK individual tax paying investor chooses to elect to crystallise the gain to date, pay income tax and benefit from Reporting Fund Status going forward. Where there is no gain, no income tax is due on transition and the individual benefits as though their shares always had Reporting Fund Status.

Careful consideration is required before entering the regime as it may not be beneficial for all strategies, and we can advise on this. To expand, Reporting Fund Status may not be suitable for funds whose activities might be considered ‘trading’ (rather than investing) from a UK tax perspective. For example, a high frequency quantitative trading strategy may result in high levels of Excess Reportable Income (ERI), which is explained below, meaning that Reporting Fund Status may not be beneficial.

The Reporting Fund Status regime taxes investors on any income arising in the fund on an annual basis and the capital growth of the fund upon disposal. A fund which has Reporting Fund Status must comply with a number of requirements on an annual basis as the following need to be prepared:

  • A calculation of ‘reportable income’ to identify any ERI. This calculation is performed per share class or series that has Reporting Fund Status and is broadly a calculation of revenue income less revenue expenditure in the year. UK investors are then taxed on their share of any ERI arising. As most fees are typically revenue in nature for these purposes (except performance fees), calculations often result in nil ERI. Any dividend paid by the fund reduces the amount of ERI to be included in the investor’s tax return.
  • A report to investors stating the amount of ERI (even if there is nil ERI).
  • A documentation pack which needs to be submitted to HMRC and this must include a copy of the reportable income calculation, the report to investors, a declaration of compliance by the fund and its audited financial statements.

The deadline to meet these requirements is six months from the fund’s year end, albeit that there is no penalty unless the information is not provided within 10 months.

Those funds which have Reporting Fund Status and then invest in other offshore funds can benefit if the underlying fund has Reporting Fund Status as well. This is relevant to the fund’s annual reporting requirements as it will have to include any ERI from the underlying fund in its own reportable income calculations. Where the underlying fund does not have Reporting Fund Status, the investor fund under most circumstances, will have to include the movement in value of the underlying fund in its own reportable income calculations, thus potentially leading to a larger taxable figure for investors.

Share Classes

All the shares in the same class must be treated equally, thus it is necessary to create different share classes to accommodate varying rights. These include the rights or characteristics which relate to the reporting regime and it is common for a fund which holds Reporting Fund Status to have a separate share class or series for UK investors. A share class which is established for UK based employees / partners of the management company may also be set up and benefit from Reporting Fund Status.

Funds may also issue units in ‘series’ on a monthly basis. Whilst a separate Reporting Fund Status application is not required for every series (i.e. an application is made at the share class level as noted below), annual calculations must be submitted to HMRC for each series.

Timing is important.  An application for one or multiple share classes to have Reporting Fund Status must be made and submitted to HMRC before the financial year end for which Reporting Fund Status is sought. Where interest in a fund has been issued in the final three months of its year end, the application deadline is extended to three months from the date on which such interests were issued to investors.

Subsequently funds must undertake ongoing compliance and submit reports, calculations and supporting documentation to HMRC on an annual basis for each share class or series with Reporting Fund Status.

 

Also see link to our podcast on UK reporting fund status and key considerations for fund managers and investors in conversation with Cummings Pepperdine LLP.