Bringing Asset Holding Companies to the U.K. With a New Tax Regime

The U.K. continues to lead the European asset management industry, with the largest market outside of the U.S., at over 9 trillion pounds ($12.7 trillion) of assets under management. Despite that, rigid tax rules in the U.K. have resulted in asset management teams frequently acquiring investments into asset holding companies (AHCs) set up outside of the U.K.

Luxembourg is a particularly popular choice, with a comparatively flexible tax regime allowing asset managers to set up reliable investment platforms while minimizing the risk of duplicative layers of tax for their investors.

Looking to the future of the investment management industry in a post-Brexit world, the U.K. government has been considering what would be needed to make the U.K. a more competitive jurisdiction for AHC structures.

Following two rounds of consultation over the last year, the government is now looking to entice asset managers back onshore with the anticipated launch of a new beneficial tax regime designed to remove the barriers to widespread use of U.K. AHCs. If successful, this regime could further cement the U.K.’s dominance in the industry, while delivering organizational and administrative benefits to U.K. funds.

This article considers how we expect the new rules to work, as well as highlighting the key challenges which the government faces in achieving its goal while limiting the tax benefits to genuine fund structures.

Current Rules for U.K. Asset Holding Companies

To predict what the new regime might look like, it is worth first considering the challenges which it is expected to address. The overriding objective of asset holding structures is to ensure that investors are not put in a materially worse position than if they had invested directly. Under current U.K. law, that can be difficult to achieve with a U.K. company.

For example, when a U.K. company sells an investment it will, by default, be subject to U.K. corporation tax on its capital gains. Although relief is potentially available through the U.K.’s substantial shareholding exemption, it can be difficult for a fund to know with certainty whether the prescriptive conditions will be met at the outset of the investment—in particular, requirements in respect of the sufficiency of the investee’s trading activity.

In addition to the risk of tax within the structure, it can also be difficult for a U.K. AHC to repatriate sale proceeds to the fund’s investors, as returns delivered via a typical share buyback procedure will be treated for U.K. investors in the same way as a dividend, effectively converting the fund’s capital receipts into income.

U.K. AHCs also incur stamp duty when using a share buyback to repatriate funds. While stamp duty is a less material concern given the low 0.5% rate, it still represents an additional tax cost to the use of U.K. companies compared to other jurisdictions.

Another obstacle for U.K. AHCs is the practicality of funding investments using shareholder debt. Over recent years, the importance of shareholder debt for investment platforms has been reduced in many jurisdictions, following the introduction of restrictions to the tax deductibility of finance costs (in response to the Organization for Economic Co-operation and Development’s base erosion and profit shifting project).

However, shareholder debt remains a useful tool for structuring interim returns to investors by way of interest payments and repayments of principal.

For U.K. AHCs, there is a risk of tax drag due to the imposition of withholding tax at 20% on annual interest paid to an overseas lender. This can usually be managed either by claiming relief under the U.K.’s extensive double tax treaty network, or structuring shareholder debt within the exemption for listed Eurobond securities. However, this adds administrative burden for U.K. companies and, in cases where a treaty is unavailable, could represent an additional cost.

For many funds, the use of a Luxembourg investment platform represents a simple and reliable means of circumventing those challenges.

When a Luxembourg AHC sells an investment, it is comparatively easy to access Luxembourg’s European-style participation exemption from tax on its capital gain, as the conditions refer to the size and duration of the company’s interest in the investee, without generally referring to the investee’s underlying business. No stamp duty should be payable when the sale proceeds are subsequently repatriated to the fund’s investors, and the capital nature of the proceeds should be preserved in the hands of U.K. investors.

Additionally, Luxembourg does not impose withholding tax on interest, making shareholder debt a simpler proposition.

For funds generating more substantial income returns, such as credit funds investing in a portfolio of underlying loans generating interest income, Luxembourg structures may be particularly attractive due to the availability of profit participating loan arrangements. These can be used to repatriate changeable levels of interim returns while retaining an appropriate taxable margin in the Luxembourg AHC, proportionate to its role as an intermediate vehicle.

This structuring does not work in the U.K., where tax deductions are denied for returns on profit dependant loans.

Landscape for a New Regime

We will not know the precise details of the new rules until the publication of draft legislation in the coming weeks. However, the government has given helpful indications of what the general framework might look like following the second stage of its consultation.

Rather than an overhaul of the U.K.’s existing tax code, we are expecting the new rules to constitute a bespoke regime which qualifying U.K. AHCs can join by making a corresponding election. Qualifying AHCs opting into the regime will then benefit from beneficial tax rules designed to accommodate investment platform structures.

This is likely to include an exemption from tax for the U.K. AHC when it exits from an investment. While some conditions may apply, we expect these to be equivalent to a European-style participation exemption, rather than the more difficult U.K. substantial shareholding exemption. Similarly, the regime is likely to permit U.K. AHCs to repatriate sale proceeds to investors without converting gains into income for those in the U.K. An exemption from stamp duty on share buybacks would also be welcomed by the industry.

The rules may also simplify the barriers to funding a U.K. AHC with shareholder debt, including an exemption from withholding tax on interest. The rules should also allow tax deductions for U.K. AHCs on profit participating debt, to facilitate the holding of income generating investments without disproportionate tax leakage in the U.K.

In line with other jurisdictions like Luxembourg, we would expect this to remain subject to transfer pricing principles (as well as other general restrictions on deductions for finance costs) such that the U.K. AHC is taxed on a margin. However, tax on the AHC’s income ought to be modest, in line with its limited function as a holding vehicle.

Those changes would also need to be supported by rules switching off various anti-avoidance provisions across the U.K. tax code which might otherwise cut across, and potentially counteract, the intended benefits.

These would be significant derogations from U.K. tax law, and so the government is proposing to gate the regime behind strict eligibility criteria to ensure that it can be accessed by its intended audience only. As a starting point, the regime is likely to be available only to AHCs held to a sufficient extent by widely held qualifying funds or institutional investors.

Further eligibility criteria may include a requirement for the AHC’s investments to be managed by an independent regulated asset manager, as well as a requirement that the AHC’s activities are limited to holding investments for the benefit of the ultimate investors.

Challenges for the Treasury

The U.K. government will need to strike a balance between ensuring that the benefits of the new regime are exclusive to genuine widely held investment structures, without adding undue complexity or burdensome requirements that could hinder adoption.

The eligibility criteria mentioned above will be particularly sensitive—not least since there are no such criteria for Luxembourg AHCs to enjoy similar treatment.

There is a risk that asset managers will not regard the wider U.K. AHC regime as viable if the ownership requirements are so prescriptive as to bar access for more complex structures. For example, it is not uncommon for funds to hold their interests in AHCs indirectly through one or more intervening vehicles, or for private co-investors to hold minority interests in the AHC. Accordingly, the ownership requirement may prove unpalatable if it cannot accommodate these features.

Further difficulties may arise if the requirement for independent management does not accommodate self-managed funds, or if the drafting of an activity requirement introduces too much uncertainty.

Rather than locking the regime behind prescriptive and unwieldy gateways, the government could potentially sidestep these issues by drafting the eligibility criteria generously, while building targeted anti-avoidance rules into the regime to exclude bad actors.

The government faces more structural challenges around how to differentiate between latent capital gains accruing for AHCs within the regime, which ought to benefit from exemption, and latent taxable gains accruing either before an AHC joins or after it leaves.

Clearly, it will not be appropriate to penalize an existing U.K. AHC upon entry by triggering an unfunded tax charge on its accrued gains, although this might work if the gain becomes chargeable only on a future disposal. Similarly, asset managers may be put off if loss of eligibility carries draconian tax consequences.

A better approach might be for the assets of an AHC exiting the regime to be rebased to market value, effectively “banking” any accrued exempt gains while leaving future capital growth taxable as normal.

What Next for Asset Managers?

Once the draft legislation is published, asset managers currently using overseas investment platforms will need to consider whether the new regime is enough to justify bringing their future investments onshore. This will require managers to work through the final eligibility criteria to determine whether the regime is accessible for the types of structures utilized by their funds.

Close scrutiny of how the regime delivers its benefits to qualifying entrants will also be necessary. While the Treasury is keen to include as wide a range of funds as possible, there are likely to be unintended edge cases where genuine widely held funds with more novel structures fall foul of restrictions or requirements built into the regime to prevent avoidance.

The regime is also expected to include some compliance obligations for U.K. AHCs opting in, including a requirement to submit reports to HM Revenue & Customs. While these obligations ought to be relatively manageable, managers will need to weigh the extra administrative burden against the benefits of holding their investments in the U.K.

The Treasury is alive to these concerns and has conducted its extensive consultation process with a view to structuring the new rules in a clear and reasonable way, giving asset managers as few reasons as possible to choose another jurisdiction over the U.K.

The Treasury’s engagement with the industry thus far has been promising, but whether this objective can be met will be put to the test once the draft legislation is published.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Rhiannon Kinghall Were is head of tax policy and Alex Ereira is a senior solicitor with Macfarlanes. The authors have been heavily involved in the development of the AHC regime from initial concept through to the recent consultations.

The authors may be contacted at: rhiannon.kinghallwere@macfarlanes.com or alexander.ereira@macfarlanes.com