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Unattractive face of offshore funds

For many investors, the idea of putting their money offshore has an almost mystic allure, conjuring up thoughts of returns out of reach of the taxman. The reality is not quite so simple and, in some cases, investing offshore can even be tax-disadvantageous.

I would like to give an overview of the situation concerning the sale of offshore funds back into the UK. It is a topical area as there is a possibility that the Government could come under attack from the European Commission for anti-competitive behaviour in this area.

There are many differing opinions on what the EU should be about. One thing on which most people agree, however, is that it should allow for a common market, that is, one where goods and services can be traded freely within its borders. One area where this should be easily achievable is financial services, particularly the sale of mutual funds.

The EU Ucits directive sets common standards which funds need to meet to be sold across borders. Broadly speaking, if a Ucits-qualifying fund is established in one EU country, it can be made available for sale in any EU country (subject to some registration requirements with the regulator in the target market).

The Ucits directive would seem to create a level playing field. In practice, however, some countries have barriers inhibiting this business. In the case of the UK, these are tax regulations in the form of the offshore fund rules. In summary, this legislation means that gains realised in offshore funds without distributor status are liable to income tax rather than capital gains tax. This is very unattractive to UK investors since it means that taper relief and the CGT annual allowance are not available to reduce the gains liable to tax.

Gains realised from offshore funds with distributor status will be taxed in the hands of the investor as if they were UK-domiciled funds. So, if the fund has distributor status, there is no problem. The single market is working.

Unfortunately, to qualify as a distributor fund in the eyes of the Inland Revenue, there can be no accumulating class of shares issued by that fund. Continental investors have a preference for accumulation shares, so the result is that an offshore fund cannot be constructed that is both attractive to Continental investors and tax-efficient for UK investors.

The offshore fund rules have been identified as “perhaps the most notorious example of harmful tax practice” in a report produced for Fefsi, the European investment funds industry association. It is also the subject of lobbying by UK trade bodies such as the Fund Managers&#39 Association and Autif.

The EU treaty requires that members should not persevere with tax rules which distort competition so it seems highly likely that these rules will be withdrawn at some stage. In the interim, in what scenarios might offshore funds be considered appropriate?

Direct holdings in distributor funds – for all UK residents. The holding of these funds is fairly tax-neutral. The CGT treatment is identical to the holding of an onshore fund. Income tax is a little more complex but should not be seen as too material.

Isa/Pep investments – the tax-free status of these wrappers means that holding any offshore funds is broadly tax-neutral compared with UK funds. The most significant difference is the lack of the reclaimable 10 per cent tax credit for offshore funds. But this difference is fairly marginal when considering the low level of income paid on most equity funds together with the fact that this concession is due to be removed in April 2004.

Cash investors – by investing in an offshore roll-up fund, an investor&#39s gains (effectively, rolled-up interest) will be liable to income tax. On the face of it, this is no different than if they held their cash in the UK. The advantage is one of timing. Interest earned in the UK is taxed as it arises but interest rolled up in an offshore cash fund is taxed when it is realised. If the investments are held for the long term, this deferral of tax payment can be a significant benefit, compounded by the earning of interest on all amounts deferred.

UK-resident, non-UK-domiciled investors – investing in offshore distributor funds will give the CGT efficiency of holding an onshore fund with the IHT efficiency of keeping the assets outside the UK. This means the investment will not form part of the investor&#39s estate for tax purposes.

Buying offshore funds can offer some benefits but these tend to be in quite specific cases. It is easy to get carried away with the technical structure of a product rather than focusing on the underlying investment suitability. Intermediaries need to be mindful of this in advising clients.


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