Rise of non-UK investment companies to continue

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Issues of tax domicile have figured in the UK election, with arguments over ‘non dom’ status and the transparency of overseas territories. However, as the dust settles on some of the rhetoric, it is essential that this does not cloud the legitimate benefits that offshore jurisdictions have brought to the listed investment company sector.

The rise of non-UK domiciles has been one of the most significant developments in the sector over the past decade. Back in 2004, Channel Islands investment companies managed just £5bn of assets. Today they manage just shy of £40bn, accounting for more than 30 per cent of the sector. Though tax has played a role in this, this has had nothing to do with avoidance, but reflects the fact that the UK has taken time to develop a funds tax regime that is sympathetic to the asset classes that investors have been looking for in recent years.

There is an overarching philosophy for the taxation of funds. Namely, investors should pay no more tax than if they had invested directly in the underlying assets. After all, why should you be punished in tax terms simply for investing via a fund rather than direct? If you end up paying significantly more tax through a fund, many investors will simply abandon the fund structure and either invest direct or, if that is not practical, not invest at all. Any additional tax raised would be minimal and investors would lose out in terms of choice and diversification.

So there are two basic choices over how a fund and its investors can be taxed; you can tax the investor, and exempt the fund, or vice versa. Almost every major fund jurisdiction has accepted that the most suitable choice is to tax the investor, not the fund. After all, most of the largest investors (e.g. pension funds) are tax exempt, so taxing the fund would create the very tax penalty (compared to direct investment) that the regime should be trying to avoid.

Prior to 2000, most investment companies invested in what we might broadly describe as ‘long-only’ equity mandates. By and large, the UK tax regime worked pretty well for these funds. UK dividends could pass through the fund without the loss of tax, and capital gains were exempt. Overseas dividends were taxable but, due to the offset of management expenses and double tax relief, rarely resulted in a significant cost to investors.

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However, the closed-ended sector was already well served by these types of funds. As new launches moved towards ‘alternative’ asset classes, the UK tax regime failed to keep pace. Property, debt and hedge funds all struggled to fit into the UK tax regime, bringing the risk of double taxation, so it was inevitable that they sought out locations where they could achieve the correct tax result for investors. For many years since the turn of the century, non-UK investment companies have dominated fundraising.

Things have moved on since 2000, of course, with the UK adjusting its own tax regime in response. The UK REIT regime was introduced, though initially with a 2 per cent conversion charge that effectively prevented existing non-UK property investment companies from converting. The abolition of the conversion charge has since seen a number of these investment companies subsequently adopt UK-REIT status. The taxation of overseas dividends has been aligned with UK dividends. We have seen the introduction of a new regime to enable tax efficient investment into debt instruments and a new ‘whitelist’ of financial transactions that prevents the double taxation of common hedge fund strategies.

So, do all these changes mean that there will be a shift back to UK domicile? Looking at the current figures for fundraising by investment companies, you might be forgiven for thinking so. To date in 2015, about £2.5bn has been raised by the sector, with approximately 65 per cent being raised by UK-based companies. However, these figures are heavily influenced by the launch of Neil Woodford’s Patient Capital which at £800m was the largest UK investment trust launch ever.

Though 2015 may buck the trend as a result, my expectation is that future fundraising will still favour non-UK funds. Though the UK tax position has improved considerably, there are still technical challenges to be overcome, and today other factors, such as regulation, also have their part to play in domicile choice. However, as the majority of management fees are paid to UK-based fund managers, we should recognise the economic benefits this brings not just to the overseas jurisdictions, but to the UK as well.

But I think we will see greater balance in where investment companies choose to domicile in coming years. As a trade body that is domicile neutral, we welcome this. The more jurisdictions that are competing for this business, the greater the pressure for each to compete in terms of service standards and costs, and providing an appropriate and up-to-date tax and regulatory framework. All of which, ultimately, is good for shareholders. 

Key Takeaway: The pre-election rhetoric around tax domicile and changing tax regime is likely to lead to more investment companies choosing a new domicile, which is likely to lead to improvement in service standards and costs – great news for shareholders.

Ian Sayers is chief executive at the Association of Investment Companies.