In my last post, I looked at the process of moving a UK limited partnership aboard. One critical matter which warrants closer examination in a post of its own is the offshore fund legislation. Whenever an offshore partnership has UK partners there is a risk that your partnership may be treated as an offshore fund. The offshore income fund (OIF) rules are intended to ensure that offshore arrangements cannot convert income into capital and so avoid income tax. Very broadly, the tax effect is to calculate profits as capital gains, but then to tax those gains as if they were income. So it is critical that any company, trust, or partnership in question does not qualify as an Offshore Income Fund. To check whether it does, a series of questions must be answered:
Firstly, is there an offshore fund entity? TIOPA s355(1)(c) expressly states that two or more persons carrying on a trade or business in partnership are not an offshore fund entity. Unfortunately, this isn’t necessarily a “get out of jail free” card. This only applies to a transparent partnership, so a partnership (such as one arising under German law) which is opaque for CGT purposes would not benefit from this rule. A transparent partnership that holds shares in an underlying company may be treated as a ‘fund of funds’. If so, each underlying arrangement must be considered separately. It seems reasonable to expect that if a direct shareholding in the company would be liable under the OIF regime, interposing a partnership should not avoid that liability. An offshore LLP may fall within the definition of a body corporate (TIOPA s355(1)(a)) in which case the partnership exemption has no relevant application in any event.
"...The key is to consider these rules before making a disposal..."
This brings us onto the next question: is there a mutual fund? Here we look to TIOPA s356, which sets out three conditions that must be met for a mutual fund to exist:
Condition A: the purpose or effect of the arrangement is to enable the participators to participate in the acquisition, holding, management or disposal of the property or to receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income;
Condition B: participants do not have day to day control of the management of the property. Day to day control does not exist by reason of rights to be consulted or to give directions.
Condition C: under the terms of the arrangements a reasonable investor would expect to be able to realise all or part of an investment on a basis calculated entirely or almost entirely by reference to the net asset value of the property or an index of any description. Condition C is satisfied if there is a liquidation date for the partnership.
The condition to take note of here is C, whereby our hypothetical partnership might qualify as a mutual fund if the partners can acquire buy-back rights to the underlying assets based on the proportion of the partnership in which they have rights. There are two exceptions to the definition of a mutual fund that might assist, whereby:
Condition D: a reasonable investor would expect to realise all or part of the investment only in the event of termination of the arrangement and
Either Condition E: the arrangement is not designed to be terminated on a specified date or a date determinable under the arrangement; or
Or Condition F: the arrangement is so designed but (i) the arrangement is not designed to produce a return that equates in substance to a return of interest [this needs to be the only agreed return] and (ii) none of the assets is a relevant income producing asset or the participants are not entitled to the income from the asset or to benefit from that income or any income after expenses any income is required to be paid or credited to the participants and a participant who is a UK resident individual would be subject to income tax on the amounts so paid or credited.
Simply providing for the possibility of the partners voting to terminate the arrangements does not automatically mean that the arrangement is designed to be terminated. Also note that the exception will not apply if the partnership is not excluded from the income profits of the underlying company.
Next, is the fund a non-reporting fund? This is straightforward: if it has applied to HMRC for reporting status, it is a reporting fund. If it has not done so, it is a non-reporting fund.
Now we ask: is this a non-transparent fund? There are two kinds of transparent funds that need to be considered: limited partnerships and Baker Trust Unit Trusts. A so-called Baker Trust is one which is transparent under its territorial law for income purposes but not for capital gains purposes. Limited partnerships are transparent, but underlying companies that comprise more than 5% of the partnership’s value must be considered as well. So a limited partnership that controls an underlying company may count as non-transparent.
Finally, is the fund exempt under the unlisted trading company exemption? This exemption is found in the Offshore Funds (Tax) Regulations 2009/3001 reg 31A. Intended to remove private equity firms from the legislation, the exemption sets out four conditions which, if met, remove the tax charge on disposal of an interest in an offshore fund on or after 27 May 2011.
Condition A: The disposal is of an interest in an offshore fund. For our purposes, this would be the partnership share and not the underlying partnership assets.
Condition B: The sole or main purpose of the fund is to invest in qualifying companies. Qualifying companies are trading companies (or holding companies of a trading group or subgroup as per TGCA 1992 Sch 7AC para 20-24, 26, 27) where the shares of the company are not listed on a recognised stock exchange, admitted to trading on a regulated market, or used to a substantial extent for investment transactions undertaken in the course of trade. This is a question of fact judged on a case-by-case basis.
Condition C: From the date on which the interest was acquired and until 12 months before the date of disposal, the fund met the investment condition. This condition is also met if the fund’s only asset is cash from the start of the fund’s first period of account until either 3 months or the point at which it meets the investment condition, whichever came first. The investment condition is that at least 90% of the value of the assets of the fund (excluding cash) consists of: (i) direct or indirect holdings in qualifying companies; (ii) shares or securities which are listed on a registered stock exchange that the fund intends to dispose of as soon as reasonable practical; (iii) listed shares where it is reasonably believed that they will no longer be listed within 12 months and thus will become shares in a qualifying company; or (iv) shares that would have qualified under (iii) above, but now will no longer cease to be listed and which the fund intends to dispose of as soon as reasonably practicable.
Condition D: The participants in the fund have access to and can obtain sufficient information to demonstrate that the fund intends to dispose of any holdings of shares or securities within regulation 31B(1)(b) or (d).
And there it is. If all of the above questions return an answer in the affirmative, then the disposal of the partnership share will attract a tax charge under the OIF regime.
The key is to consider these rules before making a disposal; don’t assume they won’t apply. As always, proper planning and consideration of the facts well ahead of time avoids headaches and the unexpected ire of HMRC!