Tax Talk: Offshore funds rules – don’t get caught out

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We explain when the rules apply and look at some of the traps for taxpayers investing in offshore funds.

Offshore investments are a common element of any diversified investment holding. But holdings subject to the Offshore Funds Regime can present particular complications.

The rules for offshore funds are very complex and can interact in unexpected ways with other tax rules. So, it pays to be informed and we recommend taking specialist advice.

Separate guidance for non-domiciled taxpayers and offshore investments will feature in next month’s Tax Talk.

What do the offshore funds rules do?

The Offshore Funds Regime is a set of anti-avoidance rules designed to prevent taxpayers from using offshore structures to turn income (taxable at up to 45%) into a capital gain (taxable at 20%).

Without the rules it would be possible to invest in an offshore structure that accumulates the income within the structure (without paying any tax), then dispose of the investment and pay Capital Gains Tax (CGT) on the total. This would defer tax charges and save up to 25%.

The Offshore Funds Regime prevents this by subjecting the gains on the disposals of an offshore fund to Income Tax rather than CGT.

As the income accumulates it is not subject to Income Tax. Instead, the gain on disposal is treated as income (and taxed at 45%) rather than as a capital gain (which are taxed at 20%), thus cancelling out the tax saving.

When do the offshore funds rules apply?

At a very high level, these rules apply to corporate mutual funds, where.

  • the arrangements allow for the management of pooled investments and
  • the value of the investor’s holding tracks the value of the underlying investments.

It’s important to note that whilst these rules don’t apply to partnerships, they can catch arrangements that are transparent for Income Tax but opaque for CGT. For example, certain unit trusts or contractual arrangements, such as ‘fonds communs de placement’ (FCPs), are within the scope of the offshore funds rules.

If a UK investor invests in a structure that is transparent for Income Tax, but within the Offshore Funds Regime, they will be taxable on the income as it arises in the fund (as it is transparent for UK Income Tax).

The ultimate disposal will also be chargeable to Income Tax (as it’s within the definition of an offshore fund). This can be a problem: there has been no advantage to the UK taxpayer (no income has been rolled up), but the rules are still turning the disposal and capital growth into income.

Alternatively, if the fund is registered as a reporting fund (see below), the treatment of income is the same, but the ultimate disposal is considered a capital gain and taxed at 20%.

When investing in offshore funds, it’s vital that UK resident investors study the tax treatment of any overseas investment. We would be able to advise on this.

The tax charge and double standards

As we’ve said, when a fund is within the scope of the Offshore Funds Regime, a gain on disposal will be taxable as Income Tax (rather than CGT). But the same treatment does not apply to losses. A loss will remain a capital loss. That means losses arising from non-reporting funds cannot be set against the income gains, even on the same holding.

The mismatch in treatment can produce a higher tax burden. This is particularly problematic when combined with the disposal matching rules.

Matching rules are used to determine which purchases and disposals are matched against each other to calculate the gains.

Order for matching rules
1. against purchases on the same day as the disposal
2. against purchases in the 30 days after the disposal 
3. against all other holdings on an average cost basis

Here is an example of an individual’s transactions:

Date AmountPurchaseSale
1 January 2022Purchase 10050,000
31 January 2022Sell    (100)150,000
5 February 2022Purchase 100200,000
31 March 2022Sell    (100)250,000

In economic terms, the individual has made an overall gain of £150,000.

For tax, the disposal on 31 January is matched against the purchase in February (using rule 2), giving rise to a loss of £50,000. This is a capital loss and cannot be set against income.

The disposal in March is matched against the purchase in January (using rule 3), giving rise to a £200,000 gain that is liable to Income Tax at 45%, with no relief for the earlier capital loss.

The loss can only be set against capital gains (with relief at 20%).

Could reporting funds be the solution?

Under the regime, funds can register with HMRC as a reporting fund.

A reporting fund will report to investors all the income arising throughout the fund’s life. This will be taxable regardless of whether it has been distributed or not. Any undistributed income is called excess reportable income and is deemed to arise six months after the fund year-end.

This means that each year the UK investors will report and pay Income Tax on the income arising in the fund.

Whilst the reporting fund status will produce a dry tax charge on the undistributed income, crucially an investor will pay CGT at 20% on a disposal of a reporting fund.  

Reporting fund status can also avoid the issue on the mismatch of gains and losses and the treatment of funds which are transparent for Income Tax.

When a reporting fund gain isn’t a capital gain

There are circumstances when an investor in a reporting fund would not benefit from CGT treatment on disposal.

This happens when a fund changes from a non-reporting to a reporting fund after the investor has invested in it. In this situation, the investor does not automatically qualify for capital gains treatment on disposal, and they would have to make an election on the change in status.

The election treats the investor as making a deemed disposal (and deemed acquisition) at the market value of their interest in the fund, at the point when it is converted into a reporting fund. This crystallises any gains from the date of investment to the date of conversion. Any future gains will be treated as capital gains.

The election also gives rise to a dry income tax charge on the deemed disposal. But it allows the investor to claim CGT on future growth. The requirement to make an election is easily overlooked and can be a costly mistake. Often the change in status will be early in the fund’s life when gains are minimal. It will usually be better to pay the charge at the time of conversion than pay Income Tax on the ultimate disposal.

If you have any questions about the issues raised in this article, please contact Stephen Kenny or your usual PKF contact, who would be happy to help.