In 2001, HM Revenue & Customs (HMRC) published non-statutory guidance in its statement of practice 1/01 in the UK tax code on its interpretation of the conditions of the investment managers exemption. HMRC is proposing to revise this non-statutory guidance in a new statement of practice (SoP) and to publish this by the end of June 2007.
HMRC published a first draft of the revised SoP on 20 October 2006 on its website for public consultation and held a meeting in May for invited industry bodies and professional advisers, which McDermott attended, to discuss the detail of this draft revised SoP. HMRC gave advance notice as to the content and application of the SoP ahead of publication.
We summarise below this advance guidance from HMRC and give some practical advice to assist UK investment managers and their overseas clients in managing their current arrangements and compliance with the IME.
The UK Tax Code
A non-resident person trading in the United Kingdom through an investment manager will be within the charge to UK tax on worldwide profits attributable to the activities of that manager if the investment manager constitutes a "permanent establishment" (p.e.) of the non-resident.
The investment manager will not constitute a p.e. of the non-resident (which will therefore not be within this charge to tax), if the investment manager is "independent" of that non-resident and provides services to that non-resident in the ordinary course of the manager’s investment management business. The terms of a relevant double tax treaty may also provide for a similar exemption.
The UK tax code has a specific set of rules, known as the "investment managers exemption" (IME), which also exempts non-residents from this UK tax charge provided all relevant conditions are satisfied. If the IME applies, the manager does not constitute a permanent establishment of the non-resident. The IME was the subject of the proposed revised non-statutory guidance discussed at the HMRC meeting in May referred to above. The main points of interest arising out of this meeting are summarised below.
The revised SoP will be applicable from 1 January 2008, but may be relied on by the non-resident before that date if it is advantageous to do.
From 1 January 2008 there will be a two-year transitional period during which existing arrangements between non-residents and their UK investment managers can be re-structured in order to comply with the revised SoP. Accordingly, non-residents whose existing arrangements do not fall within the revised SoP on or after 1 January 2008 have two years to become compliant.
Where a non-resident failed to re-structure within that two-year transitional period for genuine commercial reasons, HMRC would still consider allowing a non-resident a further grace period provided that the non-resident is making a continued and genuine effort to become compliant.
HMRC does not propose to introduce a formal advance clearance procedure for the IME due to lack of resources. Instead, guidance will be given on an informal basis (by HMRC designated specialists) in response to individual requests from non-residents and their agents.
HMRC was also concerned that a formal clearance would become a "hallmark" of quality (for example, in the offshore funds industry) and would result in non-residents applying for clearance in all cases rather than only in cases where there is real uncertainty as to whether the IME applies.
The Independent Capacity Condition
The existing SoP 1/01 applies a "safe harbour" rule so that where a non-resident’s activities fall within certain prescribed factual circumstances, the independent capacity condition will be satisfied.
HMRC stated that the safe harbour practice will be replaced with a "hierarchy" in the revised SoP comprising a number of factual circumstances (listed below).
If the non-resident satisfies any of these circumstances, the UK investment manager will automatically satisfy the "independent capacity" condition.
In cases where the first four circumstances listed do not apply, the application of this condition will be determined considering all the factual circumstances and applying Organisation for Economic Co-operation and Development (OECD) principles as to what constitutes an "independent agent acting in the ordinary course of his business".
In all cases the terms of a relevant double tax treaty will apply in any event so a treaty claim should be made where available.
Effectively, the first four circumstances will operate as a form of "safe harbour" provision:
- The non-resident is a collective fund which is "widely held" within 18 months of its launch.
- The non-resident is a collective fund which is "actively marketed" (even if not widely held within 18 months of launch). The fact that the fund is quoted is no longer relevant to this condition (as it was for the purposes of SP 1/01).
- Services provided to the non-resident by the UK investment manager do not amount to more than 70 per cent of the investment managers’ entire business (we understand this will be reviewed over an 18-month period).
- The UK investment manager although failing to satisfy the third circumstance above can show an intention to satisfy this circumstance.
- Any other cases not falling within the four circumstances above are determined on their own facts applying OECD principles as to what constitutes an independent agent acting in the ordinary course of that agent’s business.
- Any other cases not falling within the above five circumstances can make a claim pursuant to any double tax treaty in place between the relevant jurisdictions. HMRC acknowledged that a double tax treaty claim will override and apply in priority to the IME/UK domestic provisions.
The IME conditions require that the UK investment manager receives remuneration for his services that is no less than is customary for his class of business.
HMRC explained that its approach to this condition would be to apply UK transfer pricing legislation which in turn implements and is construed in accordance with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
HMRC considers that where arrangements between the investment manager and the non-resident are UK transfer pricing compliant (which includes the compilation of appropriate transfer pricing documentation), this condition would be satisfied.
HMRC emphasised that even if a transfer pricing adjustment is required in any case this would not necessarily mean that this condition is not satisfied where parties have otherwise complied with their UK transfer pricing obligations.
The IME only applies in respect of investment managers carrying out only "investment transactions" on behalf of the non-resident.
HMRC confirmed that the following would constitute "investment transactions" capable of benefiting from the IME:
- Carbon emissions credits (so designated by additional legislation)
- Cash-settled real property derivatives provided by a third party and not linked to specific properties but only to an indices of property in a wide portfolio
- Cash-settled commodity derivatives
Any further guidance on what is an "investment transaction" was a policy issue which could only be provided by further specific legislation and not the SoP.
Concerns had been expressed by the industry that a single "inadvertent" trade by an investment manager which does not constitute an "investment transaction" would cause the non-resident to fail the IME.
HMRC will, by concession, allow non-residents to disclose any "inadvertent one-off transaction" without prejudice to the non-resident’s position provided that the investment manager was not acting negligently in making such a trade.
Practical Points to Note
HMRC reiterated its commitment to maintaining the certainty and flexibility of the IME which is vital in today’s competitive global marketplace. HMRC was keen to maintain dialogue with industry on the application of the IME in order to meet this objective.
The overall message from HMRC was that it does not wish to deny the benefit of the IME but that its main concern in monitoring the application of the IME is to ensure that UK investment managers are returning an arm’s length level of profits for UK tax purposes. HMRC wants to ensure that profits of UK investment managers are not being diverted offshore and out of the UK tax net. HMRC stated that this would be achieved by means of the application of the UK transfer pricing legislation (via the customary remuneration condition).
Provided that investment managers and their clients are not engaged in "abusive practices" for the purposes of taking advantage of the IME, HMRC would not seek to challenge arrangements which complied with UK transfer pricing legislation.
In light of the above guidance, compliance with UK transfer pricing legislation and undertaking transfer pricing studies backed up by appropriate supporting and contemporaneous transfer pricing documentation will go a long way to ensuring that non-residents can rely on the availability of the IME.