Aiming For Compatibility?

JONATHAN SCHWARZ, barrister, examines the compatibility of the offshore fund rules with European Community law.

PLANS BY THE Government to reform the taxation of offshore funds have largely been welcomed by the investment management industry and professional advisers. It is widely accepted that there is need for change on pragmatic grounds to reflect the current open environment within which investment takes place. In part, the move is driven by regulatory issues in Europe pressing towards a single market in financial services. The need to comply with European Community law is frequently mentioned, but seldom analysed in more detail.

The purpose of this article is to look at the European Community law questions raised both by the existing rules and any future reforms. The need to comply with European Community law in both cases is clear. First, any future system will need to be fully compliant if it is to be effective. Secondly, regardless of any reforms, to the extent that the existing offshore fund régime is contrary to Community law, this may provide a defence to assessments or, in some cases, claims for compensation from the Inland Revenue.

Fundamental freedoms

It is well established that even in the absence of harmonisation, the tax laws of Member States must be consistent with Community law. Two basic rights in the EC Treaty are potentially in issue in relation to cross-border fund management:

Article 49 - the freedom to provide services; and
Article 56 - the free movement of capital.

Both Articles have been the subject of tax cases involving cross-border investment in the European Court of Justice. In Safir v Skattemyndigheten [1998] STC 1043, the Court struck down a Swedish rule which imposed a different tax régime on life insurance products based on where the insurer was established. In that case, a Swedish resident policyholder was liable to a special tax in respect of a policy issued by a United Kingdom life company. Similar policies were not taxed if issued by Swedish life companies who were themselves subject to tax. The Court ruled that it was contrary to Community law for any national legislation to impede a provider of services, such as insurance, from actually exercising the freedom to provide them, or which had the effect of making the provisions of services between Member States more difficult than the provision of services exclusively within one Member State. Such treatment was only supportable if it could be objectively justified.

Free movement of capital was the ground for striking down discriminatory Dutch taxation of dividends in Staatssecretaris van Financiën v BGM Verkooijen (Case C-35/98) [2002] STC 654 (ECJ). In that case, an exemption available to Dutch resident individuals on modest amounts of dividends received from Dutch companies, but not on similar amounts received from companies established in other Member States, contravened the provisions relating to free movement of capital.

Offshore fund régime

In their current form, the offshore fund rules apply to any collective investment schemes constituted by a non-resident company, a unit trust scheme with non-resident trustee or other arrangements under foreign law which create rights in the nature of co-ownership (section 759(1), Taxes Act 1988). By comparison, onshore equivalent schemes are generally authorised and unauthorised unit trust schemes or limited partnerships.

The central difference between onshore and offshore collective investment schemes is that, in the case of offshore funds generally, a disposal gives rise to an income tax charge in circumstances where the disposal of an equivalent onshore fund would give rise to a capital gain (section 757). The precise impact of this has changed since the rules were first enacted in 1984, as the difference between income tax and capital gains rates became aligned. However, today most investors would, as a result of the offshore fund rules, not have access to the annual exemption for chargeable gains and no opportunity for taper relief (and indexation up to 1998).

There are other important points of difference:

• There is no deemed disposal on the death of an investor in respect of an onshore fund, although the base cost is uplifted to market value at the date of death. In the case of offshore funds, death gives rise to a deemed disposal at market value triggering an income tax liability at that time.
• Rules permitting exchange of securities under section 135, Taxation of Chargeable Gains Act 1992 do not apply to the acquisition of offshore funds by companies or funds which are not themselves offshore funds. Reconstructions and amalgamations under section 136 cannot take place without triggering a taxable disposal where offshore fund interests are exchanged for non-offshore fund interests.

Distributing funds

The only way to escape income tax treatment for investors is for the fund to be certified as a distributing fund by the Inland Revenue. The key requirements are:

• distributing 85 per cent of income annually (section 760(2), Taxes Act 1988) - income in this sense is the higher of accounting income and profits (other than capital gains) computed according to United Kingdom tax rules;
• having an acceptable profile of underlying investments (section 760(3));
• certification as a distributing fund is an annual process;
• if at any time an offshore fund fails to qualify as a distributive fund, then all the gain is taxed as income and not just for periods in respect of which the fund fails to qualify;
• if an umbrella fund, every sub-fund must satisfy the requirements or no part will be certified.

Are these provisions contrary to European Community law? In relation to the free provision of services, Article 49 precludes the application of national legislation of Member States which, without objective justification, restricts the freedom to provide services within the Community. This includes legislation which has the effect of making the provision of services between Member States more difficult than the provision of services exclusively within one Member State (EC Commission v France (Case C-381/93) [1994] ECR I-5145 and Safir v Skattemyndigheten). It is therefore necessary to determine whether the legislation creates obstacles to the freedom to provide services and whether, if this is the case, the obstacles are objectively justified. The offshore fund régime contains several obstacles. The norm, i.e. uncertified funds, imposes several significant disadvantages in the tax treatment for United Kingdom resident investors in European based funds as identified above.

Another difference between onshore and offshore collective investment schemes is in the treatment of income generated by the fund. In general, onshore funds either treat income as distributed or require distributions to investors. Compulsory distributions in relation to offshore funds only apply to approved distributor funds. The original purpose behind offshore funds was to limit the tax attractions of offshore roll-up funds where interest essentially accumulated tax-free until the investment was cashed in, and then taxed at capital gains tax rates which were considerably lower than income tax rates. The rules, however, apply across the board regardless of the underlying investment and, indeed, regardless of whether distributions are actually made (except in the case of approved distributing funds). Income tax treatment also applies to that part of any gains attributable to underlying investments, as well as any rolled-up income. It also applies to any appreciation as a result of currency fluctuations. On the other hand, interests in offshore funds may be sold without stamp duty or stamp duty reserve tax, unlike their onshore counterparts.

It is unlikely that the benefit of deferral in relation to undistributed income will be viewed by the European Court of Justice as offsetting the disadvantages. For example, in Compagnie de Saint-Gobain Zweigniederlassung Deutschland v Finanzamt Aachen-Innenstadt (Case C-307/97) [2000] STC 854, the Court held that discrimination in one respect cannot be cancelled by more beneficial treatment conferred in another area.

Does the availability of distributor status remedy the discrimination? The régime relating to certified distributing funds, although eliminating the disadvantages of offshore fund status, creates several obstacles. First, a compliance cost is imposed on funds based in other Member States, which is not imposed on United Kingdom based funds. Secondly, certification is only possible within the requirements of the legislation. Thus, funds that do not meet the investment profile of section 760(3), Taxes Act 1988 cannot qualify. Similarly, since the whole of a fund must be a distributing fund, it is not possible for a non-United Kingdom based European fund to be offered to both United Kingdom and other European investors as an umbrella fund with different classes of shares to meet differing investment requirements. The manner in which distributable amounts are determined is also more burdensome.

If these are indeed obstacles, can they be objectively justified? The reason that the offshore fund rules were enacted was to prevent tax avoidance. This has been rejected by the European Court of Justice as a justification (ICI v Colmer (Case C-264/96) [1998] STC 874 and Metalgesellschaft Ltd and Others v Commissioners of Inland Revenue (Case C-397/98) [2001] STC 452). In Safir, the Court regarded cost differential and the information burden as being obstacles. Similarly, special administrative requirements applicable to foreign based policies were regarded as obstacles. The Court in that case rejected the reasons cited by the Swedish Government, namely the need to fill the fiscal vacuum arising from the non-taxation of savings in the form of life policies taken out with non-Swedish companies. In Safir, the Court regarded the restrictions on freedom to provide services as being sufficient to invalidate the Swedish rules, and therefore declined to consider whether there was also a restriction on the free movement of capital.

In Verkooijen, the Court held that the unavailability of the exemption (in that case, 2000 Dutch Guilders) for dividends paid because the paying company was not Dutch resident was contrary to the prohibitions on free movement of capital. In particular, Council Directive 88/361 requires Member States to abolish restrictions on movements of capital taking place between persons resident in Member States. In order to facilitate this, capital movements are classified into various categories which include collective investments (Annex 1, paragraph IV). In Verkooijen, the Court noted that the failure to permit the exemption in respect of dividends paid by companies in other Member States had the effect of dissuading nationals from investing their capital in companies in other Member States and also has a restrictive effect as regards companies raising capital across borders. This was because less favourable tax treatment is given to foreign investments than local investments. This differentiation was regarded as a restriction on capital movements within Article 1 of EC Council Directive 88/361. The Court rejected the need to preserve the cohesion of the tax system (Bachmann v Belgium (Case C-204/90) [1994] STC 855) as being applicable in this context. It likewise rejected arguments that loss of revenue was to be regarded as an overriding reason in the public interest which could be relied on to justify a measure in principles contrary to a fundamental freedom.

However, as a result of the Maastricht Treaty, several defences under Article 58 are available to Member States in the context of free movement of capital. These include in particular the right to apply relevant provisions of tax law which distinguish between taxpayers 'who are not in the same situation with regard to their place of residence or with regard to the place where their capital is invested'. These rules do authorise different tax treatment for investments made in and outside a Member State. As derogations from the general principle, these rules are likely to be strictly construed. The scope for differentiation on this basis is therefore wide, although its limits are unclear. However, because of the rule relating to the freedom to provide services, this may provide little practical support for a régime which does discriminate.

Past breaches

In addition to setting the ground rules for a new régime for taxing collective investments, Community law has a bearing on past tax liabilities. European Community law may thus be invoked as a defence to a tax assessment. In addition, where improperly imposed tax has been paid, it may be reclaimed. The procedure to be adopted will vary according to circumstances. In some cases, this may be a simple matter of submitting an amended return. Where that is not possible, proceedings may need to be commenced in the High Court in the same way as are currently under way in Hoechst AG and another v Commissioners of Inland Revenue and HM Attorney General (the advance corporation tax group litigation).

The Inland Revenue has generally been reluctant to concede European Community law issues and the claimants have thus been compelled to pursue these issues through the courts. Whether this remains its approach in the light of the decision of the European Court of Justice in Metalgesellschaft Ltd, and Hoechst AG (joined cases C-397/98 and C-410/98) [2001] STC 452, which requires the payment of compensation for tax laws in breach of Community law, where the breach is sufficiently serious, remains to be seen.

Jonathan Schwarz practises at 3 Temple Gardens Tax Chambers, London, tel: 020 7936 3988, e-mail: jonathan.schwarz@taxbarristers.com, website: www.taxbarristers.com.

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