United Kingdom

Author: | Published: 3 Oct 1999
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By comparison with other European countries, asset composition of UK Funds remains heavily weighted in favour of equities. London remains one of the world's most important centres for investment management and other financial services and Edinburgh also has a thriving asset management industry. In a research report published by Arthur Andersen, it was found that, globally 85% of respondents identified Europe as the market which would drive global industry growth within the next five years, and within that number 30% of asset managers and 39% of corporates identified the UK as one of the top three growth markets over the next five years.

RETAIL FUNDS

The Financial Services Act 1986 and regulations made pursuant to the Act provide the framework for the regulation of the marketing of CISs in the UK. In brief, UK retail funds will tend to be either domestic UK authorized unit trusts or, open-ended investment companies (OEICs), investment trust companies or regulated CISs established overseas (principally UCITS established within the EU or designated territory schemes established in any one of several designated territories). In addition, a large number of completely unregulated schemes are also being sold to the UK retail market through authorized financial intermediaries or independent financial advisers (IFAs). This article looks at each of them in turn.

Authorized unit trusts and OEICs

Authorized unit trusts and OEICs are CISs which comply with detailed regulations issued by the UK Financial Services Authority (FSA). These detailed rules cover, among other things, the constitution of the CIS, the powers and duties of the trustee and manager, the permitted investment and borrowing powers, and rules relating to pricing and valuations.

Different rules apply to different categories of authorized unit trusts; thus there are special rules for futures and options funds (FOFs), geared futures and option funds (GFOFs), property funds, warrant funds, securities funds, money market funds, feeder funds, funds of funds, umbrella funds, etc.

Once authorized, subject to the rules of the FSA and any other regulatory organization applicable to the promoter, an authorized unit trust or OEIC may be publicly advertised and sold in the UK. Many authorized unit trusts and OEICs are widely advertised in newspapers and other publications from where they may be sold off the page. In addition, an authorized unit trust scheme obtains exemption from tax on its capital gains.

The unit trust is a CIS where the investments of the CIS are held by a trustee on trust for the investors and managed in accordance with the directions of the fund manager.

The authorized unit trust was for many years the principal form of open-ended fund sold to the UK retail market. However, with the globalization of the CIS industry, legislation in 1996 was enacted to create the legal framework necessary for an open-ended CIS in a corporate form which would be more easily understood by European and other non-UK investors, as well as having the benefits of limited liability – the open-ended investment company (OEIC).

Investment trusts and venture capital trusts

An investment trust is, in fact, not a trust at all but (generally) a closed-end investment company which derives its income wholly or mainly from shares or securities, and which is incorporated in the UK or overseas, but which is tax resident in the UK and whose shares are listed on the London Stock Exchange and which complies with certain Inland Revenue requirements eg as to the spread of investments and the distribution of its taxable profits. As with an authorized unit trust, capital gains realized by an investment trust are exempt from tax. As the investment trust is listed on the London Stock Exchange it will be required to produce listing particulars in accordance with the Act and the Listing Rules of the London Stock Exchange. These Rules contain detailed disclosure requirements which enable the investment trust to be sold and advertised on a public basis in the UK.

In 1995 legislation was passed creating venture capital trusts. These vehicles are similar to investment trusts and in particular are exempt from corporation tax in respect of capital gains realized on investments, but, to qualify, a venture capital trust must invest 70% by value of its assets in unquoted shares of trading companies and meet certain other requirements. The creation of these vehicles was intended to encourage venture capital investments and significant tax benefits are available to persons investing in venture capital trusts.

UCITS

The 1985 EU Directive relating to undertakings for collective investment in transferable securities (UCITS) was implemented in the UK by the Act. In broad terms, it permits a CIS constituted in one member state and certified by the relevant authorities of that member state as complying with the Directive, to be marketed to the general public throughout the EU subject to the domestic marketing rules in each member state. Certain categories of authorized unit trusts referred to above are eligible to qualify as a UCITS fund.

Importantly, the same Directive also provides the framework for enabling UCITS established in member states other than the UK to be sold and advertised on a retail basis in the UK subject to the UK domestic marketing rules. In practice, Ireland and Luxembourg, because of their favourable tax regimes and flexible CIS laws, have been the most widely used jurisdictions in Europe for the establishment of UCITS funds aimed at the UK market. In order to market a UCITS fund in the UK the operator or manager of the scheme must give at least two months notice to the FSA and specify the manner in which the marketing is to be made. The FSA has the right within two months of receiving any such notification, to object on the grounds that the proposed manner of marketing does not comply with UK law.

Other regulated CISs

A CIS which is not a UCITS fund may nevertheless be a regulated collective investment scheme (and hence may broadly be publicly marketed and sold in the UK as if it were a UCITS fund) if either it is a designated territory scheme or is otherwise approved as a regulated CIS by the FSA. A CIS is a designated territory scheme if it is established and authorized in a designated territory and is certified by the regulatory authority in that designated territory to comply with the rules of such territory applicable to such schemes. Bermuda, Guernsey, Jersey and the Isle of Man have all been granted designated territory status.

Schemes which are not designated territory schemes and are not UCITS funds may still obtain individual recognition from the FSA provided that they can demonstrate to the FSA that the scheme itself affords adequate protection to investors, particularly with regard to the matters which are applicable to UK authorized unit trust schemes. In practice, very few schemes have been approved (or applied for approval) by the FSA pursuant to these provisions. It should also be noted that in the case of both the designated territory schemes and specially approved FSA schemes no prospectus or other form of investment advertisement may be issued in the UK unless its contents have been approved by a person who is authorized under the Act to conduct investment business in the UK. In approving any such investment advertisements such authorized person would have to comply with the rules of both the FSA and of any other regulatory organisation of which he is a member.

Retail promotion of unregulated schemes

If the CIS does not fall within any of the above regulated categories (and provided it is not a closed-end company, to which special rules will apply) the CIS may not be publicly advertised or sold off the page in the UK. However, promoters of such unregulated CISs may still access the retail market through authorized IFAs in the UK. This is particularly useful if a fund manager or other promoter is trying to sell a fund which, by virtue of the country of establishment or its structure or investment policy is incapable of qualifying as a regulated CIS. In brief, such unregulated schemes may be sold in the UK by authorized persons, including authorized IFAs, among others, pursuant to the Financial Services (Promotion of Unregulated Schemes) Regulations 1991. In brief, these regulations enable such IFAs or other authorized persons to promote and sell such unregulated CISs to other authorized persons and professional and business investors and, most importantly, to clients of the IFA or other authorized person (including newly accepted clients of the IFA or other authorized person). The IFA will have an obligation to any client only to sell him a CIS if the IFA is satisfied that the product is suitable for that client.

PEPs and ISAs

It is not really possible to understand fully the UK retail market for CISs without considering Personal Equity Plans (PEPs) and Individual Savings Accounts (ISAs). PEPs were originally introduced as a strategy to encourage wider share ownership. As from April 1999 new ISAs will be offered to replace PEPs. A maximum of £7,000 ($11,250) in the first year (1999-2000), falling to £5,000 in subsequent years, may be invested in ISAs free of tax by each individual investor. An ISA can include three components: cash; life assurance; and equities.

A maximum of £3,000 in the first year, falling to £1,000 in subsequent years, can be invested in cash. A maximum of £1,000 can be invested in life assurance in any year of operation of the scheme. Further sums up to the overall £5,000 limit may be invested in equities including most investment trusts and regulated CISs. . There will be no lifetime maximum limit on amounts invested. Investments in ISAs will be completely free of income and capital gains tax and in addition the scheme will benefit from the payment of a 10% tax credit for the first five years on dividends received from UK equities. In the past similar favourable tax treatment granted to PEPs meant that many investment trusts and CISs were sold to be held in PEPs and fund managers now regularly promote their own PEPs in conjunction with their stable of investment trusts or other CISs. These benefits are likely to remain available on the introduction of ISAs.

INSTITUTIONAL FUNDS

As indicated above, many CISs are formed for sale to pension funds, insurance funds, charities and other institutions in the UK. Many CISs sold to institutions may well be sold to the retail market as well or may (for example to take advantage of the tax breaks) be structured in the same manner as a retail fund (eg an investment trust). However, many of the institutional funds may have investment objectives which are incompatible with them being structured in any of the above forms. Alternatively a CIS may be targeted at institutions not just in the UK but also simultaneously in other jurisdictions in which case (for tax or regulatory reasons) a UK unit trust or investment trust may not be appropriate and a CIS formed in a neutral jurisdiction may be preferred. Most institutional funds which are not structured in one of the forms described above for retail funds are likely to be structured in one of the following forms.

Offshore and other non-UK funds

Typically an offshore fund targeted at the institutional market would be structured as an open- or closed-ended investment company established in a tax haven such as the Cayman Islands, Bermuda, Channel Islands, Mauritius and its shares would often be listed on a stock exchange such as Ireland or Luxembourg. However, offshore funds may also take the form of limited partnerships, offshore unit trusts or even contractual investment schemes. Furthermore funds established in jurisdictions other than the traditional tax havens (eg in Luxembourg, Ireland, the US, Switzerland) are also increasingly being targeted at UK institutional investors. Many offshore funds have their investment portfolios managed or advised by fund managers located in the UK; such offshore funds should not be subject to UK taxation on non-UK source profits provided that certain conditions are met, and provided, in particular, that the central control and management of the offshore fund is undertaken in such a manner as to ensure that the offshore fund does not become resident in the UK for tax purposes. Most of these schemes (other than certain closed-end investment companies which fall within a different regime) would comprise unregulated collective investment schemes under the Act. Although unregulated collective investment schemes cannot be promoted to the public in the UK, pursuant to the Financial Services (Promotion of Unregulated Schemes) Regulations 1991 referred to above, such unregulated schemes can be sold to most institutional investors in the UK by virtue of the institutional investor either being an authorized person under the Act, a business investor or a person whose ordinary business involves the acquisition and disposal of property of the same kind as the property in which the CIS will invest.

Exempt unauthorized unit trusts

An exempt unauthorized unit trust is a UK unit trust which restricts unitholders to investors who are resident for tax purposes in the UK but exempt from taxation on capital gains. Unit trusts structured in this way are, like authorized unit trusts, exempt from tax on capital gains, but do not have to comply with the detailed FSA Rules relating to the constitution of the trust and its investment powers, etc. Thus it is an ideal vehicle where the targeted investors are UK pension funds or charities, but the investment policy or proposed structure is incompatible with achieving status as an authorized unit trust (eg because it is proposed that the fund be closed-ended or adopt a more aggressive investment policy than that permitted for authorized unit trusts). Such trusts are a popular vehicle for attracting investment by pension funds and charities.

REGULATION OF INVESTMENT MANAGERS AND OTHERS INVOLVED IN THE PROMOTION OF CISs IN THE UK

In addition to providing the framework for the regulation of the marketing of CISs in the UK, the Act also regulates, directly and indirectly, the activities of investment managers in the UK and other persons involved in the management or promotion of CISs in the UK or otherwise involved in the financial services sector.

Under the Act, persons may only conduct investment business in the UK if they are authorized persons. The establishment or operation of a CIS, the giving of investment advice and arranging deals in investments, including promoting an investment in a CIS, constitute investment business and hence persons carrying on any such activities in the UK must be authorized persons. A person becomes an authorized person by applying to be regulated by an appropriate regulatory body. In the case of fund managers what would typically be the Investment Management Regulatory Organization (IMRO) while persons involved in the establishment or promotion of collective investment schemes and the sale of shares in them would probably seek regulation by the Personal Investment Authority or the Securities and Futures Authority. In considering whether to admit any person or company as a member, an SRO will seek to establish that the persons concerned are fit and proper persons to conduct investment business and that the applicant has the necessary financial resources, and has sufficient systems and administrative capability to conduct the business. Once a member of an SRO, the authorized person must comply with the SRO rule book at all times. These cover, among other things, the general conduct of the investment business, as well as client reporting requirements, complaint procedures and capital adequacy requirements and detailed provisions relating to the terms on which a member may conduct business with a client, and the contents of the agreement between the member and the client. A breach of the rule books can in certain cases give rise to investors/clients being able to claim damages or cancel an investment arrangement.

New legislation is scheduled to modify the regulatory regime for those involved on the management or promotion of CISs in the UK. The FSA will become the sole body responsible for the authorization and supervision of CISs and fund managers in the UK. While the basic definition of what constitutes investment business will not differ significantly under the new legislation, there will inevitably be changes to the manner in which regulation is carried out as the existing staff of the SROs move to the FSA and the new FSA rule book comes into effect.

HEDGE FUNDS

Despite the trading difficulties of several certain high profile hedge funds, the market is nevertheless expanding through both supply and demand. The article by John Budzyna and Clive Bouch covers the growing appetite of the major institutions backing their home grown managers, and the recent announcement that CALPERS is to increase its exposure to alternative investment management products are examples of the former. In an environment where technology has made it possible for portfolio managers to operate without the infrastructure offered by larger institutions, it has become increasingly common for individual traders and asset managers to leave major investment banks and institutions to set up their own operations focusing on the developing alternative investment market. This process started in the US, but is now occurring to a significant degree in London, and to a lesser extent in Europe.

A fairly typical structure is for a corporate fund to be established in an unregulated, zero tax, offshore jurisdiction, which would in turn be managed, directly or indirectly, by a UK-regulated investment management company. This would be run by the former traders or asset managers and funded on a performance fee basis by the fund.

Appropriate tax structuring is essential in these circumstances to avoid any unnecessary UK taxation on the profits of the fund, which can arise for two main reasons. Firstly there is the question of the tax residence of the fund, and secondly the question as to whether it is carrying on a trade in the UK by virtue of its arrangements with the UK investment management company — and its owners.

The constitution and actions of the board of directors of the fund are of critical importance when deciding the issue of tax residence to ensure that "central management and control" is, and is seen to be exercised outside the UK. If the Inland Revenue regards the offshore fund as UK resident, its worldwide income and profits will be subject to the current corporation tax rate of 30%. Consideration also needs to be given to UK tax exposure of the fund's trading profits, and a view taken as to whether the fund is investing or trading. If it is trading, the UK investment management company should structure its arrangements and interest (if any) in the fund to fall within the "investment management" exemption whose different conditions are found in Section 127 of the 1995 Finance Act. If the criteria for this exemption are not met then the Inland Revenue can assess the UK investment management company on the relevant proportion of the trading profits of the offshore fund.

It is here that the different interests of the institutional backer, or the individual managers themselves become of crucial importance. The structuring of how the manager receives its share of the performance fee needs careful consideration, given the requirement for the manager to be paid at the "customary" rate in order to obtain this tax exemption. Careful planning is needed given the variety of ways in which this fee or "carried interest" can be structured, particularly where the manager is a UK subsidiary of a US group setting up in the UK and keen to replicate its US structure driven by US law. The existence of any related party having more than a 20% equity interest in the fund can also remove the exemption from a proportion of the fund's profits.

The market for potential investors needs to be considered carefully. The principal customer base of most hedge funds comprises high net worth individuals and corporates or other large institutions. Pension funds, in particular, may well require a hedge fund to be listed on a recognized stock exchange such as the Irish Stock Exchange in order to comply with their own investment restrictions and in this case listing requirements will need to be examined to ensure that they make suitable provision for listing hedge funds.

European Distribution – A Key Challenge

One of the key challenges facing the European asset management industry is to successfully develop the means to distribute products on a European wide basis. Historically, differing legal and tax environments within Europe, as well as different investment cultures and language barriers has hindered the development of pan-European investment funds. Despite experiencing rapid growth the European market is still regarded as relatively undeveloped and one that offers significant potential revenue. For example, funds under management in the US are estimated to represent approximately 57% of GDP while the corresponding figure for Europe is 23%. The situation, together with the arrival of the euro and the fiscal imperative for a number of European governments to re-assess the sustainability of state-sponsored pension provision are seen to offer significant opportunities for cross-border product and service provision. The pressure is therefore building to overcome technical, cultural and language barriers to develop pan-European distribution capabilities. The use of e-commerce to increase direct sales is an important factor in this area; also noticeable are the building of strategic alliances and the development of "Band-stretch" as fund managers seek to capitalize and leverage off the goodwill associated with widely respected brands and household names in sectors other than the financial services sector. Hence we have seen movement into the sector from airlines, retail stores and other industries which have transactional brand strength. All these developments are creating new legal and technical challenges for fund managers and their advisers.


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Arthur Andersen

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United Kingdom

Tel: +44 207 438 2255

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