There is no successful business which the tax authorities do not get around to plucking eventually, and hedge funds are no exception. A post-Budget consultation paper issued today by the UK Inland Revenue threatens to restructure the eighteen-year-old tax treatment of offshore funds in ways which analysts fear could do serious damage to the hedge fund industry if they are implemented.
The regime introduced in 1984 aimed primarily at preventing UK investors using UK funds to turn income into capital gains (which were taxed at a lower rate) by allowing income to accumulate in an offshore fund. Clearly, life has changed since then. With income and capital gains tax rates no longer so far apart, and hundreds of Luxembourg and Dublin based funds being sold across European borders under the UCITS directive, the offshore funds environment has changed considerably since 1984. In particular, European fund managers resent having to distribute income rather than allow it to roll up within funds in order to be allowed to sell their products in the UK.
The Inland Revenue says no change is an option, but the disinterested observer would quickly conclude it is about as likely to choose as it is to abolish the rules and revert to the pre-1984 regime. (“It would be surprising if no representations to this effect were made,” smirks the author of the paper about the idea of repeal, before dismissing it as an absurd idea.) And nobody will believe the Revenue when it says its chief ambition is to reduce the burden of compliance on fund managers and their investors: the UK Inland Revenue has spent much of the last decade transferring the burden of compliance from itself to the taxpayer through initiatives such as Self-Assessment.
Indeed, the real threat to the hedge fund industry would certainly add to the compliance burden: it is the proposal outlined in paragraphs 5.3.15 and 5.3.17a (to tax investors in funds annually on a mark-to-market basis) and in paragraphs 7.5 and 7.6 of the Appendix (II) which sets out the likely shape of a new tax regime (“Investors … return as taxable income any appreciation in the market value of the fund during the year … To the extent that a fund loses value during the year those investors may return a loss, but that loss can only be relieved against profits of a similar type, which either arise in the same year or a later year.”). Rules of this kind would oblige UK-based hedge fund investors to pay tax on notional sums of income which they may never receive.