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Fund of Alternative Investment Funds (FAIFs)

On 22 February, the Treasury announced a new elective tax regime that would facilitate the introduction of FAIFs. The announcement coincided with a consultation paper issued by the Financial Services Authority (CP 08/04) outlining the regulatory framework for FAIFs. Today the Government has issued the draft regulations for the implementation of UK authorised FAIFs.

The FSA consultation paper (and an earlier consultation CP 07/6) proposed changes to the non-UCITS retail scheme (NURS) regime to allow UK funds to invest in other alternative investment funds. The changes included relaxing the restriction on investing in unregulated investment schemes, including other NURS funds and applying a due diligence criteria to fund managers investing more than 20% in unregulated funds.

Although the proposal was widely welcomed it was noted at the time that existing UK offshore funds rules would make the proposals unworkable in the UK. Many offshore alternative investment funds do not apply for UK distributor status. As a result a UK fund which invested in non-distributing offshore funds would be liable to tax on the disposal of its interests in those funds as if it were income (offshore income gains).

The 22 February document sets out the tax framework for the regime. This allows UK authorised funds to elect for exemption from the offshore funds regime. Instead the investors in UK authorised funds that make the election (Tax FAIFs) will be taxed as if the Tax FAIF was an offshore fund. This framework effectively moves the point of taxation of the offshore income gains from the fund to its investors. CP 08/4 also discusses some of the tax issues, particularly the concern about genuine diversity of ownership, and says that the FSA rules will include diversity tests equivalent to those proposed under the FAIF regime.

The draft regulations issued today provide some detail on the operation of the FAIF regime – eg an election should be made before the first day of the accounting period to which it applies, and such elections are irrevocable. They will be effective from the date that the regime is implemented by the FSA.

Our view
We welcome the introduction of the FAIFs regime as a simple and practical step to extend the range of available onshore retail schemes. The current proposal is only effective for pure fund of alternative funds and will be unworkable for mixed funds. The Treasury has said that it will continue to consider whether it is possible to extend the regime to enable mixed funds to benefit.

The regime has been introduced at a time of significant change in the rules for both capital gains tax and offshore funds. The reduction of the capital gains tax rate to 18% has amplified the difference in tax treatment of income and capital to the extent that investment in vehicles which are taxed as income (including non-distributing offshore funds, and now Tax FAIFs) may be significantly less attractive.

This is particularly true of investments designed for the retail market where the headline rate of tax will be a significant factor in the decision to invest. Sophisticated investors already invest in offshore funds of hedge funds with a tax treatment that is no less attractive than the current proposals.



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