New UK fund vehicle will give Cayman, Ireland and Luxembourg a run for their money
Fund managers have traditionally based their funds offshore to ensure they can distribute their funds to investors everywhere without worrying that the income and capital gains they generate might be taxed at a higher rate than their investors appreciate. ACS, the as yet little noticed onshore vehicle created by the UK government and tax authorities, might be about to rewrite that logic.
Ed Turner of HSBC provides an overview of ACS, the new UK fund vehicle:
One of the minor mysteries of the European investment fund industry is why London has made so little impression on it as a domicile and administration centre. While Dublin (€3.8 trillion in assets under administration) and Luxembourg (€3.6 trillion) have waxed mightily over the last 25 years as fund domiciles and centres of fund accounting and transfer agency services for managers distributing funds in Europe, the United Kingdom (UK) has failed to establish itself as a competitive domicile. An important reason for that is the lack of a tax-transparent fund vehicle.
In the 2013 Finance Act, the British government included a measure designed to fix this. Despite its distinctly unappealing nomenclature, the Authorised Contractual Scheme (ACS) is a tax-transparent fund structure fit to rank alongside the Luxembourg Fond Commun de Placement (FCP), the Irish Common Contractual Fund (CCF) and the Netherlands Fond voor Gemene Rekening (FGR) as a viable vehicle for managers looking to manage and/or distribute funds in Europe without attracting a tax treatment disadvantageous to investors.
The immediate prompt for the new measure was the UCITS IV directive, implemented in July 2011. This allowed UCITS funds to be structured as master-feeders, in which local feeder funds invest in a master fund which actually invests in the markets. These structures were of interest not just to fund managers distributing in multiple European markets, which need a tax-efficient structure, but to corporate pension plans looking to run multiple national funds as a single pool of assets.
“It was felt that the UK, within its fund range, was missing a trick,” says Ed Turner, the head of tax product at HSBC Securities Services, which is already administering $24 billion in ACS fund structures. “It had a corporate structure and a trust structure, but it did not have a tax-transparent or tax-neutral structure in which the fund is not taxed at all, but investors are taxed as if they held the investments directly. So if master-feeder structures took off under UCITS IV, and managers wanted master-feeders to be tax-transparent to avoid adversely impacting the feeders from a tax perspective, the UK would not be able to take advantage. ”
Turner says that pension funds investing into American equities provide an ideal illustration of how tax transparent structures in general, and ACS in particular, can have a material impact on fund performance. For example, the basic fund structure in the UK is the open ended investment company (OEIC), and it is subject to a 15 per cent withholding tax on dividends paid from the United States. This is better than the société d'investissement à capital variable (SICAV), the Luxembourg equivalent (where 30 per cent tax is withheld) but obviously inferior to pension funds entitled to receive dividends gross from the United States. In fact, on a three per cent dividend yield, an OEIC can cost pension funds or sovereign investors 45 basis points a year in lost investment performance. A previous effort to address this problem in the UK, via a pension fund pooling unit trust vehicle, had failed.
So the government, in the shape of Her Majesty’s Treasury (HMT) and Her Majesty’s Revenue and Customs (HMRC) set up a working group to devise a better answer. Turner was actually a member of the group. The group opted to replicate the FCP and CCF structure, and the ACS measures in the 2013 Finance Act duly introduced funds that can be structured as either partnerships or through co-ownership.
“There are slight differences between the two,” explains Turner. “The partnership scheme is transparent for income and capital gains but it cannot be an umbrella structure, so each fund has to be structured as a partnership. It has not proved popular so far. The co-ownership structure is friendlier for asset managers. It is transparent for income but opaque for capital gains, so investors pay capital gains only when selling units in the fund, and it accommodates umbrella structures.”
Turner is aware of just six ACS funds being set up so far. The first was a US equity fund aimed at UK pension funds, with the goal of outperforming comparable vehicles by achieving zero withholding tax. It is managed by BlackRock and competes directly with a range of CCF funds managed by Vanguard. HSBC is itself acting as administrator to a £15 billion ACS set up by a large UK life and pension office, which found it a tax-neutral way (for policyholders and pensioners) of consolidating and managing the assets of dozens of smaller funds into a single pooled fund, which they can run at a lower cost with better performance.
But Turner predicts that 2016 will be a “big year” for ACS structures in the funds industry. The British government is encouraging mergers of local government pension funds, partly to create larger pools of money to invest in infrastructure projects, but also to cut operating and transaction costs. “The co-ownership variant of the ACS could be the best vehicle for them, because it will not impact their withholding tax treatment as pension fund investors,” explains Turner. “So they can be moved into the ACS structure on a cost-neutral basis. As larger pools, they will be able to access better managers and negotiate lower investment management fees.”
The pension funds of the 32 London borough councils launched an ACS in December and are already negotiating better terms with fund managers. Turner thinks managers will to some extent be bypassed altogether, as other pension funds invest in the large ACS instead. “Asset managers will be challenged by these structures,” he says. “They will have to establish an ACS of their own in order to remain competitive, even if it is not tax-advantageous for investors.”
He also thinks that UK asset managers which have set up life assurance companies in order to attract UK pension fund business – the logic is that they also offer a tax-efficient investment vehicle for pension fund assets – can use ACS as a solution to the pressure on their capital positions from the Solvency II directive. Life companies, unlike asset managers, own the assets they manage, so fund managers are carrying client monies on their balance sheets, and now face a significant increase in their capita reserve requirements under Solvency II.
“A number of UK asset managers are finding that Solvency II obliges them to put aside considerable sums of money against their life company assets, which they cannot then invest,” explains Turner. “The life company is becoming less efficient for them as vehicle.” An ACS offers the same tax efficiency, and keeps the client assets off the balance sheet, so they do not have to set money aside to meet the Solvency II capital requirement. It will be tempting, says Turner, for managers with life companies to close them down, or run them down, and divert assets into an ACS.
In fact, ACS offers every large fund manager running multiple funds potentially lavish cost savings. “You can set up a master fund to manage the assets, supported by a distribution vehicle in Ireland or Luxembourg for offshore investors and a UK distribution vehicle for onshore retail investors, and allow institutional investors directly into the ACS,” says Turner. “And you can place the assets of existing onshore and offshore fund ranges into the master fund, and get the economies of scale, without any adverse tax consequences. It is a more efficient way to manage existing assets.”
But the largest users of ACS may well be small to mid-sized fund managers and even start-ups that are presently using orthodox fund vehicles regulated under the UCITS or AIFMD legislation, or by the Cayman Islands Monetary Authority (CIMA). For example, HSBC is administrator to the Equitile fund management start-up headed by Andrew McNally (formerly UK chairman of Berenberg) and George Cooper (late of Bluecrest Capital Management) that saw competitive advantage in both its management company and its funds being regulated onshore by the Financial Conduct Authority (FCA).
“Being onshore, and transparent, clearly helps to win the trust and confidence of investors,” says Andrew McNally. Equitile is setting up an ACS as a master structure and will direct the appropriate investors into the ACS to get the superior withholding tax treatment, plus all the benefits of being completely transparent about it. Equitile will also use an OEIC to gather investors which are not gross funds. In other words, the ACS allows them to get institutional and retail business into the same fund.
Interestingly, Equitile aims to distribute its UK-based ACS funds outside the UK. “Traditionally, UK funds have been seen as a product for the UK market,” says Turner. “There are UK fund managers which sell their UK fund range across borders, but most UK managers sell UK-domiciled funds to UK investors only. As clients get used to the structure, ‘Brand Britain’ will be an additional attraction in markets such as Scandinavia and Asia.”
This is a much more important development than the ACS abbreviation implies. In effect, fund managers can obtain all of the tax transparency benefits of an offshore domicile while remaining onshore. That this is a deliberate act of policy by the UK government – the export promotion body, UK Trade and Investment (UKTI), as well HMT and HMRC have sponsored ACS – can only increase the confidence fund managers have in the vehicle. More importantly, it will increase the confidence of investors, which in turn will increase their propensity to invest.