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ESG: The metrics jigsaw


UK joins the race

A new tax-transparent fund, launched this summer, puts the UK on the map for pension pooling. Gail Moss explains

Determined to leave no stone unturned in the dash for growth, the UK government has followed Ireland, Luxembourg, the Netherlands and now Germany in offering its own tax-transparent funds (TTFs) to woo institutional investment from Europe and further afield.

Not only will these vehicles provide tax savings for UK pension funds and other tax-exempt investors, it is hoped they will attract business to the UK, both for asset managers and service providers.

A third of all European investment assets are managed in the UK, according to the Investment Management Association, but only 10% of these assets are domiciled in the UK.

TTFs enable tax-exempt investors to reduce (in some cases to zero) the withholding tax on dividends, which is due when investing through other types of fund, for instance, an open-ended investment company (OEIC).

Many tax authorities give pension funds tax breaks so they pay as little as possible on directly-held investments. This usually means paying no tax on domestic or overseas investment income, the latter being managed via double taxation treaties with other countries. These allow tax-exempt investors to reclaim withholding tax on dividends from those countries.

For example, if a UK tax-exempt investor such as a pension fund holds Microsoft Corporation shares (quoted on NASDAQ), the 30% withholding tax levied by the US on dividends is reduced to nil.

However, when the shares are held in a mutual fund vehicle such as an OEIC, the OEIC itself determines the amount of tax that should be withheld.

For a UK pension fund using an OEIC, US withholding tax would be 15% – half the full rate, but still an investment cost. Using a Luxembourg SICAV would mean a UK pension fund suffered the full 30%. This kind of fund is referred to as tax-opaque.

Assuming a 2% dividend yield, a 15% tax deduction from an OEIC costs pension funds 30bp per year.

Northern Trust has estimated that European pension funds investing into a MSCI World Equity index fund could benefit from savings of up to 49bp in a TTF over a ten-year period.

In contrast, a TTF allows the authorities to ‘look through’, treating the pension fund as a direct investor. This means investors can access their tax treaty benefits and avoid, or reduce, withholding tax.

Generally, the benefit is greatest for equity holdings; coupons on bonds are normally not subject to withholding tax.

But income from alternatives can also be taxed if the investor is not tax-exempt. For example, a UK pension fund may directly own real estate in the Netherlands without paying tax on rents, while an OEIC would pay tax. So a TTF would be beneficial here too.

Two main types of institution are likely to set up a TTFs in the UK. Multinational companies providing employees with separate pension plans in different countries could use a TTF to pool assets, avoiding duplication. For instance, separate contracts between each different pension plan, and the asset managers and other providers, would be replaced by a single contract for the scheme as a whole, thus lowering costs.

“There will also be better quality information on all the pension funds, because it will be provided by a single custodian,” says Gavin Bullock, partner, Deloitte. “That means better governance and oversight, besides economies of scale.”

The TTFs could help manage risk by allowing funds to diversify their investments. They are likely to appeal to asset managers wishing to attract funds from both UK and overseas institutions.

The UK TTFs, which will also be known as authorised contractual schemes (ACS), have been designed for institutional investors but individuals can access them through feeder funds.  

The new law was enacted in June, with the FCA giving permission for the new structures in early July.

Each UK TTF (or ACS) will assume either of two legal frameworks:
• The first, a co-ownership scheme, is a collective investment scheme modelled on the Irish common contractual fund (CCF), This is a unitised scheme established by contract, under which investors own the assets beneficially as tenants in common; the scheme is not legally separate from the investors.
• The second type of fund is a limited partnership established under the Partnership Act 1907, registered with Companies House and regulated by the Financial Conduct Authority (FCA).

Both types of UK TTF can be authorised as UCITS, non-UCITS retail schemes (NURS) or qualified investor schemes (QIS).

Besides their legal differences, the two frameworks have subtle tax particulars.
The co-ownership scheme is transparent for income tax but opaque for capital gains tax (CGT). Taxable investors may therefore incur tax when they sell units in the scheme.
In contrast, the partnership is tax-transparent for CGT, as well as income tax.

A co-ownership scheme can be established as an umbrella fund. It can provide different compartments (sub-funds) of investments – global equities, or global fixed income – giving investors the flexibility to place whatever amounts they wish in different asset classes.

In contrast, a partnership cannot be divided into sub-funds, so each investor’s holdings will mirror the composition of the portfolio as a whole.

The partnership structure could be suitable for real estate and infrastructure investing, while the core business for the co-ownership model is likely to remain equities, bonds and other asset classes.

Unlike UK opaque funds, neither type of fund is subject to corporation tax and both benefit from stamp duty exemptions. So a UK-based pension fund will be able to switch assets in and out without incurring tax, which can be difficult to achieve with opaque funds.

Other European TTFs are designed as contractual funds, so the availability of a partnership vehicle as well could give the UK a competitive advantage. However, Luxembourg is developing a partnership version of its fonds commun de placement (FCP).

“One key concern of the new funds is the additional cost of running a tax-transparent fund, which will be passed on to the investor,” says Bullock. “But, in most cases, the tax savings on income will more than compensate for this.”

He says the prime users will be large UK groups – say in the FTSE – which will pool money, relating to both the UK and overseas pension schemes, within the UK.
In spite of the obvious merits of TTFs, few have been launched across Europe – only 20 CCFs have been set up in Ireland, for instance.

But Bullock does not see this as evidence that a UK TTF will not work.

“There are not many international groups based in Ireland or Luxembourg,” he says. “A vehicle for UK-headquartered companies will make a big difference, and a number of US-based international groups have told us they’d like to pool their assets here.”

He says that US institutions with European TTFs have based them in Ireland, because of the common language and cultural familiarity.

“But for those yet to set one up, there will be an incentive to use the UK vehicles. There is a much bigger pension fund industry in the UK than in Ireland or Luxembourg.”

He also expects a large take-up by UK-based life funds, which could attract money from both domestic and overseas pension funds.

“The likelihood is that we’ll see more asset managers moving on to the platform quicker than pension funds, because they are competing against each other, whereas pension funds aren’t,” says Bullock.

Nathan Hall, partner at KPMG, expects the new schemes to be successful.

“There has been an uptick in interest and the UK has launched its version at a great time,” he says. “Since the first CCFs were launched, administrators have developed their systems and tax authorities have increased their understanding of the structures. Pension funds are focusing on return, and eliminating unnecessary withholding tax has become more important. Regulatory change is also causing groups to consider whether the vehicle can bring reduced costs for UCITS managers and insurance groups”

But he acknowledges that transparency is complex to administer: “Funds need to apportion income on a daily basis according to investor type, and administrators have had to invest in resources to get to where they are. However, the costs are coming down, particularly if there’s volume of business.”

Aaron Overy, head of asset pooling development, Northern Trust, says the co-operative model is likely to be the more popular, particularly since some pension funds are limited in terms of the number of partnerships they may participate in. For instance, Local Government Pension Scheme funds may only invest up to 30% of their assets in investment partnerships.

“Furthermore, the administration is more complex, because as new investors come in at different times, the shares are valued at different prices,” he says. “That means there has to be series accounting and equalisation. On the other hand, partnerships are better for securities lending because it is easier to differentiate between investors in different locations, so investors are treated individually and get their revenue.”

In contrast, the co-ownership model may use a blended tax rate where investors have different treaty rates.

And, he says, the big users of the new TTFs will be investment managers with global equity funds, because they can now set up an ACS right from the start, rather than using an OEIC or unit trust.

“We think investment managers and possibly life companies will also move their existing OEICs to TTFs,” adds Overy. “An onshore tax-efficient vehicle will be very attractive to UK investors.”

He also believes the new funds will reinvigorate the efforts of Ireland and Luxembourg in the TTF market.

“However, the jury is out on how attractive a UK version will be to other European countries,” he says. “Pension funds could come to the UK and set one up, but it will definitely be led by provision, ie, asset managers, rather than demand.”

Overy expects the first ACSs to be running by the first quarter next year. “It’s been designed well,” he says. “We believe that asset managers will market it quite hard. A dozen clients are talking to us about it at present, which tells us this has got legs.”

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