It’s fair to say that VAT as applied to financial services has been more of an irritant than say other taxes such as Income Tax and Capital Gains Tax for example, which are given serious consideration, and where mitigation occurs.

    However, VAT is a tax ultimately borne by the final consumer and is often equally important.

    This is particularly so since 2012 when the Retail Distribution Review was implemented, and attention turned to the concept of the cost of investment advice. A prominent feature of this is the running cost of managing money referred to as the Annual Management Charge (AMC). This may or may not be subject to VAT, and this is why the consultation is important.

    The consultation published on 9 December 2022 is the long-awaited follow up to the 2020 Spring Budget in which a wide-ranging review of the UK’s funds regime, covering both tax and relevant areas of regulation, was promised. The main objective of the review was to identify options to make the UK an even more attractive location to set up, manage and administer funds, as well as support a wider range of more efficient investments better suited to investors’ needs.

    As part of this review the UK government promised to introduce a new tax regime for Qualifying Asset Holding Companies (QAHCs) in certain fund structures and explore ways to simplify the VAT treatment of fund management fees for UK domiciled funds.

    Very broadly, the UK Special Investment Fund (SIF) exemption currently applies to Authorised Unit Trust schemes (AUTs), Open-Ended Investment Companies (OEICs) and funds and similar collective investment undertakings which compete in the UK retail market (i.e. for investment by the general public) under comparable conditions to funds falling under the UCITS Directive. (This sets out common EU rules for the regulation of ‘Undertakings for Collective Investment in Transferable Securities’). Any management of funds that do not qualify as SIFs is subject to VAT at the standard rate (currently 20%).

    For private equity managers raising funds structured as English limited partnerships this means that the VAT exemption is unavailable. Consequently, the fund’s general partner needs to be VAT grouped with the UK manager/adviser to mitigate UK VAT leakage. By contrast, a fund structured as, for example, a Luxembourg ‘SCSp’ benefits from a VAT exemption in Luxembourg in respect of management and certain related services provided to it.

    Legal clarity

    This technical consultation sets out the proposed reform of the legislation that provides for the VAT treatment of fund management.

    During the UK’s membership of the EU, and subsequently (under the EU Withdrawal Act 2018), the UK fund management industry could choose to rely on the ‘direct effect’ of the EU VAT Directive or UK legislation.

    Therefore, both HMRC and the financial services sector have found it difficult to apply the SIF exemption found in the EU VAT Directive consistently and with certainty. The government seeks to remedy this in UK VAT law, by providing legal clarity and certainty.

    As part of its wider agenda, the government has stated its intention to remove retained EU law. Given that there is a significant level of uncertainty for businesses relying on retained EU law, fund management is an area of VAT policy that could benefit from legislative reform.

    The consultation: proposed changes to UK VAT rules for fund management

    The UK government has stated that the aim of the consultation – which forms part of its wider agenda to remove reliance on retained EU law – is to consolidate both the existing UK exemptions and retained EU law in the UK statute to ‘provide a clearer, more certain legislative basis for decisions by fund managers and HMRC’.

    The government has simultaneously noted that its approach is “not intended to result in a significant policy change in VAT treatment for the fund management industry”, but is meant to clarify the existing regime with which the industry is already familiar. It’s therefore meant to be a clarification exercise as opposed to a means of introducing fundamental change.

    As regards the specific proposals, the government has explained that:

    1. It will retain the list of exempt fund types currently set out in the UK VAT rules, for the sake of continuity of treatment of existing funds. The government does not intend to expand this list in future.
    2. Legislative changes will be made to incorporate relevant case law and guidance into UK law, resulting in the establishment of defined criteria for eligibility for the SIF exemption from VAT.

    These criteria would require that:

    (a) the fund is a collective investment;

    (b) the fund operates on the principle of risk spreading;

    (c) the return on the fund’s investments depends on their performance, and holders must bear the risk connected with the fund; and

    (d) the fund is subject to the same conditions of competition, and appeals to the same circle of investors, as UCITS (i.e. funds intended for retail investors).

    To ensure the correct interpretation of criteria (a) to (d) above, the government is also proposing to include a clear definition of ‘collective investment’ in the VAT legislation, which it says would broadly mirror that provided within the Financial Services and Markets Act 2000.

    Other possibilities such as extending the range of funds qualifying for exemption, broadening the meaning of ‘management’ and/or introducing a reduced or zero VAT rate for UK private equity funds do not appear to be under consideration currently.

    Clearly the ability to avoid VAT at 20% on a fund management fee provides a very significant commercial advantage and it’s to be regretted that the review does not attempt to clarify any other grey areas.

    One of these had been the issue of whether advice is given as part of the overall service. Advice per se is standard rated and it appears that if there is a client review then the exemption may not apply. Nevertheless the move to remove reliance on EU law may be welcomed by many.

    Next steps

    HMRC has requested feedback from affected individuals and organisations including, in particular, UK fund managers as to whether its proposed approach would serve the intended purpose of refining and clarifying the UK law covering the VAT treatment of fund management, and whether such reforms would have any adverse effects.

    The consultation ended on 3 February 2023. HMRC will now publish a formal response, including next steps.

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