Consultation on the VAT treatment of fund management
There had been much speculation regarding the contents of the consultation, particularly in light of repeated delays in its publication. Brexit has given the UK freedom to shape its VAT rules as it pleases and therefore the possibilities were potentially endless. In the end, the consultation which has emerged is modest in its objectives and narrow in scope. Nonetheless, it deserves a cautious welcome.
The consultation essentially boils down to the question of whether a new principles-based definition of a VAT-exempt “special” investment fund (SIF) should be added to the VAT Act to sit alongside the existing list of funds to which SIF status has been granted.
The VAT Directive contains a VAT exemption for the “management of special investment funds as defined by the Member States”. The Directive therefore appears to give Member States free rein to decide which funds should qualify for VAT exemption and the UK accordingly implemented the Directive by including in the VAT Act a list of the funds which would qualify for VAT exemption in the UK.
However, subsequent case law of the European Court of Justice (CJEU) determined that Member States did not have as much discretion as appeared to be the case. “Special” had a particular meaning in EU law and the role of each Member State was only to determine which types of funds existing in its jurisdiction fell within that meaning. The principle of fiscal neutrality also meant that funds which displayed similar features, and which were therefore in competition with one another, could not be treated differently for VAT purposes.
In 2007 the CJEU decided in Claverhouse that the UK’s definition of a SIF was too narrow; it afforded VAT exemption to certain types of open-ended funds while taxing similar, and therefore competing, closed-ended funds. The UK accordingly added certain closed-ended funds to the list contained in the VAT Act.
There then followed several cases on pension funds (Wheels, PPG and ATP), with the CJEU ultimately concluding that funds comprising defined contribution scheme assets qualified for VAT exemption while those comprising defined benefit scheme assets did not. Again, the UK expanded the list of SIFs contained in the VAT Act.
Finally, in Fiscale Eenheid X the CJEU decided that the exemption could not be limited to funds investing in transferrable securities and found that a fund investing in real estate qualified as a SIF. Again, the UK updated the VAT Act.
In ATP the CJEU described the characteristics which made a fund a SIF as being:
- the pooling of assets by investors to whom the benefit of each investment is to be paid;
- the spreading of risk over a range of securities; and
- the bearing of investment risk by the investors.
In Fiscale the CJEU noted that to be sufficiently comparable to a SIF, and therefore in competition with SIFs, the fund in question must be subject to state supervision. Comments made by both the CJEU and Advocate General suggested that AIFs might meet this requirement and, indeed, several EU jurisdictions (including Luxembourg and Ireland) consider AIFs to be SIFs.
The question, in light of the CJEU case law developments above, was where the limit would eventually be drawn in the seemingly ever-expanding range of funds falling within the EU definition of a SIF.
Given that the UK is no longer a member of the EU, the UK Government is able to set out the definition of a SIF in legislation without the inconvenience of taxpayers challenging it before the CJEU. In theory it can list whichever funds it likes, with the management of any funds which are not on the list being taxable by default.
The consultation essentially boils down to the question of whether a new principles-based definition of a SIF should be added to the VAT Act to sit alongside the existing list of funds which the VAT Act identifies as being SIFs. The consultation contemplates the following criteria, which would be written into legislation:
a) the fund must be a collective investment, the definition of which will broadly mirror that used by the Financial Services and Markets Act 2000;
b) the fund must operate on the principle of risk-spreading;
c) the return on the investment must depend on the performance of the investments, and the holders must bear the risk connected with the fund; and
d) the fund must be subject to the same conditions of competition and appeal to the same circle of investors as a UCITS (Undertakings for Collective Investment in Transferable Securities), that is funds intended for retail investors.
The requirement for state supervision (as mentioned by the CJEU in Fiscale) has been purposely left out, the explanation given in the consultation document being that it is unnecessary given the existence of requirement (d). Presumably, what the consultation document means by this is that any fund intended for retail investors will require FCA authorisation and will therefore, by definition, be subject to state supervision.
Potential impact of the proposed changes
It must be tempting for the Government to take the opportunity presented by Brexit to bring an end to the debate over which funds qualify as SIFs. The Government could simply maintain a list in legislation, which would have to be respected by the courts, with there being no threat of taxpayer challenge before the CJEU. Such an approach could, however, give rise to arbitrary results and distortion of competition – outcomes which the CJEU has sensibly sought to avoid when crafting the evolving definition of a SIF.
The proposal to introduce a descriptive definition is therefore to be welcomed insofar as it aims to ensure that funds operating in a similar manner and competing for the same investors are treated equally for VAT purposes.
Prior to Brexit there had been a debate over whether certain types of life funds and charitable funds qualified as SIFs under the principles laid out by the CJEU. That debate may well be re-ignited by the introduction of any principles-based definition of a SIF in the VAT Act.
The proposal set out in the consultation would also draw a line under question of whether AIFs should be treated as SIFs for UK VAT purposes. That will be welcomed by UK managers of non-UK AIFs, who currently benefit from VAT recovery on their costs.
At present the UK treats non-UK UCITS funds as non-SIFs so long as, broadly speaking, they are not actively marketed to UK retail investors. The advantage of such treatment is that UK managers of such funds are entitled to recover the VAT which they incur on their costs (and the fees charged by the UK manager will be outside the scope of VAT due to the fund’s location). On the face of it, that treatment could change unless criterion (d) of the proposed definition of a SIF is refined such that it only includes funds intended for UK retail investors. Such a refinement seems likely given that the consultation document describes the proposed changes are not being intended to result in any significant changes to the current VAT treatment of fund management. It would also be somewhat strange for the UK to put funds marketed to EU retail investors on an equal footing with those marketed to UK retail investors, having previously distinguished between them when the UK was part of the EU’s common system of VAT.
Issues not covered by the consultation
The consultation is perhaps most notable for what it does not address. The most common complaints about the fund management VAT exemption, and the topics which most often give rise to disputes between taxpayers and HMRC, concern the definition of “management” and “tainting” issues where management services relate to both SIFs and non-SIFs, or where a single fund meets the definition of a SIF in respect of some of its assets but not others.
In common with most other types of financial services businesses, asset managers have in recent years increasingly sought to increase efficiency by outsourcing to third parties, a move which has been driven in large part by technological advancements. The extent to which outsourced fund management services, and particularly technology-enabled activities, qualify for VAT exemption has given rise to disputes in both the UK (e.g. the Blackrock case and the debate over research fees following MiFID II) and EU (e.g. the joined cases of K and DBKAG). The CJEU has gone some way in explaining the criteria which must be fulfilled for an outsourced service to fall within the fund management VAT exemption – most notably in the case of GfBk – but questions still remain and disputes still arise over how the test laid down in GfBk should be applied in practice.
The issue of tainting gives rise to arbitrary and unfair results. Where a manager of both SIFs and non-SIFs delegates a service of management to a third party it is unclear whether that service is capable of qualifying for VAT-exemption to any extent if the outsourced services relate to both the SIFs and non-SIFs and are performed by way of a single supply. In Blackrock – where the majority of the funds in question were non-SIFs – the CJEU sided with HMRC in finding that fees for the outsourced services could not be apportioned and did not qualify for VAT-exemption to any extent. HMRC appear to take the view that the same applies if there is any non-SIF usage of a subcontracted management service. Managers of both SIFs and non-SIFs may therefore incur VAT on services relating to their SIFs which will not be incurred by SIF-only managers.
A similar issue has arisen in relation to pension funds, where managers of funds comprising both defined benefit and defined contribution scheme assets have been required to charge VAT on their management fees whereas managers of funds containing only defined contribution scheme assets are not required to charge VAT. Whether or not a beneficiary of a defined contribution pension scheme bears the cost of VAT may therefore depend on whether their assets are pooled with the assets of defined benefit schemes.
The consultation document asks whether there are any VAT-related modifications the Government might introduce in addition to the proposal for a principles-based definition of a SIF and it may well be that responses raise the issues outlined above. However, elsewhere the consultation document states that options for policy reform beyond the proposed SIF definition are outside the scope of the consultation and it therefore appears unlikely that much progress will be made on other matters as part of the present consultation.
The deadline for responding to the consultation is 3 February 2023. Macfarlanes intends to respond to the consultation and one of our VAT specialists will be more than happy to discuss the consultation with you.