Relaunching the United Kingdom as the European centre of alternative Asset Management
In an attempt to claw back some of the business lost as a result of Brexit, the UK Government has launched a version of the “asset holding companies” (AHCs) that made Luxembourg and Ireland such attractive destinations.
The UK asset management world, whether traditional or alternative, has historically thrived from its base in the City of London. Big headlines around the time of Brexit honed in on the ability of the UK funds industry to withstand the loss of marketing, distribution, and investment management passporting rights across the European Union, given the withdrawal of the United Kingdom from the Eurozone and the European regulatory regimes under the Markets in Financial Instruments Directive and the Alternative Investment Fund Managers Directive.
Whilst the United Kingdom has no doubt lost some business to the Eurozone, particularly in the banking and capital markets sectors, asset management has been relatively lightly impacted as a result of these factors. Nevertheless, since the 2020 Spring Budget, the UK Government has been, behind the scenes, cooking up quite revolutionary plans to transform the UK funds regime in a drive to ensure the ongoing competitiveness and sustainability of the financial services sector from a tax and regulatory standpoint.
In short, this has the look and feel of a territorial “land grab” in an effort to recapture the US$ trillions of assets under management gradually lost to Luxembourg and Irish-domiciled funds and asset holding companies, both in the traditional and alternative funds markets, because of more favourable tax and regulatory regimes in those jurisdictions.
LAUNCH OF THE UK ASSET HOLDING COMPANY TAX REGIME
Against that backdrop, as of 1 April 2022 the United Kingdom has launched its own version of the more typical Luxembourg or Irish AHC that is aimed at housing non-publicly listed or traded debt or equity, the customary investment assets of choice of the global private equity and credit industries.
Given the considerable expertise in portfolio management sat in London, it is expected that this enhanced attractiveness of UK funds will help open doors for asset managers to sell UK funds around the world, with a view to capturing a greater slice of the tax revenues and service fee income that integrally surrounds the housing and servicing of fund asset portfolios.
What Exactly is an Asset Holding Company?
An AHC is the entity that sits beneath a fund and typically holds the investment assets. It will also customarily be the counterparty to the fund’s agreements with counterparties, such as asset managers, asset servicers, custodians, banks, and others. The “asset holder” will ordinarily be in corporate form—as limited liability status will ensure that external liabilities to creditors and counterparties will not taint the fund vehicle— usually a transparent entity such as a partnership in the alternative funds market.
Corporate form also historically guaranteed an asset holding company’s access to double taxation treaties and related benefits, including treaty residence and eligibility to reliefs from withholding tax on interest and dividends, as well as source country exemption from capital gains when exiting investment positions held in third countries.
Why Does the United Kingdom Need a New Tax Regime for AHCs?
Put simply, whilst the United Kingdom has all the talent and expertise needed to drive a thriving funds industry, the actual assets under management tend to be housed overseas because of long-standing difficulties with the UK tax regime. Whilst Cayman and the Channel Islands have grabbed hedge funds’ assets (hedge fund assets not typically needing the benefit of tax treaties), Luxembourg and Ireland have adopted flexible tax regimes in order to attract the more illiquid asset classes associated with private equity, credit, and direct lending.
It is expected that this enhanced attractiveness of UK funds will help open doors for asset managers.
The legacy UK tax regime struggled with the concept that an AHC is nothing more than a “conduit” and should not interpose a new level of taxation between the investment asset and investor. Whilst European competitors permit payments on equity to be deducted from the tax base as a means to maintain AHC tax neutrality, this was not the case in the United Kingdom; investment gains may have been exempt from UK tax, but only after a labyrinthine and tortuous tax analysis. And paying cash up to the fund by the AHC would typically require managers to list debt instruments on a stock market, adding deal costs and requiring a level of public disclosure about the investment strategy. These were the principal, but not all, of the obstacles.
What’s So Good About the New Tax Regime?
The new UK tax regime is a big deal for UK, European, and US managers in the alternative funds space. The UK Government has largely addressed all the legacy tax issues that made the UK less attractive as a location for AHCs in private equity and credit structures. The new regime closely mirrors, but improves on, the tax regimes for AHCs in Luxembourg and Ireland, and means that all alternative managers will need to consider the UK AHC as a base for global and pan-European structures.
Key features of the new regime include
- Allowing returns on equity at the AHC level to be tax deductible
- Exempting dividends on assets from treaty jurisdictions, and granting a blanket exemption on capital gains
- Switching off the UK withholding tax rules when the AHC pays up the chain to the fund/investors
- Allowing investment returns to investors to be taxed as “capital” where the return mirrors underlying capital gains on exiting an investment
- Permitting AHC shares to be bought back by the fund, as a way to repatriate capital, without penal UK stamp taxes
This all represents a seismic shift in the UK tax landscape and mirrors the very successful legislative reforms enacted to prop up the UK securitisation market in the mid-2000s.
The arrival of the UK AHC regime also comes at a poignant moment in the context of international and European tax developments. The common “go to” private equity and credit structures, typically involving one or more European asset holding companies stacked under the fund, have been battered by the winds of global tax reform: asset holding companies lacking (what is commonly referred to as) “substance” have had problems accessing treaty benefits (under “principal purpose” and limitation on benefits” clauses) and investee jurisdictions, including the United Kingdom, are increasingly challenging (post-Indofoods and the Danish Cases) whether standard AHCs can establish beneficial ownership of assets and income flows, resulting in increased withholding taxes on cash flows and devastated fund internal rates of return.
This all represents a seismic shift in the UK tax landscape.
If that were not bad news enough, the proposed new “substance” rules intended to apply to European holding companies under the anti-tax avoidance Directive III (ATAD III) is only expected to make typical European structures more onerous and costly to run, given the Directive’s requirements to employ local operational staff, rent real premises (rather than just a brass plate), and initiate local banking arrangements in the AHC jurisdiction.
Crucially, the new UK AHC is expected to be unaffected by the tax problems that beset legacy structures and that are afoot under ATAD III. Managers will almost certainly have real management and operational substance in the United Kingdom anyway, and are less likely therefore to be dogged by calls for evidence from overseas entities as to all the non-tax reasons why their holding companies are sited in jurisdictions distant from their leadership and operational capabilities.
Alternative managers, given the winds of tax reform, will be wise to consider eligibility under the new rules. At the very least, if an existing overseas fund platform is long-established, it should consider if the platform is sufficiently robust to withstand increased muscleflexing from revenue authorities.