Offshore mutual funds are mutual funds, structured typically as either companies or unit trusts, which are set up outside the UK and thus outside the scope of UK taxation; investment therein takes the form of shares or units.
Mutual funds aggregate the investors’ monies and invest them in an appropriate spread of underlying investments; the performance of the investors’ investment thus depends upon the performance of the fund’s underlying investments.
For tax purposes, there are two types of offshore fund, namely, reporting and non-reporting, investments which are treated very differently for capital gains tax (CGT) purposes.
On the sale of an investment in a reporting fund, any gain is a capital gain subject to CGT. With respect to sales on or after 23rd June 2010 the rate of CGT is either the 18% or 28% rate depending upon the availability of any unused portion of the investor’s basic rate band or 18% before this date and on or after 6th April 2008 (independent of the investor’s marginal rate of income tax).
On the sale of an investment in a non-reporting fund any gain made, whilst capital in nature, is subject to income tax not CGT. The charge to income tax is an attempt to penalise investors who by investing in non-reporting funds (who report little by way of dividends) are attempting to turn income (taxed at income tax rates) into capital growth (taxed at lower CGT rates).
The gain on the non-reporting fund is thus subject to income tax at the investor’s marginal rate of income tax, possibly as high as 50% (the additional rate of income tax which applies from 6th April 2010).
The difference in the rate of tax applying on gains arising on each type of fund may thus be quite significant; for the typical investor the comparison is likely to be a 50% rate of income tax versus a 28% rate of CGT or, possibly, corresponding rates of 40% and 28%; For other taxpayers the comparison is likely to be a 20% rate of income tax versus a 28% rate of CGT (in theory, due to manner in which CGT calculations are performed after the Finance Act (No 2) 2010 changes, for some taxpayers the comparable rates may be a 20% rate of income tax versus an 18% rate of CGT).
The annual exempt amount of £10,100 for the tax year 2010/11, applicable for CGT purposes, is applicable to reporting fund investors but not non-reporting fund investors.
Further penalisation occurs in the event that losses arise on the sale of the investment in the non-reporting fund; such losses are off-settable only against capital gains of the investor but not his “income gains”.
Ted Bloggs, a 50% income taxpayer and a 28% CGT payer, invests £25,000 in non-reporting fund “A” and £40,000 in non-reporting fund “B”. On the sale of both investments in the tax year 2010/11 he makes a loss of £17,000 on A and a gain of £17,000 on B.
He is unable to offset one against the other and thus is exposed to income tax at 50% on the £17,000 gain but is only able to relieve his loss of £17,000 against any capital gains, saving CGT at only 28%.
A further point to note is that on death the investment is treated as having been sold possibly precipitating a taxable gain (whereas an investment in a reporting fund on the death of the investor is not so treated and thus no CGT charge arises on death; in fact, any beneficiary under the investor’s will inherits at the investment’s market value at the date of death, obtaining the so-called “tax free uplift” on death).
Before investing check with the promoter of the fund (and/or HMRC) whether it is a reporting or non-reporting fund.
Offshore non-reporting mutual fund investments are high risk investments; when such risk is combined with income tax treatment on any gains made on sales, yet with no corresponding loss offsets, such investments are primarily for the wealthy investor only; for those of more moderate means there are many more tax attractive forms of investment.
By Malcolm Finney