Contents > Trustees & Depositaries > CTCL Citicorp Trustee Company ... > CTCL NV 050301 Tax Treatment...
Page last published: 26 January 2009

Citigroup® Global Transaction Services
Fiduciary Services
Citicorp Trustee Company Limited
Informal Compliance; March 2005

CTCL home page

This document is solely for information and we will not be responsible for updating any information contained herein. It is not intended to provide specific advice on any other matter. If advice is required you should consult your own advisors, legal or otherwise. No responsibility for any loss occasioned as a result of using this document is accepted. Under no circumstances is it to be considered an offer to sell or a solicitation to buy any investment or product. Citibank International plc (Luxembourg Branch) is regulated by the Financial Services Authority.
Citigroup(®)Global Transaction Services
© Citibank, N.A. 2005. All rights reserved. The information and materials contained in these pages, and the terms, conditions, and descriptions that appear, are subject to change. Any unauthorised use, duplication or disclosure is prohibited by law and may result in prosecution. Citibank, Citidirect, Citigroup and the Umbrella Device are registered service marks of Citicorp throughout the world. Citibank, N.A. is incorporated with limited liability under the National Bank Act of the U.S.A. and has its head office at 399 Park Avenue, New York, NY 10043, U.S.A. Citibank, N.A. London branch is registered in the U.K. at Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB under No.BR001018 and is authorised and regulated by the Financial Services Authority. VAT No. GB 429 6256 29. Ultimately owned by Citigroup Inc., New York, U.S.A.

United Kingdom

Citicorp Trustee Company Ltd
Citigroup Centre
Canada Square
Canary Wharf
London E14 5LB
United Kingdom

Luxembourg

Citibank International Plc (Luxembourg Branch)
58 Boulevard Grande Duchesse Charlotte
L-1330
Luxembourg

Ireland

Citibank International plc Ireland Branch
1 North Wall Quay
Dublin 1
Ireland

Contact details

Sean Quinn European Head of Fiduciary Services sean.quinn@citigroup.com Tel: +44 (0)20 7500 5619 Fax: +44 (0)20 7500 5835	Stefano Pierantozzi Head of European Fund Compliance stefano.pierantozzi@citigroup.com Tel: +44 (0)20 7508 6651 London	Adam Willis Compliance Resource adam.willis@citigroup.com London
Darren Burrows Head of UK Funds Compliance darren.burrows@citigroup.com Tel: +44 (0)207 500 8847 Fax: +44 (0)207 508 0363 London	Cian O'Callaghan Compliance and Technical Manager cian.ocallaghan@citigroup.com Tel: +44 (0)207 500 8834 Fax: +44 (0)207 508 0363 London

The Tax Treatment of the use of Derivatives

Bundling and Soft Commission: An Update

The Simplified Prospectus

MiFID - The Directive on Markets in Financial Instruments

UCITS Synthetic Funds of Hedge Funds

Taxation of Qualified Investor Schemes

ICVCs - Removal of The Requirement to Hold an AGM

Sean Quinn
Managing Director
Citicorp Trustee Company Limited

The Financial Services Authority ("FSA") has just released its Financial Risk Outlook for 2005. This includes a synopsis of the key risks facing the fund management industry.

It is not surprising to anyone involved in the industry that the key risk identified relates to the burdens imposed by the volume and complexity of new regulations emanating from Europe. This poses a real challenge to us all and it is perhaps with a hint of sympathy that the FSA warns that "Firms that fail to apply adequate resources to dealing with reforms may be exposed to legal and regulatory risks, as well as potentially missing out on business opportunities."

Other key risks identified by the FSA are those of maintaining confidence in fund governance and the related risk of managing conflicts of interest. There is clearly no room for complacency here but, equally, a degree of perspective needs to be maintained. The extent to which the market timing issue affected the UK was minimal and discussions around conflicts of interests have centred almost exclusively on the issue of softing and unbundling, where the industry and the FSA have made much good progress already.

Outsourcing also appeared on the FSA's list of key risks. It is no doubt sensible that this should feature on the FSA's radar screen at this time, given that the move to outsource has been one of the most discernable trends of the fund management industry over the past 5 years. It will be important, however, that the FSA gives due acknowledgement to the benefits that can be derived from well-controlled outsourcing - an ability to lower risk, benefit from economies of scale and to focus on managing funds.

Whilst the risks which the FSA has identified relate to fund compliance matters, governance and control issues, equal prominence should be given to the risk that the UK fails to remain a competitive jurisdiction for the funds business.

In this regard, much useful work can be done at the European level to harmonise the various different approaches taken to the Management Company Directive and to ensure that the UK does not miss out on business opportunities because of the more protectionist approaches taken by other Member States in respect of the passporting of management company services.

Closer to home, a key objective must be to achieve certainty and competitiveness with regard to taxation arrangements, in order that the potential for competitive product development promised by COLL can be realised.

Therefore, the Treasury's December confirmation that Qualifying Investor Schemes should be taxed in the same way as other authorised investment funds is to be greatly welcomed. However, a lack of certainty remains, following their statement that such tax treatment will only apply "where each investor holds less than 10 per cent of the fund."

It is in the interests of all that this issue is resolved as soon as possible. Also, the Inland Revenue's deliberations on the tax treatment of funds needs to be brought to a satisfactory close.

This will include whether the assumption that authorised funds operate for investment purposes will remain should there be an increase in the usage of derivatives and, in particular, in the use of derivatives to effectively short sell - a subject which is discussed in our first article, which has been kindly provided by Aedana Ward of Deloitte & Touche LLP.

2005 also promises to be a challenging year for the FSA and for the tax authorities, not just for investment managers and depositaries!

Inland Revenue Discussion Paper Questions The Tax Treatment of the use of Derivatives by Authorised Investment Funds

COLL discussion paper - progress to date

The Inland Revenue published a discussion paper in July 2004 seeking views on the taxation of Authorised Investment Funds (AIFs). The discussion paper was largely prompted by the introduction of the new collective investment scheme sourcebook (COLL) which permits AIFs to invest in a wider range of investments. The discussion paper raised numerous issues covering the broader spectrum of taxation of investment funds but one aspect which caused some surprise, was the resurrection of the question of tax treatment of derivatives so soon after Finance Act 2002. Clearly the Inland Revenue anticipates an increased appetite for the use of derivative strategies by AIFs as, much to the dismay of the industry, the paper has raised the question of whether the tax treatment of derivatives should be revisited.

Responses to the discussion paper were published at the time of the Pre-Budget Report in December 2004. However little clear indication was given as to which direction the Revenue may take on either specific issues or the wider issues raised in their discussion papers.

There was however one clear signpost in the Pre-Budget report, namely that the Government intends to overhaul the tax treatment of authorised investment funds.

Hidden within the detail of the full Pre-Budget Report (para 5.104) is an ominous statement that the Government intends to clarify the taxation of unit trusts that have multiple classes of units and may introduce a measure that applies the taxation of the arrangements for AIFs only to those funds where each investor holds less than 10 per cent of the fund. The IMA is currently holding meetings with Treasury and Revenue officials on these proposed measures to effectively disapply AIF tax treatment to some private funds. To date, the Treasury have indicated that it is not their intention to affect adversely the mainstream use of AIFs.

More importantly, however, the Revenue and Treasury have finally confirmed in writing to the IMA that Qualifying Investor Schemes will be taxed as AIFs.

Derivatives

Turning specifically to the questions raised on the tax treatment of investment in derivatives by AIFs, the discussion paper acknowledged that the industry would like greater clarity on the Inland Revenue's views regarding the increased use of derivatives now permitted within AIF's. Three suggestions were put forward in the discussion paper to achieve this:

Re-examine the tax treatment of derivatives

New guidance/legislation on aspects of derivatives/hedging strategies which might be subject to tax

Provision of industry assurance that the income/capital distinction for tax purposes (which is driven by accounting treatment) will not result in loss to the Exchequer.

The discussion paper's concerns appear to be founded on the proposition (which we do not necessarily agree with) that derivatives are somehow different from the underlying securities that they relate to and therefore require special focus. More specifically, the paper appears concerned with the ability to replicate certain positions, the use of derivatives as investments in their own right, shorting and other hedge fund strategies akin to trading that might be afforded to investors given the wider range of investment activity allowed by COLL. The discussion paper also questioned whether the present income/capital divide can be continued in the light of those opportunities.

Re-examine the tax treatment of derivatives

The tax treatment of the use of derivates in investment funds was addressed in detail in the recent past in FA 2002 Schedule 26. These measures were welcomed by the industry at the time as giving greater clarity by aligning the current tax treatment of derivatives (which meet the definition of a relevant contract) with accounting treatment.

The introduction of IAS has created concerns on the tax treatment of derivatives and the enactment of the Loan Relationship and Derivative Contracts (Disregard and bringing into Account of Profits and Losses) adds yet another layer of tax legislation to consider in determining the tax treatment of derivative contracts. It may, therefore, be more appropriate to consider whether a review of the tax treatment of derivatives is necessary when the implications of the adoption of International Accounting Standards become clearer and in particular when agreement is reached on the wording of IAS 39.

Issue new guidance

There is considerable concern that a review of the existing tax treatment of derivatives has been mooted in the context of AIFs, particularly in view of the fact that the industry had begun to draw comfort from Inland Revenue Bulletin 60. In the context of commenting on the repeal of section 468AA ICTA 1988 (which treated futures and options transactions as investment transactions for authorised funds), IRB 60 states that "the general and prevailing assumption is that authorised funds will not be conducting a trade. They are investment vehicles and regulated as such."

In the majority of cases where derivative and hedging strategies have been undertaken to date by AIF's, most funds employ hedging strategies and enter into derivative contracts to hedge currency or market volatility in respect of their existing investment strategies. The use of these investment techniques by funds evolved primarily as a mechanism to mitigate risk and protect asset values as opposed to being undertaken as investment strategies in their own right. Risk mitigation for AIFs is a very valid objective which should be encouraged rather than the subject of possible increased scrutiny.

The suggestion that legislation may be enacted to determine circumstances in which derivative transactions might be taxable for investment funds must by definition be founded on the assumption that there will be circumstances in which derivative activities may in certain situations constitute a trade. In reality, however, most returns generated by derivative activities undertaken by AIFs are likely to be capital in nature. Indeed, we believe that even in the case of hedge funds, a similar argument can be made.

It is difficult to agree with the premise on which some of the discussion paper's comments must be founded, namely that derivatives should not be considered as investments in their own right. Clearly investor demand and the burgeoning offshore hedge fund industry has indicated that significant numbers of investors view access to hedging strategies and their returns as an integral part of diversifying their investment portfolio. Such investors do not regard their investment in offshore hedge funds as mainly speculative or trading in nature, albeit it is acknowledged that such investment strategies carry a greater degree of risk.

The purpose of AIFs is to facilitate collective investment. Investors' motives relate to investment rather than trading. Adopting a purposive approach, surely the objective and outcome of the investments should be the determining factor as regards the tax treatment? The objective of AIFs is to generate an investment return for investors. There has been no evidence to date that AIFs use of derivatives have been used by investors to access investment strategies which they might otherwise undertake directly to mitigate tax liabilities.

At worst, it may be the case that the use of derivative and hedging strategies may potentially result in deferral of some tax in that a greater proportion of the investment return may be received as capital and therefore not subject to tax at fund level. However, these gains are caught when an investor realises that investment. It should not be overlooked that for many individual investors, the investors, if they were able to undertake derivatives transactions themselves, would not fall within FA 2002 and instead would be taxed under the normal income / capital divide. Consequently, investment via an AIF merely seeks to provide some deferral until an investor realises their holding. This is, of course, the same for funds investing wholly in securities, and it is difficult to see why there should be any policy justification for treating derivatives differently from other investments.

The position for exempt investors is even more straightforward - leaving the only possible concern being the tax treatment for corporate investors. Such concerns could, however, easily be addressed by enacting legislation which would apply to corporate investors to prevent abuse. This would surely be a simple legislative alternative to grappling with the tax treatment of derivatives, yet again.

Finally this has to be seen in the wider context. Deferral of tax until the investor realises their interest has become a primary driver of the movement of investment into offshore funds. Similar deferral through UK funds would not contribute further to the erosion of revenues to the Exchequer (as investors may instead switch their investment to UK funds as offshore hedge funds are repatriated). It may in fact have the opposite effect, by restoring more of the economic interest in the UK. Furthermore, the impact of such tax deferral as regards AIFs may result in minimal loss to the exchequer in the near term as many AIFs are awash with excess management expenses.

Industry assurance

The discussion paper expressed concerns on the possible loss of revenue to the exchequer arising from the use of derivatives and questioned whether the income/capital should be maintained in view of this.

As already outlined above, any possible exploitation arising from investment in derivatives by AIFs is more likely to emanate from corporate investment rather than individual investment. Individual investment issues relate to deferral as it may result in less tax sticking at the fund level.

Similar concerns were expressed some years ago as regards corporate investors investing in AIFs which were heavily invested in debt instruments. This resulted in the introduction of the loan relationship rules and in particular, the introduction of Para 4 Schedule 10 Finance Act 1996 which taxes UK corporate investors on a mark to market basis on holdings in certain AIFs which meet the non qualifying investment test. It may be that the introduction of similar tests and tax measures for corporate investment in AIFs could be an appropriate mechanism to deter corporate investors from using AIFs to achieve tax deferral or mitigation.

In summary, it is difficult to see why the taxation of derivatives in AIFs needs to be revisited at this time and this is something which should be strongly resisted unless the Inland Revenue can demonstrate compelling reasons why recent legislation should be overhauled. The current income / capital divide works and may only need to be revisited when the implications of IAS become more certain.

Moreover, given the uncertainty caused by the very suggestions in the discussion paper, it would be helpful if the Revenue could restate their presumption that AIFs will not be conducting a trade. Indeed given the industry's nervousness, it may be helpful if this could be enacted in legislation akin to the old s468AA ICTA 1988. The Inland Revenue should not lose sight of what AIFs are there for; namely, to provide an investment return to investors and consequently that presumption should be followed for the purposes of determining the tax treatment. Any concerns about potential abuse would need to be properly articulated by the Revenue, but these concerns could be addressed at investor rather than fund level if appropriate and there is a precedent for doing this.

By Aedana Ward, Senior Manager in the Financial Services Tax Practice of Deloitte & Touche LLP

Bundling and Soft Commission: An Update

In April 2003, the FSA published Consultation Paper CP176 - Bundled Brokerage and Soft Commission Arrangements in which it stated its concerns that fund managers who use bundled and soft commission arrangements face conflicts of interest in their relationship with brokers and are not directly accountable to their clients for expenditure on bundled and softed items.

The main justifications which the FSA used to support its position were:

Bundling and softing arrangements can lead to conflicts of interests between fund managers and brokers because fund managers might be tempted to trade with particular brokers because they can access other services the brokers can offer. This in turn can lead to "overuse" of these supplementary services;

Customers themselves may lack the information required by them in order to make informed decisions concerning fund managers' expenditure;

There has traditionally been a distinction from a regulatory context, between bundling and softing. However, both have the same economic consequences; and

Due to the principal-agent relationship that exists between the customer and the fund manager, the customer cannot always accurately judge whether its agent has acted in its best interests.

To address these issues, the FSA proposed two measures in CP176:

Limiting the range of goods and services that could be purchased with commission; and

Requiring fund managers to value the goods and services that could still be bundled or softed, and to rebate an equivalent amount to their customers' funds.

The proposed measures created a firestorm within the industry (and nearly 150, almost all hostile, responses), so much so that the FSA appointed Deloitte & Touche to carry out further research on the costs and benefits of the proposals.

Then, in May 2004, the FSA decided to hold back from pushing forward with its own proposals for regulatory reform. Instead, it undertook to come back with further clarification on what goods and services could be purchased with commission. Further, as regards the proposed requirement of having to value goods and services bundled or softed and the rebate provision, the FSA opted instead to give the industry until the end of 2004 to deliver a suitable alternative response.

Recent Developments

There have been several recent developments on these issues and these are discussed below.

FSA clarification on what goods and services can be bought with commission.

In November 2004, the FSA published a supplementary policy statement PS 04/23 "to assist the industry to continue its progress towards a market-based solution to the transparency and accountability issues raised by soft and bundled brokerage commissions."

The FSA is adopting the approach that commission should only arise in relation to 'execution' and 'research' and has provided definitions for these terms. It also defines "non-permitted services" which do not fall within either of these categorisations.

"Non-permitted services": these are services which do not fall within the scope of "execution" and "research" and are defined as those services not directly connected with investment decisions, execution or research. They include:

Services related to the valuation or performance measurement of portfolios;

Dedicated telephone lines;

Subscriptions for publications;

Most custody services; and

Travel, accommodation or entertainment costs.

"Execution": according to the FSA, this includes all services provided by a broker which meet the following criteria:

They are demonstrably linked to the arranging and conclusion of a specific transaction; and

They arise between the point at which the fund manager makes an investment decision and the point at which the transaction is concluded.

These execution services would include booking and processing of orders, related costs arising directly from trading and activities which would constitute active order management, i.e. advice on order handling, programme trades etc.

"Research": according to the FSA, "research" embodies the concept of rigorous value-added analysis, with clear intellectual content that assists fund mangers to make investment decisions in relation to their clients' portfolios. Research will not include raw data fields, but will include original written research, discussions between fund managers and research providers and possibly "artificial" intelligence.

IMA response to PS 04/23

The IMA has broadly welcomed the FSA's approach in PS04/23 of providing a list of items that cannot be paid out of commission and then providing principles for determining what constitutes "execution" and "research." It also welcomes a number of the FSA's other suggestions in the policy statement, for example, the removal from the regulations of the terminology of "soft commissions" (the key determinant will be whether goods and services will be permitted or not, regardless of the provider).

Also, the IMA welcomed the FSA's indication that it is not, in principle, opposed to commission-sharing arrangements (CSA). The FSA acknowledges that CSAs can enable fund managers to separate decisions about the most appropriate providers of execution and research services. The FSA states in PS 04/23 that it is not opposed to CSAs provided that:

Clients of fund managers understand their nature and purpose;

The commission flows generated are properly reflected in the industry's disclosure regime; and

They do not create new and unmanageable conflicts of interest for the fund manager.

Industry progress on disclosure

Another significant development relates to the proposals which the industry has drawn up in response to the challenge laid down by the FSA in May 2004, which suggests alternatives to having to value goods and services softed or bundled and the rebate provision.

The industry response has focused on three different areas:

Enhanced disclosure of trading costs using "Comparative Disclosure";

Trading arrangements between brokers and fund managers; and

Governance of retail funds.

The enhanced disclosure is being addressed by a joint IMA/NAPF working group, which has proposed an approach based on the existing Pension Fund Disclosure Code. Like the Pension Fund Disclosure Code, two levels of disclosure are proposed:

Level 1 Disclosure: setting out the fund managers' policies and processes in relation to trading on behalf of clients, with the objective of disclosing and addressing any conflicts of interests. It will, therefore, provide a narrative on such matters as the basis on which brokers are selected, how the firm ensures best execution and information on decisions about how research is purchased; and

Level 2 Disclosure: containing numerical information, including a breakdown of total trading by counterparty and breakdown of the commission expenditure, in order to see the contribution from trades undertaken at different commission rates. This will be accompanied by a breakdown of the proportion of commission spent on execution services and that spent on non-execution services, including research.

Full details, including examples of proposed disclosures, are set out in the IMA's Consultation Paper on Comparative Disclosure.

Working groups have also been set up to look at the other two issues. Trading arrangements between brokers and fund managers are being reviewed by a joint IMA/LIBA working party and the governance of retail funds is being addressed via the IMA's CIS Governance Working Party - their recently released proposals will be featured in our next edition of News & Views.

When CP176 was released in April 2003, there was a definite hostile reaction within the industry. The debate has now moved on significantly and there is general acceptance of the need for adequate disclosure and avoidance of conflict of interests.

Further, whilst the FSA has warned that it is ready to interfere in a more intrusive manner should the industry fail to deliver a suitable response, it is pleasing that the industry has responded to this call and that the FSA has given a warm welcome to the progress made so far by the industry. The FSA has stated that the IMA/NAPF proposals on comparative disclosure "look to have the potential to deliver the improvements in transparency and accountability … and would drive greater efficiency in fund managers' decisions on execution and research." Hopefully, the next few months will see this issue brought to a suitable conclusion which meets the FSA's objectives whilst minimising the burden on fund managers.

The Simplified Prospectus

In November 2004, the FSA published CP 04/18, which sets out proposals for the implementation of the Simplified Prospectus requirements laid out in the UCITS Management Company Directive ("Directive").

The Simplified Prospectus is intended to be used as a universal marketing tool for UCITS throughout the EU, providing clear information that can be easily understood by an average investor. In other words, firms will be able to have one product guide, without the need for changes (apart from translations), to be made for each different jurisdiction where the fund is being marketed.

Following implementation, UCITS operators must publish a Simplified Prospectus for each fund, keep it up to date, offer it to subscribers, and "file" it with the relevant authorities. Consumers in all Member States will be offered a Simplified Prospectus when considering the purchase of a UCITS.

The closing date for providing feedback to the FSA on the Consultation Paper was 28 January 2005. The FSA intends to make rules by the end of February 2005 and there will then be a six-month period (currently planned to run until end of September 2005) in which firms will have to complete the re-drafting of, and publish, their new Key Features documents.

In this article, we provide a summary of some of the "Key Features" of the consultation paper and proposed changes.

The Simplified Prospectus vs the Key Features Document

As regards the presentational format of the Simplified Prospectus, the Directive requires only that "The Simplified Prospectus shall be structured and written in such a way that it can be easily understood by the average investor." The Directive, therefore, gives Member States considerable discretion on how the information in the Simplified Prospectus is to be presented by UCITS.

The FSA is proposing to take advantage of this discretion by broadly retaining the "question and answer" format presentational requirements of the Key Features regime, but replacing the existing 'point-of-sale' product information requirements, currently set out in Conduct of Business 6, with the Directive's content requirements.

This approach has a number of advantages, notably that existing Key Features documents will require few changes (and, therefore, minimise introduction costs) to achieve compliance with the Directive. Another important advantage of the detail of this approach is that customers and their advisers will continue to be able to compare the costs of investing in all packaged products (life and non-life) on a common basis.

New Content

The Directive requires UCITS to include a number of pieces of information in the Simplified Prospectus that are not currently required in Key Features. These are:

Disclosure of Charges: the Commission has recommended that these be included by way of the Total Expense Ratio (TER) method, although see below for further details of the FSA's proposals;

A 'Portfolio Turnover Rate' (PTR) figure: to reflect the volume of dealing within the UCITS fund. The PTR will be calculated on the basis of the total of transactions in securities, the total transactions in units of the UCITS fund and the reference average of its total net assets. Unlike the TER method, dealing costs will be included in the calculation of PTR;

A statement about the taxation of the UCITS: this statement would include information on the tax regime applicable to the UCITS scheme in the UK and a statement to the effect that the taxation regime for income or capital gains depends on the tax law applicable to the individual;

The historic performance of each UCITS: showing up to ten years' annual returns in the form of a bar chart. If the UCITS scheme has been in existence for less than ten years, but for at least a period of one year, annual returns should be given for as many years as are available.

Information about a benchmark: where the UCITS is managed by reference to a benchmark or uses a benchmark to apply performance fees, information must be disclosed showing how the UCITS fund compares to the benchmark over the previous ten years;

A statement about the existence of fee-sharing arrangements and 'soft' commissions: the Simplified Prospectus must contain a statement referring subscribers to the full Prospectus for detailed information on these kinds of arrangements. The full Prospectus, in turn, must set out detailed information on soft commissions. More information on soft commission disclosures is included in the article on "Bundling and Soft Commissions: An Update", above.

Content no longer required

The existing Key Features regime requires an illustrative projection to be given where the UCITS is sold to a customer who has a target in mind. The UCITS Directive does not, however, have a similar requirement in respect of the Simplified Prospectus. The FSA, therefore, will be compelled to remove the requirement from the existing regime when introducing the provisions for the Simplified Prospectus.

Disclosure of Charges

As noted above, one of the key additional requirements of the Simplified Prospectus is for disclosure of charges which the Commission has recommended is by way of the Total Expense Ratio (TER) method.

Whilst most European regulators are likely to require that only the TER is disclosed, the FSA is proposing to also require UCITS to disclose charges using the current Key Features approach based on the Reduction in Yield (RIY) method.

This is because the FSA believes that the TER is not the most effective format for the disclosure of charges, taking account of consumers' need to make comparisons across a range of different types of product with varying charge structures as it, unlike the RIY method, does not take account of front-end or exit charges and does not, therefore, represent the full cost of investing.

The FSA believes that, rather than adding confusion, showing both measures will be highly effective in promoting consumer understanding of charges. So fundamental, however, is this argument to the FSA's proposals, that it has commissioned some research into the extent to which consumers can distinguish between - and interpret - the various disclosures and have undertaken to take account of these findings when finalising the regime.

Other Changes

Whilst the above changes to the Key Features document are required under the Directive, the recommendations issued by the Commission in April 2004 regarding the content of Simplified Prospectus also contain a number of invitations to Member States to 'consider' certain requirements and various matters which Member States have an option on whether or not to implement.

Two of these are particularly worthy of note, for although the FSA is unlikely to opt to require such disclosures at this time, they may come to feature in due course.

Firstly, there is an option of requiring that a further indication of risk, using a single word or number, could be used. Whilst the FSA has indicated its intention to work with the industry in exploring the feasibility of a simple risk indicator for investment products, it is not proposing to include any requirements for such an indicator at this time.

Also, there is an option to require that all UCITS be required to disclose a benchmark, regardless of whether it has explicitly mentioned one in its objectives. The FSA is proposing not to impose this requirement, citing that it does not think this appropriate, as it presumes that all UCITS funds consistently manage themselves by reference to a single benchmark, which the FSA does not believe is the case.

Requirements regarding the provision of a Simplified Prospectus.

Whilst the Directive requires that the Simplified Prospectus must be offered to all subscribers, the FSA is proposing to retain the existing requirement that private customers must be provided with the product information. In addition to its belief that such an approach is preferable, because it should result in more informed choice and better purchasing decisions, the FSA has adopted this view because:

The EU's Distance Marketing Directive requires consumers entering into a distance contract to be given key information, such as the Simplified Prospectus, about a service; and

Intermediaries will continue to be bound by the FSA's current requirement to provide the Simplified Prospectus and the FSA believes that it is sensible that intermediaries should be subject to the same requirement in this area as those applicable to UCITS management companies.

Non-UCITS schemes

The Directive applies only to UCITS schemes. Whilst the FSA has invited feedback on the matter, there is an acknowledgement in the Consultation Paper that it is unlikely to be justifiable to require Non-UCITS funds to change their current offering documents, even though doing so may avoid some Handbook complexity by preventing multiple regimes.

Harmonisation and Super-Equivalence

Whilst the Directive is intended to have a harmonising effect across Member States, the FSA acknowledges in its consultation paper that "Consistency of presentation … is highly unlikely" and that it expects "substantive differences in approach in terms of the content to be delivered under individual Member States' regimes." Additionally, different approaches will be taken by Member States as regards the issue of whether the Simplified Prospectus must be offered or must actually be provided.

Differences in terms of the content to be disclosed in the Simplified Prospectus in different Member States are going to arise for a number of reasons:

Member States adopting different views on whether or not the Commission's April recommendations are binding;

Different approaches to those elements of the Directive where there is a "requirement to consider"; and

Different approaches to those elements of the Directive where there is "an option to implement".

Whilst there may not be as much harmonisation as could perhaps have been achieved, it is probably fair to say that it is unlikely that any of the FSA proposals will place the UK at a significantly disadvantageous position on account of their super-equivalence.

Whilst there is a risk that where the TER and the RIY methods for disclosure of charges are both used but the differences between them are not explained (the risk being that some subscribers would take the larger RIY for a UK UCITS and compare it with a TER for a non-UK UCITS), UCITS will be able to explain the differences and relationship between both figures so as to avoid such confusion.

Moreover, it is worth noting that in addressing this point the FSA has had in mind not only the effect of competition between the UK and other UCITS countries, but also the effect on competition within the UK between different types of product. Currently, all charges on UK packaged products (authorised funds, life products, pensions etc) are disclosed on a common basis. For example, although some UCITS do not apply entry charges and rarely apply exit charges, life products often do. The RIY measure enables consumers to compare the costs of buying a UCITS with a life product on a like-for-like basis. If the RIY were no longer disclosed in relation to funds, it would make it significantly more difficult for consumers to be able to do so.

It is perhaps disappointing that greater harmonisation will not be achieved between Member States as regards the Simplified Prospectus as could have been achieved.

By way of a final thought, perhaps one of the most significant developments that we will see in coming years relates to the disclosure of the risk profile of the UCITS fund and the idea of using a single word or number to indicate the risk profile of a particular UCITS fund. Whilst the FSA looks set to refrain from proposing to introduce such a requirement at this stage, it does indicate its intention to look at this in the future. In its Consultation Paper, the FSA also states that it believes that at least four Member States currently propose to adopt a single risk indicator based on volatility, in addition to the recommended qualitative description.

MiFID - The Directive on Markets in Financial Instruments

MiFID is a key stepping-stone in enabling the EU to achieve its vision of a single market, as it brings to Member States commonality in terms of rules and definitions as well as eliminating artificial barriers to cross border trading. Indeed, it may be said that ISD2 has been reborn in the guise of MiFID.

Even the FSA has acknowledged the extent of the ambitions which regulators in some Member States have that MiFID will operate to overhaul the current regulations and that it will ultimately form the blueprint for a pan-European compliance rulebook. It is not surprising then that in its recently published Financial Risk Outlook for 2005, the FSA identified as a key risk, the burdens imposed by the volume and complexity of new regulations forthcoming from Europe and cited MiFID in particular. Ominously, although with a hint of sympathy, the FSA warns that "Firms that fail to apply adequate resources to dealing with reforms may be exposed to legal and regulatory risks, as well as potentially missing out on business opportunities."

The Proposals

As stated above, MiFID threatens a fundamental overhaul of our regulation. This will extend to the Conduct of Business Rules and Financial Promotions Rules, governance arrangements, cross-border provision of services and will even touch on the appropriate level of regulatory intervention required in addressing the needs of retail and professional clients. Below, we set out a brief synopsis of some of the key points.

Governance

MiFID requires firms to establish a 'permanent, independent compliance function' and provides an extensive set of criteria to assess adequacy of internal systems, resources and procedures, accounting policies, risk management policies and internal controls.

Indeed, so wide is the scope of MiFID, that the FSA has chosen to delay implementing the systems and controls section of its Prudential Source Book for banks and investment firms, preferring to wait and see the final details of MiFID and its impact.

Conduct of Business

As regards the Conduct of Business Rules, CESR has called for comments on: client classification, the definition of investment advice, general obligations for firms to act fairly, honestly and professionally and in accordance with the best interest of the client, best execution, the suitability test, appropriateness test and execution-only business and pre-trade transparency for systematic internalisers.

Impact on the Fund Management Industry

It is clear from the above that the fund management industry will not escape the impact of MiFID. Indeed, the IMA has set out its thoughts on the areas where it believes MiFID will touch the fund management industry:

Many fund managers are investments firms, as defined under MiFID as well as clients of other MiFID firms and will be directly impacted by CESR's advice; and

CIS are financial instruments under MiFID and are often sold to retail investors by MiFID firms (e.g. financial advisers and retail brokers).

The future of Principled Based Regulation

Since N2, and as very evident in COLL, the FSA has moved away from prescriptive regulation in favour of introduction of principle-based regulation. MiFID, however, may threaten a new era of prescriptive regulation going by the contents of the directive. The directive is different in style from previously issued directives in that it is highly prescriptive and focuses on direct implementation of regulation rather than high-level principles.

Indeed, the IMA, in its response to CESR (September 2004), has expressed concern over the level of detail, noting that it finds CESR's draft advice to be "overly prescriptive and detailed" and expressing concern that CESR has attempted to prescribe delivery mechanisms rather than focus on the principles and desired outcomes.

The Target Date

The first detailed consultation document on MiFiD was issued by CESR in June 2004, with further documents having been published in October and November.

However, there is industry-wide concern that there is insufficient time for firms to adequately respond to such wide-reaching proposals in due time. As stated above, this concern is also shared by the FSA. Indeed, in a recent speech, the FSA's Callum McCarthy emphasised the widespread scope that this directive will have over conduct in both wholesale and retail markets and underlined that the timetable for implementing MiFID should be re-examined, as the present proposals are not realistic.

Perhaps in a move designed to meet the industry half-way, in late January 2005, Charlie McGreevy, the EU Internal Market Commissioner, who is responsible for the rollout of MiFiD stated that he intends to submit a proposal to the EU Commission later this year, to delay its adoption by Member States for a further year- i.e. until April 2007. This should help to allay the serious concerns of financial industry service providers, so as to, hopefully, allow for the fine-tuning of the technical aspects of the new regime, the introduction of system enhancements, the updating of internal procedures and staff re-training.

There is much sensible harmonisation that can be achieved by the Member States through the MiFID initiative, however, but there is a need to resist a vast volume of new regulation with all the associated burdens of implementation, if those changes do not offer substantive sensible change with identifiable benefits for business and investors.

UCITS Synthetic Funds of Hedge Funds

It may now be possible for retail funds to gain exposure to hedge funds whilst staying within the confines and benefits of being a UCITS scheme.

Whilst direct hedge fund exposure and investing in funds of hedge funds would not be permissible, funds are able to track the performance of a hedge fund index through the use of total return swaps. In this way, the UCITS fund can be run essentially as a synthetic fund of hedge funds.

To achieve this, by way of example, the fund could hold a basket of FTSE 100 securities and then enter into a total return swap on the basket of securities for the return on a hedge fund index.

On a practical note, as the regulations limit the UCITS fund's exposure to a swap counterparty to 10% (where the counterparty is an approved bank), the UCITS fund will need to be able to identify a number of counterparties willing to enter into such a transaction.

Fundamentally, the acceptability of such an approach depends firstly on concluding that a financial derivative instrument can be legitimately invested in, even though the underlying security of the derivative would not meet the requirements for direct investment by the UCITS fund. The

Irish regulator has recently accepted that this is the case and it is reported that the FSA recently approved the first OEIC to be launched which tracks a hedge fund index through making use of a swap transaction.

Below, we consider the UK regulations and how such an approach fits with the rules set out in the CIS sourcebook.

Regulatory fit

Whilst a UCITS fund cannot invest directly into hedge funds or funds of hedge funds, we believe that there is no reason why it cannot legitimately have the investment objective of replicating the performance of a hedge fund index.

Furthermore, whilst the UCITS fund cannot replicate the composition of the index (they cannot hold the constituent hedge funds forming part of the index), we believe that there is no reason why it cannot, as in our above example, hold a basket of FTSE 100 securities and then enter into a total return swap on the basket of securities for the return on the hedge fund index. Of course, this is only possible under UCITS III not efficient portfolio management (EPM).

Swaps are not eligible instruments under EPM, but are eligible under UCITS III subject, of course, to a suitable risk management process. Also, in this case, the swap is being used as an investment not to reduce risk or cost.

The key issue in considering whether such a strategy fits with the regulations is the question of whether it is appropriate for the underlying of a derivative to be a hedge fund index. In this regard, COLL 5.2.20(f) and CIS 5.2.22(f) simply state that the underlyings of a derivative can be "financial indices."

One approach could be to assume that all hedge fund indices meet the definition of "financial indices" without the need for further consideration. It is likely, however, that a more objective and qualitative approach will be needed in assessing whether a particular hedge fund index meets this definition. Moreover, it is obviously appropriate that at the authorisation stage, investment managers should provide the FSA with full details of any hedge fund index they want the UCITS fund to track so that the FSA can raise any objections that it may have at that stage.

It would, of course, be useful if the FSA were to define the term "financial indices". In the absence of such definition, however, there are already some useful yardsticks which can be used. Firstly, in its 2005 Financial Risk Outlook, the FSA noted some of its concerns with hedge fund indices and investment managers should be prudent to see that the indices which they are proposing to track do not fall foul of the FSA's concerns. The FSA stated that: "…hedge fund indices should be treated with caution: they can suffer from survivorship bias - the exclusion of data from failed funds - and self-selection bias, as performance reporting is voluntary."

Secondly, whilst "financial indices" is not defined in the FSA regulations, the term "relevant indices" is defined. Under COLL 5.2.33 and CIS 5.2.34, "relevant indices" are those where:

The composition is sufficiently diversified;

The index is a representative benchmark for the market to which it refers; and

The index is published in an appropriate manner.

These criteria link in neatly with the FSA's concerns as the "exclusions" and "self-selections" would call into question whether the hedge fund index can come within the criteria of being "a representative benchmark" for the market to which it refers.

Whilst the criteria to be met to come within the definition of "relevant indices" can act as a useful yardstick, it should be noted that the FSA's regulations do not state that the "financial indices" must meet the definition of "relevant indices". Rather "relevant indices" is defined for the purpose of the spread rules and to establish where index tracking funds can take advantage of the ability to invest up to 20%, 35% in exceptional market conditions, in shares issued by a single body. This is unlikely to be of any direct concern in the case of funds tracking a hedge fund index.

However, the definition of "relevant indices" is also important because, where a UCITS scheme invests in an index based derivative, if the index does not falls within the definition of "relevant indices", the underlying constituents of the index have to be taken into account for the purposes of the spread rules. In other words, a look through approach needs to be adopted. This is equally relevant to any UCITS fund seeking to track a fund of hedge funds index. That said, the underlyings of the hedge fund index are unlikely to cause a breach of the spread rules and, furthermore, as the property will not be deliverable there is no need to determine whether the delivery will cause a breach of the rules of the sourcebook.

The possibility of synthetic funds of hedge funds under the UCITS banner is an interesting development. Further, facilitation of such a product within a retail environment would set the UK ahead of other jurisdictions where, although there are developments in respect of allowing regulated hedge funds, this is very much being done under the institutional banner.

It is all the more important, therefore, that this development is handled with care. The FSA needs to make it clear whether it considers it appropriate for such products to be available to retail investors and, assuming it does, some further guidance on when a hedge fund index comes within the definition of financial indices would be useful.

Taxation of Qualified Investor Schemes

Although it was some eight months after the launch of the New Collective Investment Schemes (COLL), thankfully, consequent to the Chancellors pre-budget report (PBR) on 2nd December, the IMA received confirmation from the Treasury on 16th December that Qualifying Investor Schemes (QISs) are to be taxed in the same way as Authorised Investment Funds (AIFs).

This is not the end of the matter however, as the PBR also states that "the Government intends introducing a measure that applies the taxation arrangements for AIFs only to those funds where each investor holds less than 10 per cent of the fund."

The initial point to note is that this statement has issues for all AIFs, not just for QIS. An example of a very common scenario that could fall foul of such a proposal is that where an institutional investor has a large investment in a fund this may exceed the proposed 10% limit. Equally, holdings by a fund of funds or holding in nominee names such as supermarkets or ISA plan manager may well exceed 10% of the fund.

The Treasury statement is, therefore, very concerning. It is welcoming, however, that the IMA report that the Treasury officials have listened to and understood their representations on the matter and have confirmed that there is no intention to affect adversely the mainstream use of AIFs.

It would appear that the objective of the Treasury proposals is to prevent unit trust structures being created by wealthy individuals or corporates as a way of avoiding tax, a problem that could well be exacerbated by the launch of QISs given that they are to enjoy the same taxation of authorised investment funds but with substantially less regulation of their investment methodologies, for example no specific spread or concentration rules and a wider range of eligible asset classes.

An obvious point to make is that whilst the objective of the proposals may be sound, it would seem preferable that the tax avoidance measures be applied at the investor level rather than the fund level. Indeed, if the QIS were disqualified from being taxed as an AIF because one investor's holding exceeded 10% of the fund on one day, that would hardly be fair to the other investors in the QIS.

Other matters

There are also other issues which have the impact of creating on-going uncertainty over the taxation arrangements for all authorised funds and which may, in practice, also affect the general approach of taxing QISs in the same matter as AIFs.

As noted by Aedana Ward of Deloitte in our first article, in the Inland Revenue's discussion paper on the tax implications of the new COLL sourcebook, it questions whether the "general and prevailing" assumption that AIFs operate for investment purposes rather than for trading purposes will be appropriate should there be an increase in the usage of derivatives and, in particular, in the use of derivatives to effectively short sell.

More than any other issue, the taxation arrangements will impact on the competitiveness and success of the UK funds industry. It is welcoming to now have the general confirmation that QISs will be taxed in the same way as other AIFs. It is, however, disappointing that the tax implications of QISs schemes are still not fully determined and that there is a lack of clarity on what the future arrangements for taxation of AIFs will be.

Furthermore, it must be realised by all concerned that it can be damaging to the UK's competitiveness when announcements such as those of the Treasury in the PBR are made and cause confusion and uncertainty, even if it is clearly unlikely that they will ever come into force in the way suggested by the announcement.

Within hours of the PBR's statement, the significant harmful implications were clearly identified by the industry, the lobbying of the Treasury began almost instantaneously and, within days, the Treasury recognised the possible unintended consequences of its statement. It is disappointing that the Treasury did not consult privately with the IMA or other industry representatives before making the announcement, which would surely under those circumstances not have been made at all.

ICVCs - Removal of The Requirement to Hold an AGM

In the COLL sourcebook, the rules in respect of unit trusts and ICVCs were largely harmonised, including allowing unit classes beyond income and accumulation units, the box management process and aligning fees and expenses.

One of the few areas of remaining difference was the requirement for ICVC's to hold an Annual General Meeting (AGM). As part of the Government's two-year review of the Financial Services and Markets Act, however, the Treasury has accepted that ICVC AGMs can be dispensed with.

Corresponding changes to the OEIC regulations are expected to be made in early 2005. Thereafter, managers of existing ICVCs will be able to dispense with holding AGMs on the giving of 60 days notice to investors.

Contents

Citigroup® Global Transaction Services Fiduciary Services Citicorp Trustee Company Limited Informal Compliance; March 2005 CTCL home page

Citigroup® Global Transaction Services
Fiduciary Services
Citicorp Trustee Company Limited
Informal Compliance; March 2005

CTCL home page