The UK government, in 2011, announced an intention to introduce a tax-transparent fund vehicle in the UK. The declared objective was to facilitate the setting up of pooled master funds, which themselves would qualify under the most recent of the European Union’s frameworks for investment schemes, known as UCITS IV.1
The idea is that such a ‘contractual scheme’ would be a collective investment vehicle taken to be UK tax-transparent. By this device income and gains accrue to the investors directly as they arise (without the interposition of any separate UK tax consequence on the vehicle). The contractual scheme is not itself to be a legal entity. HM Treasury commenced consultation in January 2012.2
A declared objective of the initiative is to improve the UK’s competitive position in investment services by enabling providers to win an appropriate share of European pooled money in the form of UK domiciled funds – and thus to reinforce Britain’s claimed position as the largest asset management centre in Europe.
Any proposal designed to facilitate and reduce the complexity and cost (and tax cost) of cross-border investment is to be applauded, and to me, as a London practitioner, the prospect of winning additional custom for UK financial services providers is entirely welcome.
However, I wonder whether the hoped-for advantages may not be countered by legal difficulties to which the new funds, through their unique structure, may fall prey.
The legal architecture of the new schemes envisages initiation and establishment by contract, governed by the terms of a deed entered into between the ‘operator’ of the scheme (which one would expect to be the conventional investment manager role) and a ‘depositary’ (essentially occupying the role of a securities custodian, a depositary under an open-ended investment company (OEIC) or, under the time-established English model, a unit trust trustee of a unit trust vehicle3).
The paper envisages that the target market could be existing UK-domiciled funds, cross-border institutional money, UK domestic schemes not qualifying under UCITS4 or schemes restricted to defined professional investors.5
Shareholders in an OEIC or a closed investment company (UK investment trust) hold their investment, of course, in the form of shares in that company. Investors in a unit trust hold ‘units’ in that trust. Neither party has any legal ownership over the underlying investment property. In the case of the proposed ‘contractual schemes’, however, a key provision – introduced to maintain the UK tax-transparency desired – is that the investors should be co-owners and accordingly have, and be seen to have, legal ownership of their proportionate share of the underlying assets.6
Death of a ‘contractual scheme’ investor
At this point alarm bells should begin to ring with the lawyer. Such a vehicle may receive investments from a large number of private individuals (I), will be managed by an operator (O) and have a depositary (D) as a custodian. If the scheme is to access a diversified portfolio of assets with the declared intention of outperforming or tracking, say, an emerging markets index, investments may be made in 30 or 40 countries.
What then are the problems, if any, when the investor dies, for the personal representatives of I – O or D?
In this example a hypothetical investor has direct property ownerships of investments in several countries. Any immobilised investment held in a central depositary is likely to have the situs of that depositary.7 For shares, generally, the situs is likely to be the place of incorporation of the company. If the shares may only be transferred by registration on a particular register, their situswill be the place of that register. If transferable on more than one register, they will be situated at that register, where they would be dealt with in the ordinary course of affairs by the owner.8 A depositary receipt over a share (e.g. ADR or GDR) may shift situs to that of the receipt’s issuer. A Crest depositary instrument may have the same effect – moving situs to England where Crest operates. Bearer shares may have the situs of the holding bank. It may not be enough merely to know that I owns shares in the Montevideo Harbour Company.
The death of such a hypothetical investor leaves those administering the estate with ownership of assets sited in many countries – not all situses being quickly ascertainable. Operationally, of course, the holding may be redeemed by application to O in the UK, but I’s personal representatives (or heirs) may nevertheless be or have been under an obligation to declare and settle local inheritance and similar taxes (or merely to satisfy themselves that the need does not arise, say because the size of the estate is below a reporting exception threshold).9
However, O and D may be less comfortable since, under local law, they may be jointly, or secondarily, accountable with or after the personal representatives of the owner (or the heirs). If they have commercial operations or affiliates in the investee country the anxiety increases.
Indeed, if any accountabilities of O or D are unfulfilled for a few years, the liabilities overhang the scheme itself. Thus a later incoming investor may find the investment’s value tainted if O, several years from inception, is required from scheme funds to discharge such an investee country’s imposed tax charge.10
Allied with this question may be the need to examine any double-taxation agreements or conventions that themselves provide special rules for determining the situs of property for inheritance and similar tax purposes. Some, but not all, of these conventions allow credit against UK tax for overseas tax paid by reference to such property.
Readers may recall cases11 to the effect that it is a breach of trust for a fiduciary to pay taxes in a country that cannot compel such payment on the fiduciary. In practice, though, which O or D in such a case would, commercially, be content, consciously, to take the risk of neglecting to pay such taxes?12
Some legal systems characterise assets differently from others. Movable and immovable, tangible and intangible, realty and personalty. The characterisation may not affect local tax exposure but it may produce a different problem. If, say, a local system treats shares in a single property-owning company as realty – or a mortgage bond secured on real estate likewise – it is possible that local succession rules apply to displace the apparent terms of the will. ‘Forced heirship’ or different intestate distribution rules may apply. The personal representatives may not know of, or dispense with investigating, or choose to ignore, the issues. But the spectre for O and D of local succession-entitled claimants emerging to claim their inherited asset from such a constructive trustee will be disquieting.13
Parallel risks may arise for non-private investors. Local law may attribute ‘ownership’ of locally sited assets to a member of a trustee board comprised of individuals. For a corporate trustee owned within a group structure, ‘ownership’ may be attributed to parent or affiliates – or the exposures of the two could become intertwined at local level. Hence arise additional tax, succession and asset security risks.
Ascertaining situs of assets may not be straightforward. Bilateral and multilateral inheritance tax conventions remain woefully incomplete, even between economically active nations. They are renegotiated at a glacial pace. Few treaties reassign asset situs for the same purpose. A private investor in a contractual scheme should be aware of the traps in this article. Likewise an intending operator or depositary should appreciate the business and operational risks of these roles.
One has to conclude that a commendable initiative by the UK government may see a restricted take-up unless these considerations can be addressed. Re-engineering the collective investment vehicle as a lattice of direct asset ownership looks dangerous.14
- 1. Directive 2009/65/EC relating to undertakings for collective investments in transferable securities.
- 2. HM Treasury, Consultation on Contractual Schemes for Collective Investment, January 2012.
- 3. Paragraph 2.4 of the consultation paper.
- 4. Termed NURS: non-UCITS retail schemes.
- 5. A QIS, or qualified investor scheme. These tend to have lighter-touch regulatory reporting and prudential asset requirements than retail funds.
- 6. ‘The deed must authorise the operator to acquire, manage and dispose of property for the purposes of the scheme… As the participants own the assets, subject to the custodianship of the depositary, they have rights and liabilities under a contract made to acquire an asset or divest them of asset ownership.’ Paragraph 3.19 of the consultation paper.
- 7. See e.g. Benjamin and Yates: The Law of Global Custody (2nd ed, 2002), chapter 5. See also e.g. US Uniform Commercial Code s8-110, Art 8.
- 8. See e.g. Dicey, Morris and Collins on the Conflict of Laws, 2006, 22-044.
- 9. Indeed, even if O and D know that a minimum reporting threshold applies in country Z, or tax is nil on assets below the value of X, that may not dispose of the risk. What if I, separately, has other assets sited in country Z? Local exposure is likely to be on the aggregate of all country Z values.
- 10. Inter-investor equity in collective schemes becomes a nightmare where unclear tax exposures are concerned.
- 11. James v Borland, 1969 (4) SA 29, Re Reed (1970) 17 DLR (3rd) 199 BC CA, Re Lord Cable  1 WLR 7.
- 12. The risk of asset seizure of an affiliate or arrest of visiting executives cannot be discounted.
- 13. Under English law there are various possible time-limitation windows. But in some scenarios, e.g. D continues to hold the investment in the country concerned, there will be no time bar at all.
- 14. To be fair, an earlier model did work. UK pension plans sponsored by the same employer were permitted to centralise their investment management in a common investment fund (CIF). Because UK pension plans were free of domestic tax for most purposes, but collective funds were not, this was useful. Under the prevailing tax theology, to avoid tainting the favourable tax position, it was a condition of tax approval of CIFs that the documentation stipulated that each participant had direct ownership of its proportionate share of the underlying assets.