Fund management services: VAT exemption update or a hidden bear trap

The current consultation purports to aim to clarify and future-proof the current regime for VAT exemption for special investment funds, without significantly changing the current treatment. However, beneath the surface of these proposals lurks a hidden cause for concern which may affect the competitiveness of fund managers with responsibilities for overseas funds, for instance where there is UK-based management of (e.g.) Luxembourg-based SICAVs which have been sold to UK investors.

The issue arises because the current regime generally allows UK-based fund managers to supply their services to overseas funds VAT-free, whilst at the same time recovering VAT on their related costs. It is this ability to recover VAT on costs of managing overseas funds that provides at least a measure of international competitiveness for the UK industry, but which is potentially under threat from the new proposals.

To understand why this should be, it is necessary to explain some key features of the mechanics of the fund management VAT regime, which differ in certain key respects from most other financial services.

The current rules

The current rules provide for differing treatment between UK and overseas funds:

• UK funds: UK fund managers’ services to eligible UK-based funds are (generally) exempt, which means no VAT need to be charged to UK funds, but the fund manager cannot recover VAT on related costs.  A list of UCITs type funds which are eligible for this exempt treatment is set out in the current legislation. The consultation proposes to retain this list, but to extend it with some key principles which are (mostly) derived from EU case law, to identify additional eligible funds.
• Overseas funds: UK fund managers’ services to overseas funds are (generally) excluded from exemption under the current list-based approach. However, counter-intuitively, this taxable treatment is advantageous because the services (when received abroad) are treated as outside the scope of UK VAT with a right to recover VAT on related costs. As such, no VAT need to be charged to most overseas funds, but (unlike services made to the UK-based funds) the fund manager can currently recover VAT on related costs. 

There are some limited exceptions to this beneficial regime for overseas funds. Certain types of overseas funds which are individually recognised in the UK for regulatory purposes also appear in the UK legislation’s current list of funds, the management of which is eligible for VAT exemption. For UK fund managers of these funds, this exemption does not represent good news. Their fund management services will (again) be outside the scope of UK VAT (as the place of supply is outside the UK), but (as with UK funds) any related VAT will be irrecoverable, as the services concerned are exempt. Fortunately, in practice this only bites in a limited number of cases at the moment, as the legislation contains a limited ‘get out of jail free card’, in the form of Note (6A) to Group 5 of Schedule 9 of VATA 1994, which (notwithstanding the UK authorisation status of the overseas fund) excludes from exemption those funds which have never been marketed in the UK or which have less than 5% of its shares or units held by UK investors. However, for funds which are affected, this places a UK-based manager of such funds at a competitive disadvantage, compared to fund managers based overseas.

As such, it is one of the few areas of financial services where such a competitive disadvantage arises, as most other exempt types of financial services fall within the ‘specified supplies’ regime, which allows VAT recovery when those services are supplied to overseas recipients. Fund management services are excluded from this regime, but as most services to overseas funds get full VAT recovery as they do not currently get caught by the exemption, this does not cause much of a problem in practice. However, this position may change under the new proposals, and that is where the bear trap is to be found.

By extending the list of funds eligible for UK VAT exemption with the new principles-based list, the list of funds which will be caught by the UK exemption will become much wider and will potentially extend to include every UCITs (or similar) fund, wherever it is based, as they all share the identical characteristics set out in the new list. The definition of “collective investments” in s.235 of the Financial Services and Markets Act 2000, which HMRC intends to mirror for the purpose of unifying the exemption, does not contain any obvious territorial limitations to prevent this. So, the only limit will be the ‘get out of jail free card’ in Note (6A) (as described above), i.e. that the fund has not been marketed or sold to UK investors.

It seems at first blush that this may not be sufficient to filter out a lot of additional overseas funds (which may often include UK investors) from exempt treatment, or that (at least) a lot of additional thought and analysis will be required to reconfirm the current taxable treatment. It seems highly unlikely this extra burden can have been intended by the new proposals, especially as any additional irrecoverable VAT incurred by UK fund managers in servicing their overseas fund clients will place them at a competitive disadvantage, compared to their rivals in other more beneficial jurisdictions.

A solution?

One solution to this issue might be to add fund management to the list of specified supplies for which VAT recovery is always possible in respect of overseas recipients of relevant supplies.  This would bring fund management into line with other financial services and would dispense with the need to differentiate between overseas exempt and taxable funds. However, it may have the unintended consequence of encouraging managers of UK-based funds (which do not currently benefit from VAT recovery on their costs, due to the exempt nature of their domestic supplies) to move elsewhere, which would not be a good result for UK plc. This leads us back to the option of zero-rating all fund management services, wherever the location of the funds, which does seem to be the best solution for the industry. It is to be hoped that HMRC and the Treasury may change their views on this sooner rather than later, otherwise the complexity in this area of VAT is certainly set to continue.

You may refer to the consultation for further information here.

Get in touch

It will be interesting to see HMRC’s conclusions from the consultation responses. We provide comprehensive support to the financial sector in VAT related matters, feel free to get in touch with our Indirect Tax team.