HM Revenue & Customs has issued partial draft regulations intended to give effect to the policies set out in an HM Treasury consultation document from October 2007 and the responses to that document published in March 2008.

The UK's tax authority has said it welcomes comments on these draft regulations, in particular whether the draft regulations achieve the policy intentions as set out in HMT’s publications. Explanatory commentary is included within the draft regulations to show how they derive from current legislation or from the HMT documents.

One of the government’s main objectives in proposing changes to the offshore funds tax regime is to remove UK tax barriers to multi-tiered fund structures. At the same time it aims to simplify the operation of the offshore funds tax regime and provide more certainty to UK investors and funds.

It also wants to achieve (to the extent possible) economic parity with the position of UK investors in UK authorised funds while recognising that the government has no taxing rights over the non-UK vehicles themselves, and to strengthen existing anti-avoidance rules so that UK investors who choose to invest into offshore funds do so based on commercial decisions and not to obtain unintended tax advantages.

Briefly, the proposals would permit offshore funds to invest an unlimited amount in non-distributing funds and make provision for sub-funds to report information about the separation of income and capital.

Where this is not possible, the underlying fund's value would be treated as income for tax purposes. The proposals will also therefore provide certainty for investors about the tax status of the main offshore fund.

Under the current regime, an offshore fund of funds cannot hold more than 5 per cent of its investment in non-distributing funds, income has to be calculated according to UK standards and distributor status for funds is granted retrospectively, which creates tax uncertainty for investors.

The draft regulations do not change the definition of an offshore fund: the government has said it will continue discussing a new characteristics-based definition with the industry and will introduce this in Finance Bill 2009.

Furthermore, they do not cover the issue of transitional arrangements for funds which currently have distributing status under the existing offshore funds regime, nor arrangements for taking equalisation into account in calculating the reported income which will be based on current rules.

There have been a number of key changes to the proposals resulting from responses to the October discussion paper. First, the government has listened to responses on a proposed 100 per cent reporting requirement and decided to allow for a 10 per cent margin for error with further provisions to cater for funds which only miss this by a small margin. Second, the government will modify the rules for investors in offshore funds which either lose the new “reporting fund” status or become a reporting fund.

The regime will, as far as possible, be built around self-assessment principles. There will be an advance clearance procedure to allow funds to gain access to reporting fund status and, if the fund later ceases to be such, there will not be a retrospective change to the tax status of the fund’s investors unless a deliberately misleading or false application was made.

There will also be provisions dealing with minor and inadvertent breaches of the reporting fund rules and an opportunity for a reporting fund to correct such errors without impacting on its status. If there is a major breach of the rules resulting in a fund being disqualified from reporting fund status, investors will face a revised tax treatment, but only from the date the fund is deemed to leave the regime.

Subject to responses, the government intends to lay the regulations towards the end of the year with a view to the modernised regime coming into effect in spring 2009. Details of the start date and any necessary transitional provisions will be published after the period of consultation on these draft regulations.