A Tax Transparent Fund (TTF) is one in which the income, and generally gains from investments made by the fund, accrue to each investor in proportion to their holdings in the fund, without changing their character, source or timing. The TTF is “looked through,” and investors are treated for tax purposes as if they held their proportionate share of the underlying investments directly. This provides benefits to investors, allowing them to access the treaty benefits of their home jurisdiction, provided that both the jurisdiction of the investor and of the investment regards the fund as tax transparent. For example, if UK Pension Funds were to invest in US equities through an opaque fund, they would typically see their withholding tax at 15% or 30%; that tax would be 0% if investing through a TTF.
International companies initially drove the TTF growth with their interest in streamlining the investment and oversight of their individual pension plans around the world without suffering the tax drag associated with withholding tax (WHT) on equities such as in the US. Asset Managers then saw the benefit they could offer to pension funds with TTFs by improving investment performance with specialist investment strategies, reducing risk with a greater investment diversification, and without suffering the additional tax drag. Recently, similar goals from Local Government Pension Schemes in the UK as well as life insurance companies have prompted a surge in interest in TTFs as well.
To date there are four key TTFs: the Common Contractual Fund (CCF) in Ireland, the Fonds Commun de Placement (FCP) in Luxembourg, the Fonds voor Gemene Rekening (FGR) in the Netherlands and the Authorised Contractual Scheme (ACS) in the UK. Both Ireland and Luxembourg are effective in promoting global use of their jurisdictions and have investors from various jurisdictions investing in their TTFs. In contrast, there has been less focus from international investors in the UK product and Netherlands funds given the scale of their domestic market there. The uncertainty of Brexit has also been a concern for international investors considering investing in the UK ACS, especially with respect to passporting into the EU.
The UK’s ACS was the last TTF product type to be launched (in 2013) and created primarily as a response to the growth of Ireland’s CCFs, as the UK wanted to win an appropriate share of the European pooled funds market. Technically, there are two types of ACS: co-ownership, which is similar to those in other jurisdictions and almost identical to the Irish model, and limited partnership. But to date, only co-ownership ACS schemes have been established.
In December 2017, the UK enacted additional regulations relating to co-ownership ACSs (CoACSs). This and the related HMRC technical note specify reporting requirements on the scheme operator with respect to information provided to investors and the HMRC. This then enables investors to fulfil their tax obligations and for the HMRC to know who the investors are and the relevant amounts allocated to them. The regulations also require the operator of the CoACS to allocate income from holdings in offshore funds to investors in proportion to their investments, clarifies the capital gains rules (for UK investors), and for capital allowances clarifies the elective scheme details for the operator of the CoACS. These announcements were welcomed in substantiating the effects and considerations surrounding these functions.
Tax Transparent Funds started as a tax-focused product with additional oversight control. This beneficial tax treatment remains a key consideration for many users, and it targets investors with low withholding tax rates on dividends or income such as pension funds and sovereign wealth funds. However, tax transparent asset pooling offers numerous additional advantages, including the ability to lower administration costs, generate economies of scale and enhance returns through diversification of assets. Other benefits of TTFs include their ability to facilitate fund consolidation, enable master trust arrangements and governance. Recently, similar goals have prompted a surge in interest from local government pension schemes in the UK.
Insurers are also increasingly using TTFs (mostly for their pension products) to facilitate the rationalisation of funds to generate economies of scale and access beneficial tax treaty rates whilst preserving VAT exempt status. The transfer of assets to an ACS can be done with no UK stamp duty on the transfer of assets or immediate capital gains. One major drivers of insurance company adoption of ACS products has been the increased costs of Solvency II, the regulatory requirement for these entities. In many cases the infrastructure investment required for Solvency II was higher than the cost of moving to ACS.
To ensure accuracy and accountability, the interaction between the transfer agent (who provides the beneficial ownership split), custody and fund accounting services is critical. Investors must be assigned the right share class for their tax profile. All relevant documentation must be present to ensure tax treatment is correct income and must be allocated in line with the custody report, for example. Clearly, manual processes become impossible given such complexity and the need to report income and capital on a daily basis. Any solution must be therefore automated and have robust controls.
Strategic solutions need to be able to cope with the complexity of a TTF and require the ability to accurately trace income from source to investor which means:
BNY Mellon is enhancing solutions that provide transparency across all major TTFs types investors, as well as jurisdictions of investor and of investment. BNY Mellon recognises the importance of connecting different systems and functions, and especially a fully joined up operating model which incorporates transfer agency, custody and fund accounting responsibilities in a seamless way to ensure clients gain the visibility, control and efficiency they require.
Greater adoption of technology will become even more important as TTFs grow in scale and become more complicated in terms of investment type and jurisdiction. And as the number of jurisdictions and TTF types increase, administration and reporting will become even more complex. These challenges are only likely to become greater, but we strongly believe that we have the solutions and expertise to continually address them.