Investment funds in the UK (Scotland): overview

A Q&A guide to investment funds law in the UK (Scotland).

This Q&A is part of the global guide to investment funds. It provides a high level overview of investment funds in Scotland, looking at both retail funds and hedge funds. Areas covered include a market overview, legislation and regulation, marketing, managers and operators, restrictions and requirements, tax and upcoming reform.

To compare answers across multiple jurisdictions, visit the Investment Funds Country Q&A tool. For a full list of jurisdictional Q&As visit www.practicallaw.com/investmentfunds-guide.

Contents

Retail funds

1. What is the structure of the retail funds market? What have been the main trends over the last year?

Open-ended retail funds

Scotland is recognised internationally as the most important UK financial centre outside London, with a cluster of retail fund services including investment management, global custody and fund administration. Approximately 11% (GB£560 billion) of the total fund assets under management in the UK are managed in Scotland, according to the Investment Management Association.

Scotland shares a common financial services regulatory framework with the rest of the UK. The market for open-ended retail funds is well developed. Open-ended retail funds in Scotland are normally structured as either:

  • Undertakings for collective investment in transferable securities (UCITS) funds.

  • Non-UCITS retail funds (NURS).

The underlying legal structures used include open-ended investment companies (OEICs), authorised unit trusts (AUTs) and authorised contractual schemes (ACS).

In addition, fund-of-funds structures facilitating indirect investment exposure to private equity, hedge funds, and real estate funds are used. These are referred to as "funds of alternative investment funds" (FAIFs) and are subject to specific rules in relation to matters such as concentration, liquidity and due diligence, valuation and audit of the underlying funds. FAIFs can be structured as NURS to facilitate marketing to retail investors.

As in the rest of the UK, the UCITS market is preparing for implementation of the UCITS V directive, which came into force on 17 September 2014 and must be transposed into law in the UK by 18 March 2016.

Closed-ended retail funds

The market for closed-ended retail funds in Scotland is well developed. Many of the early investment trusts were launched in Scotland, for example the Scottish Mortgage Investment Trust was formed in Edinburgh in 1909.

Most closed-ended retail funds use a public limited company (PLC) structure, the securities of which will be admitted to the official list of the UK Listing Authority and to trading on the London Stock Exchange. There are specialist regimes for real estate investment trusts (REITS) and venture capital trusts (VCTs), which apply throughout the UK.

In addition, a number of closed-ended retail funds have been admitted to trading on the alternative investment market (AIM) of the London Stock Exchange.

 

Regulatory framework and bodies

2. What are the key statutes, regulations and rules that govern retail funds? Which regulatory bodies regulate retail funds?

Open-ended retail funds

Regulatory framework. The key legislation governing open-ended retail funds includes:

  • The Financial Services and Markets Act 2000 (FSMA).

  • The Open-ended Investment Companies Regulations 2001 (OEIC Regulations).

  • Several statutory instruments made under FSMA, including:

    • Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO); and

    • Financial Services and Markets Act 2000 (Regulated Activities) Order (RAO).

Retail funds must also comply with applicable regulations made by the Financial Conduct Authority (FCA) in the Handbook of Rules and Guidance (FCA Rules), including the Collective Investment Schemes Sourcebook (COLL).

Regulatory bodies. The regulator for open-ended retail funds is the FCA.

Closed-ended retail funds

Regulatory framework. The key legislation governing closed-ended retail funds includes:

  • Companies Act 2006 (CA 2006).

  • Corporation Tax Act 2010 (CTA).

  • Investment Trust (Approved Company) (Tax) Regulations 2011 (ITR).

  • Applicable FCA Rules including:

    • Listing Rules (LR);

    • Prospectus Rules (PR);

    • Disclosure and Transparency Rules (DTR).

  • Conduct of Business Sourcebook Chapter 4 (COBS 4).

  • FSMA.

  • RAO.

Regulatory bodies. The key regulators are:

  • The FCA in relation to listing, prospectus and continuing obligations.

  • HM Revenue and Customs (HMRC) in relation to taxation requirements.

 
3. Do retail funds themselves have to be authorised or licensed?

Open-ended retail funds

Open-ended retail funds such as authorised unit trusts (AUTs), open-ended investment companies (OEICs) and similar collective investment schemes must either be:

  • Authorised by the Financial Conduct Authority (FCA), if domiciled in the UK.

  • Recognised by the FCA using the "recognised schemes" provisions in the Financial Services and Markets Act 2000 (FSMA), if domiciled in another jurisdiction.

Applications to the FCA must include the following:

  • A draft prospectus.

  • A draft instrument of incorporation (for OEICs) or trust deed (for AUTs).

  • An application form.

  • The application fee.

  • A key investor information document (KIID) for undertakings for collective investment in transferable securities funds (UCITS funds).

  • Solicitors' certificate confirming that the documents constituting the fund comply with FSMA and OEIC Regulations, as applicable.

The FCA will generally process a UCITS application or a NURS application within two months.

Closed-ended retail funds

Investment trusts structured as Scottish PLCs are not required to be authorised by the FCA.

Investment trusts are required to be approved by HMRC, to be classified as investment trusts for tax purposes, in order to be exempt from UK tax on any chargeable gains realised from its portfolio of investments (see Question 13). There are various conditions for approval, including that:

  • The business of the company consists of investing its funds in shares, land or other assets with the aim of spreading investment risk and giving members of the company the benefit of the results of the management of its funds.

  • The shares making up the company's ordinary share capital (or, if there are such shares of more than one class, those of each class) are admitted to trading on a regulated market (such as the main market of the London Stock Exchange).

There are specialist regimes for real estate investment trusts (REITS) and venture capital trusts (VCTs) (see Question 1).

 

Marketing

4. Who can market retail funds?

Open-ended retail funds

Once a fund is authorised or recognised (see Question 3), it can be marketed to the public in the UK by authorised persons including the fund operator and other distributors. In addition, open-ended retail funds can also be marketed by persons who are not themselves authorised, using various exemptions in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO).

Closed-ended retail funds

The marketing rules that apply to closed-ended retail funds are similar to those applying to open-ended retail funds.

 
5. To whom can retail funds be marketed?

Open-ended retail funds

Once authorised or recognised (see Question 3), retail funds can be marketed to the public in the UK.

Closed-ended retail funds

Once admitted to trading on a regulated market (see Question 3), investment trusts can be marketed to the public in the UK.

 

Managers and operators

6. What are the key requirements that apply to managers or operators of retail funds?

Open-ended retail funds

Managers of open-ended retail funds operated in Scotland must be authorised by the Financial Conduct Authority (FCA).

In relation to authorised unit trusts (AUTs) and open-ended investment companies (OEICs), the Handbook of Rules and Guidance (FCA Rules) require that:

  • An AUT manager must:

    • be independent from the trustee;

    • be a body corporate incorporated in the UK or another European Economic Area (EEA) state, and its affairs must be managed in the country in which it is incorporated;

    • have a place of business in the UK or another EEA state; and

    • have the relevant FCA permissions to act as a manager.

  • An OEIC authorised corporate director (ACD) that is the sole director of an OEIC must:

    • be a body corporate that is an authorised person;

    • have permission under the Financial Services and Markets Act 2000 (FSMA) to act as director of an OEIC.

Closed-ended retail funds

Managers of investment trusts must be authorised by the FCA if carrying on business in the UK.

A number of FCA Rules will apply, including the Sourcebook on Senior Management Arrangements, Systems and Controls (SYSC) and Conduct of Business Sourcebook (COBS).

Investment trust directors must report on an annual basis whether the continued appointment of the manager is in the shareholders' interests as a whole (Listing Rules, 15.6.2(2)).

 

Assets portfolio

7. Who holds the portfolio of assets? What regulations are in place for its protection?

Open-ended retail funds

An authorised unit trust (AUT) must appoint a trustee to hold the fund's assets.

An open-ended investment company (OEIC) must appoint a depository to hold the fund's assets.

Formal requirements for trustees and depositories are contained in the Financial Services and Markets Act 2000 (FSMA) and the Open-ended Investment Companies Regulations 2001 (OEIC Regulations).

Legal duties of trustees and depositories are detailed in the Collective Investment Schemes Sourcebook (COLL).

Specific rules in relation to the custody of assets are detailed in the Client Assets Sourcebook (CASS).

AUTs. Trustees must be:

  • Authorised as a trustee.

  • Independent from the manager.

  • Established in the UK or another EEA state and have a place of business in the UK.

OEICs. Depositories must:

  • Be a body corporate established in the UK or another EEA state.

  • Have a place of business in the UK.

  • Have their affairs administered in the country in which they are incorporated.

  • Be authorised persons.

  • Have permission to act as a depository.

  • Be independent of the company and of the persons appointed as directors of the company.

Closed-ended retail funds

Investment trust assets are generally held by either custodians or their nominees. Investment trust custodians are not required to be independent from the manager, but must be authorised by the Financial Conduct Authority (FCA) and are subject to the Handbook of Rules and Guidance (FCA Rules), with the CASS rules being particularly relevant.

 

Legal fund vehicles

8. What are the main legal vehicles used to set up a retail fund and what are the key advantages and disadvantages of using these structures?

Open-ended retail funds

Open-ended retail funds in Scotland can be set up with a company structure (an open-ended investment company (OEIC)) or as a trust structure (an authorised unit trust (AUT)).

An OEIC is established using an instrument of incorporation, the content of which is prescribed by the Open-ended Investment Companies Regulations 2001 (OEIC Regulations). As with other types of company incorporated in Scotland or elsewhere in the UK, OEICs have:

  • A separate corporate identity.

  • A single director or directors.

  • Shareholders.

OEICs can be structured as single funds or as "umbrella funds", divided into a number of separate sub-funds, each functioning as a separate OEIC for most purposes.

An AUT is established by a trust deed between the manager and a corporate trustee, the content of which is prescribed by the Collective Investment Schemes Sourcebook (COLL) rules. As a trust structure:

  • Unit holders have beneficial ownership of the fund's assets.

  • The fund's assets are held on trust by the trustee.

AUTs can be structured as single funds or umbrella funds, divided into a number of separate sub-funds, each functioning as a separate AUT for most purposes.

In general, for operational purposes OEICs and AUTs are very similar. In each case, the share or unit price is based on the net asset value of the fund's investments.

Advantages. The main advantage of an OEIC is its marketability in non-UK jurisdictions that are more familiar with the company structure.

The trust structure of an AUT is generally less marketable in non-UK jurisdictions.

Closed-ended retail funds

Legal vehicles. Many closed-ended retail funds are structured as Scottish PLCs, with shares admitted to the official list of the UK Listing Authority and to trading on the London Stock Exchange.

Investment companies quoted on AIM or other markets do not qualify for investment trust tax status. There are specialist regimes for real estate investment trusts (REITS) and venture capital trusts (VCTs), which apply throughout the UK (see Question 1, Closed-ended retail funds).

Advantages. Some particular advantages of investment trusts are:

  • As a closed-ended vehicle, the fund is not required to provide redemption rights to investors. This creates a more stable pool of capital in the fund.

  • Investment trusts benefit from more flexible investment and borrowing powers relative to open-ended retail funds (see Question 9).

Disadvantages. The price at which investment trust shares are traded is determined by the market, and it is common for shares to trade at a discount to net asset value.

 

Investment and borrowing restrictions

9. What are the investment and borrowing restrictions on retail funds?

Open-ended retail funds

The main investment and borrowing powers for undertakings for collective investment in transferable securities (UCITS) funds and non-UCITS retail (NURS) funds are summarised below.

Limits for UCITS schemes. For the following scheme investments and investment techniques:

  • Securities admitted to official listing in an European Economic Area (EEA) state or traded on an eligible securities market (approved securities) are permitted investments, with no maximum limit.

  • Transferable securities that are not approved securities are permitted investments, but with a 10% maximum limit.

  • Government and public securities are permitted investments, with no maximum limit.

  • Regulated funds other than qualified investor schemes (see Question 14) are permitted investments, with no maximum limit.

  • Unregulated schemes and qualified investor schemes are not permitted investments.

  • Warrants are permitted investments, with no maximum limit.

  • Investment trusts are permitted investments, with no maximum limit.

  • Deposits are permitted investments, with no maximum limit.

  • Derivatives are permitted investments, with no maximum limit. Global exposure relating to derivatives and forward transactions may not exceed the net value of the scheme property.

  • Immovables (that is, real estate) are not permitted investments.

  • Gold is not a permitted investment.

  • Hedging is permitted, with no maximum limit.

  • Stock lending is permitted, with no maximum limit.

  • Underwriting is permitted, with no maximum limit.

  • Borrowing is permitted, with a 10% maximum limit (on a temporary basis).

  • Cash and near cash is a permitted investment, with no maximum limit.

Limits for non-UCITS retail schemes. For the following scheme investments and investment techniques:

  • Securities admitted to official listing in an EEA state or traded on an eligible securities market (approved securities) are permitted investments, with no maximum limit.

  • Transferable securities that are not approved securities are permitted investments, but with a 20% maximum limit.

  • Government and public securities are permitted investments, with no maximum limit.

  • Regulated funds other than qualified investor schemes (see Question 14) are permitted investments, with no maximum limit.

  • Unregulated schemes and qualified investor schemes are permitted investments, with a 20% limit (there is no maximum limit for funds of alternative investment funds (FAIFs) (see Question 1).

  • Warrants are permitted investments, with no maximum limit.

  • Investment trusts are permitted investments, with no maximum limit.

  • Deposits are permitted investments, with no maximum limit.

  • Derivatives are permitted investments, with no maximum limit. Global exposure relating to derivatives and forward transactions may not exceed the net value of the scheme property.

  • Immovables (that is, real estate) is a permitted investment.

  • Gold is a permitted investment, with a limit of 10%.

  • Hedging is permitted, with no maximum limit.

  • Stock lending is permitted, with no maximum limit.

  • Underwriting is permitted, with no maximum limit.

  • Borrowing is permitted, with a 10% maximum limit.

  • Cash and near cash is a permitted investment, with no maximum limit.

UCITS funds are subject to specific limits on spread and concentration, including the following (which exclude government and public securities):

  • Not more than 20% in value of the scheme property is to consist of deposits with a single body.

  • Not more than 5% in value of the scheme property is to consist of transferable securities or approved money-market instruments issued by any single body. This 5% limit can be increased as follows:

    • to 10% in respect of up to 40% in value of the scheme property. Covered bonds need not be taken into account for the purpose of applying the limit of 40%;

    • to 25% in respect of covered bonds, provided that when a UCITS scheme invests more than 5% in covered bonds issued by a single body, the total value of covered bonds held must not exceed 80% in value of the scheme property.

  • The exposure to any one counterparty in an over-the-counter (OTC) derivative transaction must not exceed 5% in value of the scheme property, this limit being raised to 10% where the counterparty is an approved bank.

  • In applying the limits detailed above, not more than 20% in value of the scheme property is to consist of any combination of two or more of the following:

    • transferable securities (including covered bonds) or approved money-market instruments issued by; or

    • deposits made with; or

    • exposures from OTC derivatives transactions made with a single body.

  • Not more than 20% in value of the scheme property is to consist of transferable securities and approved money-market instruments issued by the same group.

  • Not more than 20% in value of the scheme property is to consist of the units of any one collective investment scheme.

There are specific rules for investments by UCITS funds in government and public securities.

The FCA Rules also contain spread and concentration rules for NURS funds.

Closed-ended retail funds

Investment trusts benefit from more flexible investment and borrowing powers, which are not subject to any Financial Conduct Authority (FCA) limitations. However, to maintain its London Stock Exchange listing, an investment trust must:

  • Have a published investment policy relating to asset allocation, risk diversification and gearing.

  • Obtain the prior approval of its shareholders for any material change to that policy.

An investment trust must also comply with requirements of the Corporation Tax Act 2010 (CTA), the Investment Trust (Approved Company) (Tax) Regulations 2011 (ITR) and sections 833 and 834 of the Companies Act 2006 (CA).

 
10. Can the manager or operator place any restrictions on the issue and redemption of interests in retail funds?

Open-ended retail funds

The manager must, at all times during dealing days, be willing to effect the sale and redemption of interests in open-ended retail funds.

Open-ended retail funds can offer "limited issue units" (only a limited number of units are issued and/or units are only issued for a limited time).

Limited redemption can be imposed in non-UCITS retail (NURS) funds only where the NURS:

  • Is a property fund.

  • Is a fund of alternative investment fund (FAIF).

  • Has an investment objective that is to provide a specified level of return.

Redemptions can be limited for up to six months.

It is also possible for retail funds that have a dealing point on each business day to defer redemptions to the next valuation point (that is, the time each day that an investment fund is valued) if redemption requests in relation to a particular valuation point exceed 10%, subject to specific requirements.

Dealing in retail funds can also be suspended. In general, this is only permitted in exceptional circumstances and when it is in the interests of the fund's unitholders. The Financial Conduct Authority (FCA) and unitholders must be notified of the suspension and unitholders must be kept up-to-date about the suspension and its duration.

The suspension must be formally reviewed every 28 days and the FCA notified of the results.

Closed-ended retail funds

Investment trust shares are traded on the London Stock Exchange and, once the shares are in issue, they are freely traded between buyers and sellers in the market. The investment manager controls issues of new shares and share buybacks under the supervision of the investment trust board.

 
11. Are there any restrictions on the rights of participants in retail funds to transfer or assign their interests to third parties?

Open-ended retail funds

Open-ended investment company (OEIC) shares can, in general, be freely transferred, however managers can restrict transfers to ensure shares or units are not transferred to ineligible investors.

Authorised Unit Trust (AUT) units can be transferred if:

  • The registrar of the AUT approves the transfer.

  • The trust deed permits the transfer.

  • There is no stamp duty reserve tax (SDRT) payable or the trustee has been paid the amount of SDRT payable.

Closed-ended retail funds

Investment trust shares are traded on the London Stock Exchange and, once the shares are in issue, they are freely traded between buyers and sellers in the market (see Question 10). The investment manager controls issues of new shares and share buybacks under the supervision of the investment trust board.

 

Reporting requirements

12. What are the general periodic reporting requirements for retail funds?

Open-ended retail funds

Investors. Half year and annual reports and accounts must be provided to investors. The following must be prepared:

  • Short reports that are sent to all holders and include information on the fund's investment activity and performance, together with other required information.

  • Long reports that are available to investors on request. Long reports must include the accounts and a report from the auditor, the manager and trustee or depository, together with other required information.

Regulators. Depositories and trustees must provide periodic reports to the Financial Conduct Authority (FCA).

Closed-ended retail funds

Investors. Investment trusts must provide half-yearly and annual reports and accounts to investors, including a long form report on an annual basis. The reports must meet the requirements of:

  • Chapters 9 and 15 of the Listing Rules (LR).

  • Chapter 4 of the Disclosure and Transparency Rules (DTR).

Regulators. Investment trusts must file an annual report and accounts with the Registrar of Companies. The annual report must satisfy the FCA's listing rules.

 

Tax treatment

13. What is the tax treatment for retail funds?

Open-ended retail funds

The principal tax features of Authorised Unit Trusts (AUTs) and open-ended investment companies (OEICs) are as follows:

  • The fund's chargeable gains on the disposal of investments are generally exempt from UK tax.

  • The fund's income is subject to UK corporation tax at 20%. Income includes offshore income gains realised on a disposal of interests in certain non-reporting offshore funds (NROFs) and proceeds of disposal of assets bought and sold as trading transactions.

  • Certain categories of income are exempt from tax, such as income from most dividends and income from derivative contracts, options and creditor loan relationships, provided that the authorised investment fund accounts for such income using the appropriate method.

  • Funds are entitled to deduct management fees when calculating their taxable profits.

  • If 60% or more (by market value) of the fund's investments are "qualifying investments" (money placed at interest, securities, shares in a building society, qualifying units in another investment fund, certain derivative contracts and CFDs, and alternative finance arrangements) throughout the distribution period then distributions to investors are treated as payments of annual interest rather than dividends. To the extent that the distributions were derived from income taxable in the hands of the fund, the fund is entitled to deduct its interest distributions and deemed interest distributions when calculating its pre-tax profits. The fund will have to deduct basic rate income tax from distributions made to investors who do not qualify for gross payment of annual interest.

  • There are special tax regimes for certain types of open-ended retail fund, for example property authorised investment funds (PAIFs), tax electing funds (TEFs), funds investing in non-reporting offshore funds regime (FINROF), and authorised contractual schemes (ACS) which can apply when the relevant conditions are met.

  • In particular, an ACS is not a taxable entity for UK purposes and suffers no UK tax directly. An ACS is not subject to UK corporation tax, income tax or capital gains tax.

  • Funds are not required to pay value added tax (VAT) on the fees which they pay for management services.

Resident individual investors

  • Distributions treated as annual interest are subject to income tax at the savings rates (top rate currently 45%). 20% tax is deducted at source by the fund and additional tax (up to 25%) is payable by the investor. Investors not liable to income tax at the basic rate can recover the tax deducted at source.

  • Dividends received or deemed to be received are subject to income tax at the dividend rate (the effective top rate is currently 30.56%). Investors who are not liable to income tax at the basic rate cannot claim dividend tax credits.

  • A gain realised on a disposal of an interest in an authorised investment fund that is not a FINROF is subject to capital gains tax at 28% in the hands of the investor.

  • Stamp duty reserve tax (SDRT) is payable on the acquisition of units in a fund at 0.5% of the price. SDRT is no longer payable on the redemption of units by a fund except in very limited circumstances.

Non-resident individual investors.

  • Non-residents are generally exempt from UK tax on income from open-ended retail funds and from UK capital gains tax (CGT) on gains realised.

  • In relation to ACS, for direct tax purposes, investors will generally be treated as if they had invested directly in the underlying assets (apart from gains arising on the disposal of assets of a co-ownership scheme). However, foreign law advice should be taken in relation to the treatment of an ACS for non-UK tax purposes, and in particular whether it is regarded as tax transparent.

Closed-ended retail funds

Funds. The tax regime that applies to investment trusts is similar to that which applies to open-ended retail funds. In particular, investment trusts are exempt from tax on chargeable gains.

Resident investors. Investors that are resident in the UK for tax purposes are also generally in the same position as investors in open-ended retail funds.

Non-resident investors. Non-residents are generally exempt from UK tax on income from closed-ended retail funds and from UK capital gains tax (CGT) on gains realised.

 

Quasi-retail funds

14. Is there a market for quasi-retail funds in your jurisdiction?

Fund-of-funds structures facilitating indirect investment exposure to private equity, hedge funds, and real estate funds are also used (see Question 1). These are referred to as "funds of alternative investment funds" (FAIFs) and are subject to specific rules in relation to matters such as concentration, liquidity and due diligence, valuation and audit of the underlying funds. FAIFs can be structured as non-UCITS retail schemes (NURS) to facilitate marketing to retail investors.

Qualified investor schemes (QISs) that take the form of an open-ended authorised unit trust (AUTs) or open-ended investment companies (OEICs) must be authorised by the FCA in the same way as retail AUTs or OEICs, but can only be marketed to certain categories of qualified investor.

QISs benefit from investment and borrowing powers that are very flexible, for example, compared with undertakings for collective investment in transferable securities (UCITS) and other authorised funds designed for retail investors. QISs must achieve a basic spread of risk consistent with the investment objective and policy.

Reform

 
15. What proposals (if any) are there for the reform of retail fund regulation?

Directive 2014/91/EU (UCITS V Directive) came into force on 17 September 2014 and EU member states have until 18 March 2016 to transpose it into national law. This will apply throughout the UK, including Scotland.

 

Hedge funds

16. What is the structure of the hedge funds market? What have been the main trends over the last year?

Hedge funds are typically domiciled in tax efficient jurisdictions such as the Cayman Islands and Luxembourg. However, a number of Scotland-based investment managers operate hedge funds and other comparable products, including absolute return funds.

Other than traditional hedge funds, which generally use offshore fund structures, a large number of UK alternative investment funds (AIFs), including private equity and real estate funds (and their feeder funds and carried interest vehicles), fund-of-funds structures and other alternative funds, are structured using Scottish limited partnerships (SLPs). For key features of SLPs, see Question 25.

 

Regulatory framework and bodies

17. What are the key statutes and regulations that govern hedge funds in your jurisdiction? Which regulatory bodies regulate hedge funds?

Regulatory framework

The key legislation governing alternative investment funds (AIFs) includes:

  • The Financial Services and Markets Act 2000 (FSMA) and related orders.

  • The Limited Partnerships Act 1907 (LPA 1907).

  • Applicable sections of the Financial Conduct Authority Rules (FCA Rules), in particular the FUND Sourcebook.

  • Rules implementing the EU Alternative Investment Fund Managers Directive (AIFM Directive) in the UK (AIFMD Rules).

Regulatory bodies

The authorities that regulate hedge funds are:

  • The Financial Conduct Authority (FCA) in relation to marketing and operation of AIFs.

  • HM Revenue and Customs (HMRC) in relation to taxation requirements.

 
18. How are hedge funds regulated (if at all) to ensure compliance with general international standards of good practice?

Risk

The Alternative Investment Fund Managers Directive Rules (AIFMD Rules) will apply to managers within the scope of the Directive. These rules contain specific requirements in relation to matters such as:

  • Functional and hierarchical separation of risk management from portfolio management functions.

  • Implementing adequate risk management systems to identify, measure, manage and monitor all risks associated with each alternative investment fund's (AIF's) investment strategy.

  • Setting maximum leverage levels that take account of various factors including the fund's investment strategy.

  • Following a documented and regularly updated due diligence process for investments.

  • Ensuring that each AIF's risk profile corresponds to its size, assets, strategy and investment objectives.

  • Reviewing each AIF's risk management systems at least once a year and adapting them whenever necessary.

Generally, the AIFMD Rules apply to an Alternative Investment Fund Manager (AIFM) based in the UK, or managing a UK fund, or managing an offshore fund that is marketed to UK-based investors.

Valuation and pricing

The AIFMD Rules in relation to valuations apply to managers within the scope of the Directive.

Systems and controls

The Financial Conduct Authority Rules (FCA Rules) on senior management arrangements, systems and controls and the AIFMD Rules contain detailed rules on matters such as:

  • General organisational requirements.

  • Employees and agents.

  • Compliance, internal audit and financial crime.

  • Risk control.

  • Outsourcing.

  • Record keeping.

  • Conflicts of interest.

These rules generally apply to managers of hedge funds and other AIFs conducting business in the UK.

Insider dealing and market abuse

The market abuse and insider dealing rules in the Financial Services and Markets Act 2000 (FSMA) apply on a UK-wide basis (including Scotland) in relation to:

  • Activities conducted in the UK.

  • Qualifying investments that are admitted to trading (or for which a request has been made for admission to trading) on a prescribed market situated or operating in the UK.

In addition, the insider dealing rules in Part V of the Criminal Justice Act 1993 (CJA) apply in Scotland.

Transparency

The applicability of various transparency rules will depend on factors such as:

  • Whether the manager is within the scope of the AIFMD Rules.

  • Whether the fund is subject to specific transparency rules such as the Disclosure and Transparency Rules (DTR) (which generally apply to closed-ended funds traded on a UK regulated market).

The AIFMD Rules contain specific rules on matters such as:

  • Preparation of annual reports and accounts for an AIF.

  • The manager's notification and reporting obligations to the FCA.

  • Standards of disclosure in relation to information memorandums or other private placement documents.

Money laundering

The Money Laundering Regulations 2007 (MLR) generally apply to financial services business undertaken in the UK, including Scotland.

Short selling

Regulation (EU) 236/2012 on short selling and certain aspects of credit default swaps (Short Selling Regulation), related delegated regulations and the Financial Services and Markets Act 2000 (Short Selling) Regulations 2012, apply throughout the UK, including Scotland.

 

Marketing

19. Who can market hedge funds?

Authorised persons can market alternative funds of this type, in accordance with the Conduct of Business Sourcebook (COBS) 4.12, which provides exemptions to the restrictions on marketing collective investment schemes in section 238 of the Financial Services and Markets Act 2000 (FSMA).

An unauthorised person can market alternative funds of this type, provided that the recipient falls within one or more of the exemptions contained in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO).

 
20. To whom can hedge funds be marketed?

Hedge funds and most other types of alternative investment funds (AIFs) cannot be freely marketed to the public in the UK, including Scotland, but can typically be marketed to certain categories of qualified investor, for example:

  • Certified high net worth investors.

  • Certified sophisticated investors.

  • Investment professionals.

  • High net worth companies and unincorporated associations.

These investor categories have specific definitions and, in some cases, a certification process must be complied with.

 

Investment restrictions

21. Are there any restrictions on local investors investing in a hedge fund?

The restrictions on marketing (see Question 20) apply to the marketing of hedge funds and other alternative funds in the UK, including Scotland. These marketing regulations must be complied with prior to any investment being made into the fund.

 

Assets portfolio

22. Who holds the portfolio of assets? What regulations are in place for its protection?

Managers within the scope of the Alternative Investment Fund Managers Directive Rules (AIFMD Rules) are required to appoint a depositary for each alternative investment fund (AIF) it manages.

Depositary functions include:

  • Cash monitoring, ensuring that the AIF's cash flows, including subscription funds, are properly monitored and monitoring AIF banking arrangements.

  • Safekeeping of financial instruments, including holding all "AIF custodial assets" in custody.

  • Safekeeping of other assets, verifying ownership of AIF assets that are not AIF custodial assets (for example, directly held real estate assets) and maintaining a record of those assets.

  • Oversight, involving monitoring the issue of AIF units to investors, checking the valuation of AIF units is carried out in accordance with applicable law and fund documentation, and monitoring the application of AIF income.

In a hedge fund context, it is possible for an AIFMD depositary to delegate the custody function to a prime broker, being the service provider that traditionally provides custody (and other) services to the fund.

 

Requirements

23. What are the key disclosure or filing requirements (if any) that must be completed by the hedge fund?

A number of disclosure and filing obligations are required by the Alternative Investment Fund Managers Directive Rules (AIFMD Rules), if the manager is within the scope of the Directive. These include the following:

  • Minimum content requirements for investor information, for example private placement memorandums.

  • Periodic disclosure obligations, for example in relation to the risk profile of alternative investment funds (AIFs) and risk management systems.

  • Minimum disclosure requirements for AIF annual reports.

  • Periodic regulatory reporting obligations by the AIFM to the Financial Conduct Authority (FCA).

Additionally, an AIFM operating in Scotland and proposing to market an AIF in the UK must apply to the FCA for permission to market the fund.

 
24. What are the key requirements that apply to managers or operators of hedge funds?

Managers conducting regulated activities in the UK will be subject to various Financial Conduct Authority (FCA) Rules, including the Conduct of Business Sourcebook (COBS) and the Sourcebook on Senior Management Arrangements, Systems and Controls (SYSC) and the Alternative Investment Fund Managers Directive Rules (AIFMD Rules), if they are within the scope of the Directive.

Generally, the AIFMD Rules apply to an AIFM based in the UK, or managing a UK fund, or managing an offshore fund that is marketed to UK-based investors.

 
25. What are the main legal vehicles used to set up a hedge fund and what are the key advantages and disadvantages of using these structures?

Traditional hedge funds are typically domiciled outside in tax efficient jurisdictions such as the Cayman Islands and Luxembourg (see Question 16). Some undertakings for collective investment in transferable securities funds (UCITS funds) (including qualified investor scheme funds (QIS funds)) operate similar investment strategies to those used by hedge funds (see Question 16). For the key features of these types of funds, see Question 8.

Other than traditional hedge funds, which generally use offshore fund structures, a large number of UK alternative investment funds (AIFs), including private equity, real estate and other alternative funds, are structured using Scottish limited partnerships (SLPs).

Scottish Limited Partnership (SLP)

Advantages. SLPs are a useful vehicle for alternative investment fund structures that require the following features:

  • Onshore fund vehicle.

  • Separate legal personality (meaning that they can directly own assets, enter into contracts and so on, a feature not offered by limited partnerships established elsewhere in the UK).

  • Tax transparent (the UK tax authorities look through the partnership structure. Partners are taxed on their share of partnership income in accordance with their profit-sharing ratios. For capital gains tax purposes, partners are treated as owning fractional shares in the underlying assets).

  • Flexible terms of management and operation.

  • Limited liability for investors.

  • The possibility of multiple passive investors (limited partners), who do not participate in the management of the SLP.

  • Formation procedures can be relatively straightforward.

Disadvantages. SLPs are not appropriate where an offshore fund vehicle is required.

 

Tax treatment

26. What is the tax treatment for hedge funds?

Funds

Most traditional hedge funds are domiciled in offshore jurisdictions (see Question 25). These funds are generally structured to avoid any liability to UK tax. However, other than traditional hedge funds, a large number of other alternative investment funds are structured using Scottish Limited Partnerships (SLPs).

Although SLPs have separate legal personality (which is why they are often used in fund of funds structures, feeder funds, and similar vehicles) they are tax transparent for most UK taxes. This means that no income, corporation or capital gains tax is payable by the SLP itself. Instead, the UK tax authorities look through the partnership structure and partners are taxed on their share of partnership income arrived at in accordance with their profit-sharing ratios (which can be different from the ratios in which capital has been contributed). For capital gains tax purposes, partners are treated as owning fractional shares in the underlying assets.

Resident investors

As indicated above, although SLPs have separate legal personality, they are generally tax transparent and the UK tax authorities look through the partnership structure. Partners are taxed on their share of partnership income in accordance with their profit-sharing ratios (which can be different from the ratios in which capital has been contributed). For capital gains tax purposes, partners are treated as owning fractional shares in the underlying assets. The tax profile of individual investors determines their tax liability.

Non-resident investors

Alternative investment fund SLPs (AIF SLPs) are generally operated so that they are not treated for UK tax purposes as carrying on a trade, the result of which is that non-resident investors should not be subject to UK tax on gains from the SLP. Non-resident investors may, however, be subject to UK tax on investment income, although this is likely to be restricted to UK tax that is withheld at source (for example, by a portfolio company in a private equity fund). Withholding tax on UK investment income would be subject to the relevant double taxation treaty between the UK and the investor's jurisdiction of residence.

Non-resident investors who hold their interest in the AIF SLP as part of their trade (for example financial traders such as banks) are likely to be treated as carrying on part of that trade in the UK through a permanent establishment, branch or agency which is a UK representative (for example the general partner or manager of the fund). The UK resident general partner would then be treated as the investor's UK tax representative and would share responsibility with the investor for submitting UK tax returns and paying any UK tax due on the investor's partnership income. In these circumstances, the manager will often be authorised to retain an amount equal to such investor's liability to UK corporation or income tax and pay such amounts to the UK tax authorities. These tax liabilities can usually be mitigated by the use of special purpose vehicles established for the purpose of participating in the AIF SLP.

In addition, non-UK jurisdictions may apply or withhold tax on income or gains receivable by the AIF SLP from investments in those jurisdictions. In these circumstances, investors will normally seek relief under applicable double tax treaties, and the availability of relief may depend on whether the SLP is treated as fiscally transparent in the overseas jurisdiction.

 

Restrictions

27. Can participants redeem their interest? Are there any restrictions on the right of participants to transfer their interests to third parties?

Redemption of interest

Where a Scottish Limited Partnership (SLP) is used in an alternative investment fund (AIF) structure, it is generally possible to structure the vehicle so as to facilitate redemption rights, where this is required.

Transfer to third parties

Where an SLP is used in an AIF structure, it is generally possible to structure the vehicle so as to facilitate transfers to third parties, where this is required.

 

Reform

28. What (if any) proposals are there for the reform of hedge fund regulation?

There are currently no reform proposals relating to hedge funds in Scotland.

 

Online resources

Financial Conduct Authority (FCA)

W http://fshandbook.info/FS/html/FCA ( www.practicallaw.com/8-551-3232)

Description. Financial Conduct Authority Handbook of Rules and Guidance.

London Stock Exchange

W www.londonstockexchange.com/home/homepage.htm

Description. Official website of the London Stock Exchange.



Contributor profile

Andrew Akintewe, Partner

Brodies LLP

T +44 (0) 131 656 0210
E andrew.akintewe@brodies.com
W www.brodies.com

Professional qualifications. Diploma in Legal Practice, University of Edinburgh, 2001; Solicitor, Scotland, 2003; Associate Member, Chartered Institute for Securities & Investment (Corporate Finance), 2004

Areas of practice. Investment funds; financial regulation; corporate finance.

Non-professional qualifications. LLB, University of Edinburgh, 2000

Recent transactions

  • Advising a financial institution on the formation of 3 UCITS funds and 3 non-UCITS retail sub-funds in 2014.
  • Advising a leading UK manager of renewable energy and commercial forestry funds, with assets under management in excess of GB£500 million, on fund formation and regulatory matters, compliance with AIFMD
  • Structuring limited partnership components within a real estate fund structure and its fundraising on AIM and CISX, with GB£110 million raised at initial fundraising.
  • Advising a major financial institution on the Scots law aspects of a US$740 million secondary sale of a private equity fund assets to a major European private equity firm.

Languages. English

Professional associations/memberships. Law Society of Scotland; Chartered Institute for Securities & Investment.

Publications. International Comparative Legal Guide to Alternative Investment Funds 2013, 2014 and 2015.


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