Funds Annual Briefing 2022 - Spotlight on your radar

Further to the government's Roadmap to Sustainable Finance (see 'UK Roadmap to Sustainable Investing'), in November 2021 the FCA published a discussion paper (DP21/4) on Sustainability Disclosure Requirements (SDR) and investment product labels.

The FCA is seeking initial views on a three-tiered system with different levels of disclosures targeted at different types of investors. Separately, the FCA is also proposing the classification of products according to their sustainability activities and objectives.

The FCA proposes that asset managers and certain FCA-regulated asset owners should be in scope of the new disclosure rules. It tentatively suggests coverage similar to that proposed for its new TCFD reporting regime, but is open to alternative suggestions. The FCA says that it is also considering whether to introduce specific sustainability-related requirements for financial advisers and how (if at all) the regime should apply to funds that are being marketed into the UK.

Details on the proposals are set out in our briefing. We have also included a section in our 2022 New Year Briefing which looks at this in the context of the wider implementation of disclosure requirements.

The Taxonomy Regulation introduces an EU-wide taxonomy or classification system for determining whether and to what extent an economic activity can be considered environmentally sustainable. Environmental sustainability is one element of sustainability under SFDR.

The Taxonomy Regulation sets out six environmental objectives: climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy; pollution prevention and control; and protection and restoration of biodiversity and ecosystems. In order to be "taxonomy compliant" (meaning the relevant activity is classified as environmentally sustainable according to the EU's criteria and is also compliant with basic social standards) an activity must contribute substantially to at least one of these and do no significant harm to any of the others. The activity must also comply with certain social safeguards.

In July 2021, the European Commission adopted a delegated act supplementing Article 8 of the EU Taxonomy Regulation specifying the content, methodology and presentation of information to be disclosed by financial and non-financial undertakings (including large EU asset managers) within the scope of the Non-Financial Reporting Directive relating to how and to what extent their activities are associated with environmentally sustainable economic activities as defined under the EU Taxonomy Regulation – i.e., the proportion of environmentally sustainable activities that form part of their business, investment or lending activities. The obligations will be brought in on a phased basis with full reporting not required for asset managers until 2024, in recognition of the fact that they will rely on underlying companies for the data they need, and that will not be available until 2023.

In April 2021, the European Commission adopted its proposal for a Corporate Sustainability Reporting Directive (CSRD), which will largely replace the Non-Financial Reporting Directive. The Commission intends to bring corporate reporting in line with the requirements that already apply to asset managers and financial advisers under the Sustainable Finance Disclosure Regulation (SFDR).

The CSRD will, if implemented, significantly increase the number of companies that are subject to EU-wide reporting requirements. As well as most EU listed companies, all "large" EU-incorporated private companies would be covered, bringing many portfolio companies of private funds in scope for the first time. Disclosures would be subject to limited external assurance, and proportionate standards will also be developed for smaller companies which, in the case of smaller private companies, could be adopted voluntarily. The European Financial Reporting Advisory Group (EFRAG), who published an influential report in February) would be mandated to develop standards in accordance with some high-level principles laid out in the Directive, and consistent with the disclosure obligations in the SFDR. Company reports issued from 2024 (covering the 2023 financial year) would need to comply with the new rules, if the Commission's proposed timetable can be achieved (which is far from certain). Further details are in our client briefing.

New delegated legislation integrating sustainability into the AIFMD Delegated Regulation, the MiFID II Delegated Regulation and Delegated Directive and the UCITS Delegated Directive will come into force during the course of 2022.

Very broadly, the delegated legislation requires EU AIFMs, EU UCITS management companies and EU MIFID investment firms to integrate sustainability risks and factors into their policies and procedures.

The amendments to the UCITS Directive and AIFMD Delegated Regulation will apply from 1 August 2022 and the delegated regulations supplementing the MiFID Org Reg will apply from 2 August 2022.

The amendments to MiFID II product governance obligations will apply from 22 November 2022.

Following Brexit, the UK did not implement the EU's Investment Firms Regulation and Directive but will, instead, introduce its own (very similar) regime for UK investment firms, the Investment Firms Prudential Regime (IFPR).

The IFPR introduces a new prudential regime for UK MiFID investment firms with new requirements in respect of regulatory capital, internal governance, remuneration, and disclosures and reporting. The IFPR took effect on 1 January 2022.

We discussed the new rules in a number of client briefings: June 2021 briefing, July 2021 briefing and November 2021 briefing.

In November 2021, the government published its second consultation on the Future Regulatory Framework Review (FRF Review). The key aim of the FRF Review is to achieve an agile and coherent approach to financial services regulation in the UK, with appropriate democratic policy input to support a stable, innovative and world-leading financial services sector.

The consultation sets out the government's response to the feedback received on the previous consultation published in October 2020 (the Future Regulatory Framework ("FRF") Review: Consultation). It makes a series of proposals to deliver the intended outcomes of the FRF Review, building on the strengths of the UK's existing framework. The proposals include changes to the regulators' statutory objectives and enhanced mechanisms for accountability, scrutiny and oversight of the regulators by Parliament, HM Treasury and stakeholders. It also sets out how the government intends to return responsibility for designing and implementing regulatory requirements to the UK regulators, a break from the approach under EU law.

In April 2021, the Financial Services Act 2021 (FSMA) received royal assent, which was introduced to ensure that the UK's regulatory framework continues to function effectively for the UK after leaving the EU. Included in the Act is the introduction of a new Overseas Funds Regime (OFR) to allow overseas domiciled retail funds (and money market funds) to be marketed to investors in the UK. 

The OFR gives HM Treasury the power to determine that certain overseas jurisdictions provide protection to investors equivalent to that which they would receive in a comparable UK collective investment scheme and to approve certain types of collective investment scheme from those jurisdictions. Certain other criteria apply, for instance, that there is a cooperation arrangement in place between the FCA and the supervisor of the non-UK fund. Once this equivalence has been granted by HM Treasury, an overseas retail fund is then be able to apply to the FCA for recognition. Once granted, the fund is then be able to market in the UK as a recognised fund.

The OFR is available in addition to the existing and continuing provisions allowing overseas schemes to be individually recognised under section 272, FSMA. Further details are in our 2022 New Year Briefing.

In December 2021, HMT published a Call for Evidence on the Appointed Representatives Regime, and the FCA published a Consultation Paper on improving the Appointed Representatives regime. Both HMT and the FCA are concerned that the AR regime has evolved to include a wider range of business models across sectors and markets well beyond those for which it was originally designed in 1986. The FCA is seeing a wide range of harm across all the sectors where firms have ARs. This harm often occurs because principals don't perform enough due diligence before appointing an AR, or from inadequate oversight and control after an AR has been appointed.

The FCA's proposed rule changes are material and wide-ranging. Further details are in our 2022 New Year Briefing and, specifically in relation to the impact that the policy proposals on the regulatory hosting model may have on private fund managers, in our briefing published on 16 December 2021.

Significant publications relating to the Packaged Retail Investment and Insurance-based Products (PRIIPs) regimes were made in both the UK and the EU which, if implemented, will result in increased divergence between the two regimes.

UK

In July 2021, the FCA published a consultation paper on proposed targeted amendments to the scope of the UK PRIIPs regime.

The FCA proposes to:

• introduce interpretative guidance to clarify what it means for a PRIIP to be "made available" to retail investors. As the meaning of this term is currently ambiguous, the proposals include the introduction of conditions that a PRIIP manufacturer must meet to demonstrate that a PRIIP is not being made available to retail investors. These conditions include:
  • the marketing materials make it clear that the PRIIP is being offered only to investors eligible for categorisation as professional clients or eligible counterparties and that the PRIIP is not intended for retail investors;
  • the marketing and distribution strategy for the PRIIP is targeted at professional and eligible counterparty clients and not retail clients; and
  • the PRIIP is issued at a minimum denomination value of £100,000 (or equivalent sum in foreign currency).
     
• amend the regulatory technical standards (RTS) laid down in the 'onshored' PRIIPs Delegated Regulation to replace the requirement and methodologies for presentation of performance scenarios in the key information document (KID) with a requirement for the provision of narrative information on performance. The amendments will also address the potential for some PRIIPs to be assigned an inappropriately low summary risk indicator in the KID, and concerns about certain applications of the slippage methodology when calculating transaction costs.

The consultation also includes clarifying the scope of the retained EU law version of the PRIIPs Regulation as regards corporate bonds, making it clearer that certain common features of these instruments do not make them into PRIIPs.

The proposed changes to the FCA Handbook (which include the creation of a new Product Disclosure sourcebook (DISC)) and PRIIPs RTS are contained in the draft Packaged Retail and Insurance-Based Investment Products (Scope Rules and Technical Standards) Instrument 2021, which is in Appendix 1 of the consultation.

The FCA originally planned to make the final rules and amend the PRIIPs RTS by the end of 2021, with any changes made coming into effect on 1 January 2022, but the publication of a policy statement has now been delayed to Q1 2022. This will include confirmation of when the rules will take effect and any implementation period.

In October 2021, the current exemption for UK Undertakings for the Collective Investment in Transferable Securities (UCITS) funds from the requirements of the UK PRIIIPs Regulation was extended by five years to 31 December 2026 (the exemption was due to have expired on 31 December 2021).

EU

In October 2021, the ESAs launched a call for evidence to assist it in providing advice to the European Commission relating to the Commission's review of the EU PRIIPs Regulation.

Areas covered by the call for evidence include:

• General survey on the use of the key information document (KID), and complexity and readability of the KID;
  
  
• General survey on the operation of the comprehension alert;
  
  
• Practical application of the rules;
  
  
• Use of digital media;
  
  
• Scope of the EU PRIIPs Regulation; and
  
  
• Differentiation between different types of PRIIPs.

The call for evidence closed on 16 December 2021. This follows the related call for advice, published in June 2021, by the European Commission to the ESAs.

The European Commission adopted amendments to the PRIIPs RTS, including annexes in September 2021. Following non-objection from the Council and the European Parliament, the amending regulation was published in the Official Journal on 20 December 2021.

Finally, the European Parliament and the Council both settled on a twelve-month extension to the UCITS exemption to 31 December 2022, and the Commission has agreed to align the implementation date of the above PRIIPs RTS with this position (the published regulation currently provides that the implementation date is 1 July 2022).

As part of the fund review, the Government is making changes to the REIT regime in April and considering a further batch of reforms.

The changes coming into force in April include the option of an unlisted REIT for certain institutional investors and restricting the effective prohibition on corporate shareholders having an interest of 10% or more so that it only applies to those not entitled to receive gross distributions from the REIT under the UK's domestic REIT withholding tax rules. For more detail on the changes, please see our briefing.

The second phase, forming part of the call for input (also discussed above), includes proposals to abolish the interest cover test, allow a REIT to hold a single property and amend the three year development rule. Suggestions on improving the tax position for international investment by REITs are also on the table.

The government announced in the 2020 March Budget a review of the VAT treatment of fund management fees. This has been delayed and we do not know exactly what the review will cover. However, as the current scope of the VAT exemption for fund management services is unclear, Brexit should provide the UK with the opportunity to consider this area afresh, allowing it to adopt a more coherent approach than its European competitors, and it is hoped that this is what the fund review will address.

Counteraction is possible under the hybrid rules where a payer makes a potentially tax deductible payment to a hybrid entity which does not give rise to taxable income for either the hybrid or an investor in it (e.g. if the hybrid is tax transparent in its own jurisdiction but seen as opaque in the jurisdiction of an investor).

However, wide-ranging deeming provisions in the rules meant counteraction could apply even where the investor jurisdiction and the hybrid entity's jurisdiction both saw the entity as transparent. In 2018, the rules were amended so that, broadly, this issue was resolved where the hybrid was a partnership. The government has now put forward draft legislation in the Finance Bill to address this issue for other transparent entities legally constituted outside the UK (provided they are not constituted in a jurisdiction that charges tax at a nil rate). However, the draft legislation contains complex provisions placing restrictions on this relaxation of hybrid rules and applying these restrictions (prospectively) so that they also apply in relation to the equivalent longer-standing relaxation for partnerships.

A levy (from the AML regulated sector) is to be introduced to fund combatting economic crime. It is likely to apply to many within the asset management sector including portfolio managers, collective investment undertakings and investment advisers. The levy will be paid as a fixed fee based on which of four size bands an AML-regulated entity's UK revenue falls. The bands range from entities with small UK revenue (under £10.2m), which will be exempt, to those with very large UK revenue (over £1bn), for whom the levy will be £250,000.

The levy is to first apply for entities that are regulated during the financial year from 1 April 2022 to 31 March 2023, and the amount payable is to be determined by reference to their size based on their UK revenue from periods of account ending in that year. Amounts will be payable after the financial year, so the first payment will be due in the financial year from 1 April 2023 to 31 March 2024.

The levy (to be called the health and social care levy) will apply from April 2022 and will initially be collected by way of a 1.25 percentage point increase to the rates of National Insurance contributions. From April 2023 the levy will be charged separately and the rates of NICs will return to their 2021/22 tax year levels. In the context of employments, the levy will be paid by both employees and their employers (i.e. an additional 2.5% in total). For the self-employed (such as contractors or partners) the levy is payable by the self-employed person only. The rates of tax on dividend income (above the £2,000 dividend tax-free allowance) will also be increased by 1.25 percentage points from April. There have been some calls for the NICs increase to be postponed given the recent rise in living costs, but the government has not indicated that there will be any delay.

At this stage, we don't yet know whether it will be possible to transfer the employers' liability to pay the levy to an employee (once the levy becomes chargeable in its own right from 2023) nor whether it will be governed by the protocol on social security agreed with the EU (referred to above). In the meantime, we recommend that entities review their arrangements to ensure that any indemnities for tax and social security are wide enough to cover the new levy from April 2023.

The EU Commission has published a draft directive (ATAD 3) designed to tackle misuse of entities resident in EU member states that do not have sufficient substance.

Entities within the scope of the directive are subject to adverse tax consequences. There are also increased information reporting requirements which extend to entities at risk of being within scope as well as those that actually are.

For more detail please see our recent briefing on the shell entity directive which includes a flowchart to help businesses navigate the new rules and assess whether the directive is likely to apply to them.

The EU's Anti-Tax Avoidance Directive (ATAD I) was amended in May 2017. This amendment (ATAD II) extended the scope of the directive so that it applies to more hybrid structures. Member states became obliged to apply most of the measures from 1 January 2020 but that date was extended by two years for "reverse hybrids".

The reverse hybrid rules potentially apply to entities that are incorporated or established in an EU jurisdiction that treats them as transparent but as tax opaque in the jurisdiction(s) of one or more associated non-resident entities holding in aggregate a direct or indirect interest in at least 50% of the voting rights, capital interests or rights to a share of profit.

Where the rules apply, the home member state must tax the reverse hybrid on its income to the extent that that income is not otherwise taxed in that member state or elsewhere. However, this treatment does not apply to a "collective investment vehicle" (i.e. an investment fund or vehicle that is widely held, holds a diversified portfolio of securities and is subject to investor-protection regulation in the country in which it is established).

The Central Securities Depositories Regulation (Regulation EU 909/2014) (CSDR) is aimed at increasing the safety and efficiency of securities settlement and settlement infrastructures (CSDs) in the EU. CSDR provides for a new Settlement Discipline Regime (SDR) which includes:

• Shorter settlement periods (T+2 – in line with the Target2 project that went live in 2015); and
  
  
• Settlement discipline measures (e.g., mandatory cash penalties and 'buy-ins' for settlement failure and settlement failure reporting).

The SDR applies to settlement of transactions in securities, including repo, as well as transactions in money market instruments, UCITs and emissions allowances. While it does not directly apply to derivatives transactions, it will potentially need to be considered where transactions involve posting of collateral securities or physical settlement.

There are two main limbs to the SDR which apply in the case of settlement failures – cash penalties, and mandatory buy-ins.

Cash penalties will be imposed by the CSD on failing participants and will be calculated on a daily basis for each business day that a transaction fails to be settled after its intended settlement date, by reference to a fixed scale based on a fraction of a basis point on the closing price in the most relevant market. The data required for selecting the most relevant market will be published by ESMA from 1 February, and will be updated on a quarterly basis. The imposition of cash penalties has no effect on the validity of and remedies available under the contract between the transaction parties.

The SDR has been the subject of extensive comment by industry bodies and has undergone several postponements. While the European Commission has indicated that application of the mandatory buy-in provisions will be postponed pending a review of the SDR, the cash penalty provisions are scheduled to come into force on 1 February 2022. The Chancellor of the Exchequer has previously made it clear that the UK will not be implementing an on-shored version of the SDR.

The two-pillar corporate tax reform plan forms part of the OECD's project tackling base erosion and profit shifting (or BEPS).

Pillar One

Pillar One aims to align taxing rights more closely with the location of customers or users. The Pillar One rules will reallocate 25% of the profits in excess of 10% revenue of a multinational enterprise (MNE) to market jurisdictions where the MNE has a substantial engagement in that market, regardless of whether it has a physical presence there. This measure will only apply to the largest businesses in the world - MNEs with annual global turnover above €20bn (reducing to €10bn in no earlier than seven years) that have a profitability threshold above 10% and do not fall within an exclusion. There will be exclusions for extractives and regulated financial services, the details of which are yet to be published.

The OECD envisages that this additional taxing right for local jurisdictions will be implemented through a multilateral convention, and where necessary by way of correlative changes to domestic law, with a view to allowing it to come into effect in 2023.

In addition, Pillar One also contains rules to simplify and streamline the arm’s length principle for related party distributors, as well as mechanisms to provide tax certainty.

Pillar Two

The main plank of Pillar Two is the Global anti-Base Erosion rules (GloBE rules). These rules seek to establish a global minimum corporate tax rate through a set of interlinked rules.  The rules will apply to MNEs that meet a €750m turnover threshold (determined under the BEPS country by country reporting rules). There will be various exclusions, including for investment funds that are ultimate parent entities of an MNE group and pension funds (and any holding vehicles used by such funds).

The GloBE rules will impose top-up taxes where the effective rate of tax of a MNE in a jurisdiction is below the global minimum corporate tax rate (15%). The global minimum corporate tax rate will be effected by two rules: the income inclusion rule (IIR) and the under-taxed payment rules (UTPR). 

The IIR taxes a parent entity on its proportionate share of a low-taxed constituent entity’s income (similar to a CFC charge). Where top-up tax is required but the IIR does not apply (for example because the only parent is located in a low tax jurisdiction), the UTPR will apply.  The UTPR imposes top-up taxes on other group entities that meet various criteria.

In addition to the GloBE rules, Pillar Two also contains a subject to tax rule (STTR) which will allow source taxation (for example, withholding taxes) on certain cross-border related party payments that are subject to tax below a minimum rate of 9%.

The OECD's (ambitious) timetable is for jurisdictions to legislate the Pillar Two rules in 2022, with most of them taking effect from 2023 (the UTPR would take effect in 2024). To this end, in December 2021 the OECD published Model Rules for GloBE and it is anticipated that commentary on them will be published in the first quarter of this year.

From a domestic UK perspective, in January 2022 the government launched a consultation on the implementation of the GloBE rules in the UK. As part of this, the government is exploring whether to introduce a domestic minimum top up tax. Broadly, this would allow the UK to impose top up tax on low-taxed profits of a group’s entities in the UK, rather than allowing a foreign jurisdiction to do so.  The government anticipates that the parts of GloBE relating to the IIR would be included in Finance Bill 2022-23 and would have effect from 1 April 2023 and that both the UTPR and any domestic minimum tax would be introduced from 1 April 2024 at the earliest.

In addition, the EU has published a draft directive for the implementation of the GloBE rules in the EU. Under the directive, the GloBE rules would come into force in the EU on 1 January 2023, with the exception of the UTPR for which the application will be deferred to 1 January 2024.

Please note that this briefing is for information purposes only. It is not legal advice and should not be relied upon. It is not a substitute for taking specific legal advice in any particular situation. No liability is accepted by Travers Smith, its employees, partners or any other person for the content of this briefing or for the consequences of any action taken or not taken in reliance upon it.