FSA tax break welcomed

LONDON -- FSA rules that permit UK onshore quasi-hedge funds to operate on the UK mainland will have little effect on the industry unless complimentary tax changes are introduced. That was the response of many industry figures to the FSA’s relaxation of investment restrictions, which will allow onshore funds to short, use derivatives and leverage up to 100% of their net assets.

"While the FSA is very gung-ho about regulation, the Inland Revenue has not changed its tax rules yet," says Paul Sater, partner at consultancy Ernst & Young. "Until they adopt a complimentary regime, it is almost impossible for new onshore hedge funds to be economically viable."

If the Inland Revenue does nothing, by default onshore funds will be taxed similarly to regulated retail funds in the UK, and would pay corporation tax on revenues rather than capital gains, adds Tim Cornick, partner at hedge fund lawyers MacFarlanes. "It would be interesting for hedge fund managers if they were given a tax break on trading income," he adds.

If the Inland Revenue Service does make tax changes that are complimentary to the FSA rule changes, this could discourage investors from investing with offshore hedge funds and hence lead to a shift in the industry towards onshore funds.

Until that happens, the use of onshore quasi-hedge funds launched under the new regulations will remain limited. However, they may be interesting for a limited number of investors, according to Tim Spangler, partner in the investment funds group at London-based lawyers Berwin Leighton Paisner.

"Unless there are tax changes, the full impact of the FSA rule changes will not be felt," says Spangler, "and even then it will not expand the universe of potential investors. What it may do, however, even before any potential tax changes, is lead to the creation of onshore hedge funds aimed at investors that are reluctant to invest in offshore products because of the lack of regulation and perceived dangers."