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VAT exemption for the management of investment funds

Deloitte perspective

The Court of Justice of the European Union (hereafter: “CJEU”) and the Dutch courts have issued a number of rulings in relation to the VAT exemption for the management of investment funds. Some issues have been clarified, but new questions have also come up. In this perspective we set out the most relevant issues that investment funds as well as their managers may face in practice.

10 September 2018

Background of the exemption

CJEU case law is clear that the purpose of the exemption is to facilitate investment in securities for investors by means of investment undertakings. The exemption intends to ensure that the VAT system is fiscally neutral when it comes to the choice between direct investments in assets and investment through undertakings for collective investment.

Two conditions have to be fulfilled in order to apply the VAT exemption. Firstly, the customer must be a “special investment fund” (hereafter: “SIF”) and, secondly, the service must qualify as “management”. It is important to keep in mind that both terms should be read in the context of European VAT and their meaning may deviate from that of their daily use.

What is a SIF?

From CJEU case law we know that UCITS funds are SIFs. Funds that do not qualify as UCITS but are comparable to UCITS funds are also SIFs if they display identical characteristics. According to the CJEU, the following conditions must be fulfilled for a fund to be regarded as comparable to a UCITS fund.

1.    Pooling of assets by more than one investor

Firstly, the assets must be pooled by more than one investor.

There is a question about whether there is a requirement for the assets pooled by a participant to represent a minimum value of investment or a minimum percentage of the total investment in order to meet this condition. Based on a literal interpretation of the condition it should be sufficient to have a fund with two participants. However, by this interpretation if one participant represents a very small fraction of the assets (e.g. 0.01% vs 99.9%) the condition might lose its meaning. Our view is that this condition is met if the participation is not insignificant in absolute or relative terms.

In practice, there can be a fine line between individual investment and collective investment. For example, if a group of individuals invests in standard portfolios with different risk profiles, where these portfolios are composed by their asset manager and the investors have no say in the investment strategy of these portfolios, this could be considered to be individual fund management for regulatory purposes. However, from a VAT perspective it is de facto comparable to collective fund management. This issue is now pending before the Dutch court.

2.    Risk-spreading principle

Secondly, the contributions of the participants must be invested in line with the principle of risk-spreading. The type of asset the contribution of the participants is invested in is irrelevant when considering whether this condition is fulfilled.

In practice, we see little discussion on this condition.

3.    Investment risk borne by the participants

Thirdly, the investment risk must be borne by the participants. In practice, discussions primarily arise when it comes to pension funds.

The CJEU ruled that a pension fund executing defined benefit schemes does not fulfill this condition. The main reasoning is that the investment risk is not borne by the participants as the pension is determined upfront irrespective of the actual investment results. The opposite is the case for defined contribution schemes. According to the CJEU pension funds executing defined contribution schemes can qualify as SIFs.

There is a question about how to deal with (i) hybrid pension schemes that carry elements of both types of pension schemes; and (ii) pension funds carrying out different schemes.

For hybrid schemes this is partly answered by the Dutch Supreme Court. In short, the Dutch Supreme Court ruled that a pension scheme based on the number of working years and the average salary, does not fulfill the condition that the investment risk is borne by the participants, even though the participants bore some of the risk. The Dutch tax authorities take the point of view that only a pure defined contribution scheme can qualify for the exemption. Nevertheless, it is our view that if the factual background of the situation of the pension fund deviates sufficiently (i.e. by more than just some minor details) it might be worth taking the discussion to court.

With regard to pension funds carrying out different schemes, it is our view that the applicability of the exemption should be examined at a pension scheme level and not on the level of the pension fund.

4.    Regulatory supervision

Lastly, the fund must be subject to specific state supervision similar to an UCITS fund. This requirement is fairly new and was introduced by the CJEU in 2016.

Other investment fund types that do not fall within the scope of the UCITS directive, can be subject to other regulatory schemes based on national legislation or EU legislation, such as – for example – the Alternative Investment Fund Managers Directive (hereafter: “AIFM directive”). The AIFM directive has a broader scope than the UCITS directive and mainly contains a regulatory framework for managers of investment funds. In addition, the MiFID II contains supervisory rules for – among others – services provided by Collateral Managers to special purpose entities in CDO, CBO and CLO transactions.

The VAT Committee published a working paper questioning whether funds covered by the AIMFD are indeed comparable to UCITS funds. The main point of concern was whether funds targeting professional investors (AIFMD) are in competition with funds that target retail investors (UCITS). Various arguments were brought forward by the European Commission in favour and against of AIFs passing the test. In our view, the exemption does not only facilitate investments in securities for small investors, but also facilitates investments by means of investment undertakings for all kind of investors.

With regard to the AIFM directive in principle a permit requirement for managers of investment funds applies. These managers are exempt from this requirement if they qualify under the registration regime of the AIFMD. The registration regime (also called “light regime”) is less arduous than the full license regime. However, these managers who are exempt from having a permit for its management activities, are in our view still subject to (national) governmental supervision.

Another potential point for discussion arises in cross-border situations where it is important to consider from which country’s perspective it should be determined whether the requirement of government supervision is met. Member States may give a different meaning to “government supervision” (i.e. a more or less strict regulatory framework) and, subsequently, discrepancies in the scope of the present exemption may arise. Furthermore, in our view, the condition of government supervision is met if the SIF is established in a third-county (non-EU) and its manager is established in the EU, so long as the SIF or its manager is subject to government supervision in the country of its establishment. The Dutch Ministry of Finance considers the local regulatory framework applicable in Australia, the United States and Switzerland as adequate and does not apply any additional regulatory regime to Dutch funds managed by managers established in these countries. By analogy, it is our view that the condition of specific state supervision for the VAT exemption is met.

What is management?

When the customer is a qualifying SIF, it should then be determined whether the services provided fall within the scope of “management”. According to the CJEU, the management of SIFs is defined according to the nature of the services provided and not according to the person supplying or receiving the services. Therefore, services outsourced by investment managers can also qualify as management.

As mentioned in the background section, the word “management” has a specific definition for VAT purposes which may deviate from its meaning in daily use. In order to determine whether a service qualifies as “management”, the service should broadly form a distinct whole and be specific to, and essential for, the management of SIFs. The term management refers to the management of the fund itself and not to the management of the assets held by the fund. Therefore, services included in the activity of collective portfolio management are (among others) attracting new investors, portfolio management (e.g. research to potential investments), the selection and sale of assets and the administration services related to these portfolio management activities. According to the CJEU, services as mentioned in Annex II of the UCITS directive also fall within the scope. This includes – among others - services like legal and fund management, accounting services, customer inquiries, valuation and pricing, regulatory compliance monitoring, record keeping and marketing. In certain circumstances advisory services can fall within the scope of management as well.

MiFID II impacts research for investment firms, as brokers are no longer allowed to provide these services bundled with execution services. Under MiFID II investment firms need to make explicit and separate fee payments for research. Whilst the execution services are likely to benefit from the exemption, it is questionable whether research services can qualify as “management”.

The above are just some examples of the variety of services provided in practice. Therefore there is still a need for further clarification and this question of whether services can qualify as “management” should be addressed on a case by case basis.

In some cases where the services do not qualify as “management”, they may still be VAT exempt if the services provided by managers are considered to be intermediation in securities transactions.

Finally

To conclude, in our view, there are still some ambiguities when it comes to the VAT treatment of services provided to investment funds. It is important that the investment funds and managers assess the (potential) impact of case law on their business. An assessment of the business could flag potential VAT risks in order to avoid these and identify opportunities to explore.

The Deloitte Financial Services Industry team advises investment funds and managers on this matter. If your business also experiences challenges or seeks to identify any opportunities, please contact Koert Bruins, Elwin Makkus or your usual Deloitte contact.  

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