Potential tax issues arising from MiFID II
MiFID II, which is widely regarded as the most significant regulatory initiative undertaken by the European Union since 2008, will come into immediate effect (i.e. without any phase in period) on 3 January 2018.
Although MiFID II will have the most significant direct impact on MiFID investment firms (in addition to AIFMs and UCITS management companies which have additional authorisation to carry on certain MiFID activities), it will indirectly impact all funds, AIFMs and UCITS management companies which utilise a MiFID investment firm as a service provider to provide fund distribution, execution, research or other services.
A less focused upon area has been the potential tax impact of MiFID II changes on existing and new business models and practices which may arise following the implementation of MiFID II. This article explores the potential tax issues associated with some of the key MiFID II provisions that may impact funds, AIFMs and UCITS management companies.
Unbundling of research
Under the current MiFID framework, there is no requirement for a MiFID investment firm to separately invoice for the services they provide to a fund or fund management company. In practice, this has led to some brokers using “soft commission” arrangements whereby they provide research services as a complement to the execution services, i.e. as one bundled service for a single fee or subject to shared commission arrangements in some cases. However, MiFID II and the move to increased transparency over fees will spell an end to this activity and introduce a new requirement to unbundle research services from execution.
The new requirement gives investment firms two broad choices in relation to research services:
- Fund the research themselves – the “P&L method”; or
- Seek to pass on the cost of research to their clients (i.e. funds)
To date, the fact that research services have been bundled as part of a wider execution service, has meant that in most EU jurisdictions the research component of the service is normally treated as VAT exempt – usually on the basis of being ancillary to execution services provided.
However, the unbundling of the research from execution activities now raises the question of the VAT treatment applying following the unbundling, specifically the risk of VAT now applying to any separate fee charged for research. This could give rise to an incremental VAT cost on the supply of separate research services, which in many cases may not be recoverable. This will be the case unless any research services can qualify for VAT exemption as part of a VAT exempt intermediation service or under the fund “management” exemption, i.e. where the fund under management is itself a “qualifying fund” which is entitled to procure “qualifying management services” without VAT.
This issue is not confined to Ireland. The results of a recent KPMG pan-EU VAT survey across EU Member States have indicated similar concerns have been recognised in many EU Members with limited consensus reached to date on how such services are to be treated from a VAT perspective from 3 January 2018 onwards.
Discussions remain ongoing between industry and the Tax Authorities in a number of Member States. Similar concerns also have been raised in non-EU jurisdictions. For example, Switzerland is a not a Member State of the EU but the rules will affect Swiss Financial Institutions dealing with EU customers in the same way and therefore, similar concerns have been raised with respect to the VAT treatment of research services in Switzerland.
Those on the “buy” or “sell” side affected by the MiFID II changes should consider how VAT may impact on their supply or purchase of research service. In doing this they will need to understand their proposed model for investment research activities going forward.
There is no blanket answer on whether such services will attract VAT going forward or may retain VAT exemption. The analysis in each case will be fact dependent taking into account the nature of the fund under management, contractual arrangements with the fund and service provider and the remaining link, if any, between the research activities performed and trade execution carried out.
Additionally, as the quantum of fees for research activities in many cases is expected to be significant, the need to split existing commercial fee arrangements between execution and research amounts could require an exercise similar to a transfer pricing benchmarking analysis.
From a product governance perspective, MiFID II introduces additional requirements applicable to product “manufacturers” (i.e. firms creating financial instruments such as fund promoters) and product “distributors” (i.e. investment firms offering financial instruments to clients). From 3 January 2018, fund promoters will now need to undertake a target market assessment, which must be communicated to the fund distributor, who will be obliged to verify that the fund is being distributed in a consistent manner with the target assessment on both an upfront and ongoing basis.
Given that this new requirement will require additional resource from both fund promoters and distributors, from a commercial perspective it is likely that incremental operating costs will arise.
In order to determine if there will be an incremental VAT cost on top of the increased operating costs suffered under this new requirement, consideration will need to be given to whether any additional services are subject to VAT or if they can qualify for VAT exemption. For example, where a fund distributor imposes additional cost for its ongoing target market assessment, consideration will need to be given to whether the service being provided can qualify for VAT exemption as part of the distribution service or as another form of VAT exempt service provided.
Treatment of inducements
The general inducement rule under MiFID II states that investment firms must not retain third party payments or non-monetary benefits, other than where the payment or benefit:
- is designed to enhance the quality of the relevant service to the client; and
- does not impair compliance with the investment firm’s duty to act honestly, fairly and professionally in accordance with the best interests of its clients.
In light of the above, fund distribution models which involve the payment of upfront commissions or trail commissions may be impacted where the distribution channel involves the MiFID investment firm providing either a discretionary investment management service or an independent advisory service (as in order to support a fee, there must be a benefit which clearly enhances the overall quality of service to the client).
Whilst this change will primarily impact MiFID investment firms, an indirect impact may arise for funds which have commission paying share classes, as there may be a need to either amend the terms of such share classes, or reorganise investors into non-commission paying share classes. In this instance, it will be important to seek to implement any restructure in a manner which prevents triggering a tax crystallisation event for investors where possible. Although there are provisions in Irish tax legislation which allow for tax free reorganisations in the context of Irish tax resident investors in funds, consideration will also need to be given to the treatment of investors under the tax legislation of their own jurisdiction (given that most Irish funds have a significant non-Irish tax resident investor base).
Furthermore, any alternative commission arrangements or changes to fee structures should be considered from a VAT, withholding tax and tax deductibility perspective before being implemented.
Although MiFID II is primarily a regulatory development impacting MiFID investment firms, there are a number of related tax consequences which will need to be considered by funds and fund management companies alike in relation to its implementation.
These tax consequences should be considered in tandem with the regulatory impact, to ensure any potential additional costs or impacts on investors from a tax perspective are identified and quantified upfront, and managed in advance where possible.
Glenn Reynolds, VAT Partner, and Philip Murphy, Tax Associate Director, KPMG Ireland