Last week’s amendment to the ISA and PEP Regulations represents the final step in the creation of a favorable onshore tax and regulatory regime in the UK for Structured Products providers.The regulatory changes introduced in association with UCITS III together with tax changes will undoubtedly now pave the way for onshore Collective Investment Schemes becoming a replacement for Structured Product issuance.

The industry will in effect have come full circle. Many of the first Structured Products in the UK were sold as onshore Life Bonds in the late 1980s and early 1990s. Concern by Regulators as to the risk and payoff profiles of some products prompted a tightening of insurance company admissibility rules in the late 1990s. The unexpected consequence of this from HM Treasury’s point of view was that much of this business moved to the more regulatory and tax friendly haven of Dublin and other offshore domiciles.

Up until the recent changes, these Dublin and other offshore based closed ended investment companies have had a number of advantages over onshore wrappers with regards to being able to deliver structured investment returns efficiently to investors. The recent changes onshore in the UK have leveled this playing field. The resultant regulatory framework will enable existing and new providers to offer a wide range of products in a tax friendly environment where issue cost will be very low.

In a nutshell these changes are as follows;

UCITS III / PS 135

The Financial Services Authority began its overhaul of Collective Investment Scheme regulation with the implementation of Policy Statement 135 in November 2002. These new regulations reflected not only the changes associated with the implementation of new European UCITS Directive (2001/108/EC) in January 2002 but also some other important structural changes. The three significant points for the structured products industry are:-

• The ability of Collective Investment Schemes to invest in a very wide range of financial assets including derivatives on a flexible basis. Previously only very limited use of derivatives was allowed through efficient portfolio management.

• Funds can be established on a limited issue basis, so facilitating the launch of tranche based products.

• Funds may use certain nomenclature such as Capital Protected where certain low risk investment policies are followed or Guaranteed where a third party Guarantor exists

Statutory Instrument 2747/2748

The Inland Revenue recently published their update on what assets would be eligible for PEP and ISA inclusion. UCITS III funds have up until this point been ineligible for inclusion given the existing guidance was published before their introduction. Broadly speaking all UCITS III will be ISA and PEP eligible. However the Inland Revenue has introduced a test (the 5% test) to differentiate between those schemes that are sufficiently low risk, and only eligible for the cash component of an ISA (£3,000) and those which bear more market risk and are eligible for inclusion in the Stocks and Shares component (£7,000).

The absence of this guidance has postponed issuance of these funds by a number of providers. Product providers operating from Umbrella ICVCs have been unable to convert to UCITS III without compromising existing retail business.

The 5% Test

If the investor is certain or near certain of receiving back 95% or more of their initial investment at any time during the 5 years after purchase (that is the investments are not exposed to a risk of loss of at least 5%) then the test is failed.

The test is only applicable to funds which are designed to return investors capital within a five year period.

Any funds which offer guarantees over any period longer than 5 years (5 years and 1 day as cited in the Inland Revenue’s example) will not be caught by the test and will be eligible for the full Stocks and Shares ISA amount.

Taxation of Assets Held

Authorised Funds were exempted from tax on many derivative based assets as long ago as the Finance Act 1990. This guidance has been revised a number of times in the light of industry practice and consultation with practitioners and trade bodies. Recently reissued guidance gives authorised fund managers substantial scope to deliver tax free products

In summary, the result of these changes will mean that it is possible to structure Collective Investment Schemes that can deliver a wide variety of structured investment returns to investors. These products will not be limited to the ISA market but have broad appeal for larger investors. Furthermore the low cost of issuance of Unit Trusts or OEIC sub funds will lead to more competitive product terms. Many existing Collective Investment Scheme managers will be able to take advantage of existing onshore infrastructure to issue products for negligible incremental cost. The resultant savings product will have both transparency and secondary market liquidity which is seldom seen in other wrappers.

Industry Response

Structured Product manufacturers will initially rewrap many existing products as Collective Investment Schemes. Manufacturers of Life Bonds, Deposits and Dublin Companies will be rewrapping products to make them more cost and/or tax efficient. A number of these products will be out for next years ISA season. It is likely that many of the cost savings will be passed on to investors, leading to very competitive product terms.

There will be a trend to simplicity in the wake of the FSA’s CP 188, focusing on the need for clear unambiguous sales and marketing material. The recent improvement in the pricing environment for many products will facilitate this back to basics approach.

Developments in derivative pricing and asset management will lead to products launched based around ‘flagship’ funds rather than indices. We have seen a number of launches of CPPI based retail products in the UK this year some based on actively managed equity funds and some based on indices. Collective Investment Schemes will be launched on active funds not only replicating classic tranche growth products but also offering longer dated guarantees.

We will also see a trend towards more longer dated structured products as more direct With Profits replacements featuring longer maturities and/or rolling guarantees.

Development Issues

The potential for structured product providers utilising this wrapper is tremendous. However for those taking advantages of these tax and regulatory changes there will be a number of development issues.

In general the requirement to diversify will lead to a move away from ‘one bank’ solutions to a situation where product providers will need to source assets more widely and manage the investment process themselves. The recent European Collateralisation Directive does not mitigate this. Those assets will need to be constructed & managed carefully to obtain optimum operational and tax efficiency.

Limited issue funds, until the implementation of some of the proposals in CP 185, will be required to offer NAV linked redemption. Collective Investment Schemes traditionally offer investors the benefits of open-endedness; this has many advantages although it does come with a number of operational issues. The simplicity seen in the product design of many offshore and unregulated products will not be reflected here. The benefits to those who overcome these issues will be considerable.

Forthcoming Developments

Following on from the regulatory changes highlighted above, the FSA has recently finished consulting on CP 185. It is the FSA’s intention to develop Collective Investment Scheme regulation further. These proposals will not only introduce non retail funds to the institutional market but also changes to retail funds including limited redemption and a wider range of non UCITS schemes to include, for example, property. The document further underlines the FSA’s intention to focus on Collective Investment Schemes as the wrapper for much of the retail and non retail savings market.

A number of managers are looking at developing hedge funds within unit trusts and OEICs, with capital guaranteed variants of these to follow.

Given Collective Investment Schemes will in the near future vary from traditional long only securities schemes through to more defined-payoff products, property funds and hedge funds some further Inland Revenue changes are expected to facilitate these new savings vehicles. Some believe an intention to review this area may be signaled as soon as next month in the Chancellor’s Pre-Budget Report though this may be considered as a little optimistic.

This is an extract from an article on developing the use of Collective Investment Schemes as a wrapper for Structured Retail products. The full text of this article is available on barrhibb.com