Close Fund Management has launched a series of novel capital protected fund-of-hedge-funds products, which are believed to be the first instruments to give U.K. retail investors exposure to hedge funds under a capital gains tax regime. Some lawyers, however, say the product, dubbed The Close Man Guaranteed Hedge Fund, is actually subject to the harsher income tax. The first product has raised some GBP70 million (USD122 million).
Paying capital gains tax is much more advantageous to U.K. investors because the first GBP8,200 (USD14,450) of gains are tax free and the longer investors hold the investment the less of it is taxable. If investors hold the instrument for the full-life of the note, they would get 25% of the gains tax free. Under income tax rules, investors have to pay tax on all the profits.
Investors get exposure to the hedge funds via purchasing shares in a Guernsey listed company, which in turn purchases a bond from the Royal Bank of Scotland. That bond is referenced to the performance of a basket of hedge funds.
If the company has spread investment risk it will be deemed as an open ended company and investors will have to pay income tax. Nigel Farr, head of the investment funds group at Herbert Smith, the law firm which advised on the transaction, said, "This has only one asset and therefore has no diversification of risk." Anthony McWhirter, partner in the investments funds group at Freshfields Bruckhaus Deringer in London, however, said because page four of the marketing document says, "The Close Man Hedge Fund ("the Fund") is designed to give investors capital protection plus exposure to a diversified hedge fund portfolio," it may find it difficult to argue its aim isn't to spread investment risk.
Farr said, "We are absolutely clear that the [open ended] tests are not met and therefore it cannot be an open ended fund."
Close and Man Group referred comment to Herbert Smith. David Prince, spokesman at the Inland Revenue in London, said, "We do not discuss individual products."
The Financial Services Authority was shown the structure on a no-names basis prior to launch and signaled it would not investigate the product, according to a lawyer tracking the deal. Kate Burns, spokeswoman at the FSA, declined comment.
"Products of this nature require very careful consideration in light of the potential downside risk for end investors of imperfect structuring. We take a cautious approach to this space," said Tim Hailes, assistant general counsel at JPMorgan in London and co-chair of the International and Derivatives Association equity derivatives working group on hedge funds.
Rival structurers said close-ended fund structures are not transparent and regulated open-ended structures such as UCITS III compliant funds are preferable. One banker noted the lack of tax clarity on regulated wrappers (DW, 9/10) means structurers who are looking to create innovative products will use wrappers that are not transparent, such as closed-ended funds.
The offering document and prospectus are available below.