LONDON - The Inland Revenue is canvassing U.K. pension funds to see if they are engaged in taxable "trading" activities.
In pursuit of new revenue, the U.K. tax-collecting agency has been sending inquiries to executives of major British pension funds to see if their funds have violated sections of the tax code.
Corporate tax is 25%, although the government retains the ultimate sanction of stripping a pension fund of its tax-favored status.
The Inland Revenue's inquiries affect three major areas:
Sub-underwriting commissions, which institutions receive when they agree to take on part of a rights issue.
Late last year, it emerged Inland Revenue had a test case against the Barclays Bank PLC pension fund on sub-underwriting commissions it has received. The issue is expected to go before a panel of special commissioners by May.
Trades involving multiple managers of a shared client. The problem arises where, say, one manager might buy shares of a stock while another sells the same stock within a 30-day period.
Even though pension executives are likely to be unaware of such trades - master custodianship is in its infancy in Britain - Inland Revenue officials believe pension funds should be held accountable.
"It's a nightmare. How does one manager know what the other is doing?" asked Michael Robarts, director of Fleming Investment Management, London.
So-called bond-washing and dividend-stripping activities. Bond-washing benefits taxable investors because they seek to, say, sell a bond just before the dividend is paid, thus maximizing the capital gain while avoiding income. Such strategies have little or no value for tax-favored pension funds. Still, tax officials believe technical violations might have occurred.
Violations also can occur with multiple managers, if, for example, one managers sells a stock cum-dividend and another buys it back ex-dividend.
John Hinton, assistant director in the agency's savings and investment division, said there's no concerted effort to target pension funds. He said inquiries stem from a long-standing investigation by the department's special Sheffield office into a dozen major funds and possibly independent inquiries by local offices.
"There is no standard approach to this and there's no campaign against pension schemes," Mr. Hinton said.
Pension experts believe tax officials are biased against pension funds, and are seeking new ways to get authority over pension fund money.
"They dislike tax-exempt funds. therefore, they chip away at the margins," said Mr. Robarts, who also serves on the Institutional Fund Managers Association's practice committee.
There might be good reason for this suspicion. "It would be a strange Inland Revenue that didn't carry out its responsibilities," Mr. Hinton said. "It's our duty (to ensure) that all people pay the right amount of tax."
Mr. Hinton acknowledged some of the targeted practices involve technical violations. But he said there isn't any specific exemption for pension funds from the tax code's anti-avoidance rules.
Dividend-stripping rules, on the other hand, are targeted directly at pension funds and charities, Mr. Hinton said. Those rules are designed to ensure excessive amounts of capital are not withdrawn when a tax-exempt institution gains control of a company without paying tax, he explained.
Mr. Hinton observed pension funds enjoy tax exemption on investment activities, but not generally on trading. Critics said the Inland Revenue never has spelled out the difference between the two.
Instead, pension funds have had to infer the rules from court cases, most of which haven't involved pension funds. Courts have looked to six "badges of trade" to determine whether trading has occurred, including whether stock has been held for the short-term and profits are taken immediately, there are frequent transactions and the investor's motivation.
Pension funds have been given statutory tax exemptions on certain kinds of trading activities, including use of financial futures and options. But they do pay tax on other activities, including stock-lending and shorting stock, that would be exempt in the United States.
Sub-underwriting commissions generally are exempt from taxation, although they are not considered investments. In British rights issues, where existing stockholders are given the right to buy new shares and avoid dilution, a fixed fee of 2% is paid by issuers to the lead underwriters, who bear the risk of placing the stock.
The lead underwriters, in turn, lay off much of that risk to institutional investors, who in turn are paid 1.25% for promising to buy the stock even if the market price drops. In effect, pension funds are being paid an insurance premium to ensure shares are sold.
In most cases, that doesn't pose a problem under the law, where investors may participate in, say, a half-dozen rights issues a year, Mr. Hinton explained. But in a few cases, the Inland Revenue has found pension funds underwriting virtually every issue placed on the market.
"When you get to that level, we have to ask, is this more than a casual activity or a is it a well-defined profit center," Mr. Hinton said. That is, is the investor "carrying out a business of sub-underwriting?" he explained.
As a result, Inland Revenue offices have sent a standard letter to a number of large pension funds, asking what issues they have underwritten in the past three years, and asking for details about where they acquired shares and subsequent pricing histories.
Four years ago, the Inland Revenue and the National Association of Pension Funds issued guidelines on the issue. The guidelines said the government would look closely at the volume and frequency of underwriting activity, the amount of organization dedicated to such deals and the fund's intention on entering them.
Where a pension fund engaged in sub-underwriting primarily to earn commissions, it probably would be hit with a tax - which also could be assessed on any capital gains, the guidelines added.
That's why the agency's latest round of queries and some claims are seen as curious by some. Given the exemption for sub-underwriting, the agency's approach is "a back-door thing," said George Ritchie, principal at Touche Ross & Co., London.
In response, Flemings' Mr. Robarts has notified clients that the firm only engages in sub-underwriting where it is making a long-term investment decision.
Still, paying taxes on commissions is not likely to deter sub-underwriting, he wrote. Insurance companies already pay such taxes, he noted.
A potentially greater threat to the practice, however, comes from an Office of Fair Trading study issued last fall. That study, written by London Business School Professor Paul Marsh, found that between 1986 and 1993, sub-underwriters earned returns of some 480 million more than could be justified by the level of risk they underwrote. That sum represents 86% of the aggregate sub-underwriting fees paid out during the period.
The study suggests the long-established fixed fees should be dismantled. If the issue is referred to the Monopolies and Mergers Commission, it could result in radical changes on how stock is distributed within the United Kingdom.
That could lead to a U.S.-style system, where blocks of stock are subscribed by investments banks acting as principals, and subsequently sold. That would not only conflict with the U.K.'s prized principle of pre-emption rights, but would require greater concentration of risk and a more heavily capitalized investment banking community, Mr. Robarts noted.
Alternatively, U.K. issuers could turn to deeply discounted rights - a system apparently favored by Mr. Marsh - but one disliked by corporate executives because it usually involves a cut in dividends.