Lucas Harding-Cox

Lucas Harding-Cox
Chief Technical Officer

Operating an investment activity within a corporate vehicle is commonly regarded as tax efficient due to (currently) lower corporate tax rates versus income tax rates. The result is higher retained profits (after tax) to reinvest. Shareholders also have the flexibility to control the amount of income they take. This is regularly paired with carefully managed cash extraction to take advantage of personal tax allowances.

However, while the ‘here and now’ is important, the growing tax exposure for a shareholder’s estate should not be ignored.

It is well understood that where a company ‘wholly or mainly’ holds investments, Business Property Relief (‘BPR’) is not available to shelter the shares from Inheritance Tax (‘IHT’). Therefore, the shares of the investment company are fully exposed to IHT (at a rate of up to 40%).

Considering the current property market, and expected continued growth, a company that holds a property portfolio can amass significant value over its lifetime. According to the latest available UK House Price Index the average UK house price increased by 12.8% in the year to May 2022. (1). Furthermore, Nationwide reported that UK house price growth had surged to its highest level since 2004 with annual house price increases hitting 14.3% for the year to February 2022 (2).

While it has been reported that increases are expected to tail off in the long term, the immediate evidence points to continued high increases. Even if a relatively low average annual increase over the long-term, say 7%, means that a £5m property portfolio could nearly double in value in 10 years. That is before considering any additional properties acquired during that period.

A property investment company, therefore, may be a wonderful investment prospect – but a growing, and significant, tax liability for an individual’s estate.

Normal routes to reduce the estate – such as lifetime gifts to family or trusts – can be used. However, gifts may produce immediate tax charges. Deemed market value rules on the transfer of assets between connected persons (such as family members) mean that any unrealised capital gains within the shares will be realised with no relief available to defer these capital gains. Shares transferred to a trust will qualify for ‘Holdover Relief’ (under section 260 TCGA 1992). However, a transfer to a trust is a chargeable lifetime transfer for IHT. Therefore, the value of the shares that exceeds an individual’s ‘Nil-Rate Band’ (currently £325,000) will be liable to IHT at 20%. Furthermore, there is a decennial charge on assets held in a ‘relevant property’ trust (which includes most newly-settled trusts) of up to 6% the market value of the trust assets at the date of charge.

Creating a class of growth shares (sometimes referred to as ‘freezer shares’) is an alternative to gifting and one frequently favoured by property investors. While growth shares do not reduce an individual’s estate (as a gift does), they can prevent the future growth accumulating to the ordinary shareholder’s estate – and so ‘freeze’ the current value of the shares.

However, to protect against specific tax rules giving rise to a Capital Gains Tax charge (the value shifting rules), and in some rare cases even Income Tax charges (‘Employment Related Securities’ laws), it is sensible for the growth shares to be subject to a ‘Hurdle Value’ that must be met before they are entitled to any capital of the company (above that value).

The Hurdle Value needs to be sufficiently challenging to have an effect on the fiscal market value of the growth shares.

Due to the organic growth an investment company, especially those in property, can naturally achieve (without anything being done by the company owners/directors), the hurdle value may need to be some distance from the current market value of the company. This does present the possibility that the Hurdle Value is not met before the untimely demise of one of the ordinary shareholders. If this is the case, all of the company’s value would remain in their estate, with the growth shares being worth no more than their nominal value.

There is also an argument that because the ordinary shares retain control of the company (they will likely retain all the voting rights), their value is not frozen at the Hurdle Value (once it is met). A definitive position on this point has not been confirmed by current case law, but it is worth being mindful of especially where a company regularly pays dividends (only) to the ordinary shareholders.

However, a ‘Family Buy Out’ may provide an even better solution in some circumstances.

A ‘Family Buy Out’ transaction, involves the investment company being sold to a company set-up by family members, and/or or family trusts, (FamilyCo) solely in return for loan notes. The sale must be at market value, which for an investment company will most likely be its net asset value. However, there are no immediate tax charges as the exchange of shares for loan notes falls within the special capital reorganisation rules determining that there has been no disposal for tax purposes.

Stamp Duty will be payable by FamilyCo, but the rate of Stamp Duty is relatively low (0.50%).

The effect of the Family Buy Out is that the ordinary shareholders now hold loan notes whose value is fixed at their face value. Any future growth of the investment company will remain outside of their estate, instead accruing to the ordinary shares held by the family members or family trust(s) in FamilyCo.

However, managing one’s death estate is only part of the potential benefit that can be achieved from a Family Buy Out transaction. The loan notes present an opportunity to extract income from the company at Capital Gains Tax rates.

The loan notes can have a right to interest (at a fixed rate). The individual personal allowance, savings allowance, and starting rate for savings can shelter a large proportion of interest received (up to £18,570). Due to targeted tax rules (such as the Employment Related Securities provisions) it is recommended interest is charged in line with current market rates. This is likely to result in more interest being accumulated than required by the loan note holders. However, only interest that is paid is subject to tax. Therefore, interest can continue to accrue in FamilyCo for future payment.

It is important, however, to be aware that a significant interest liability can quickly accumulate. To prevent this from occurring the loan note holders can waive some, or all, of the accumulated interest. The loan note holders will need to be aware that such waivers can be brought back into their death estate if they are not survived by 7 years.

Lastly, FamilyCo will need to withhold basic rate Income Tax on any interest paid. Therefore, the loan note holders will need to complete a tax return, which they likely will already do, to reclaim the excess tax withheld. FamilyCo will need to complete CT61s, and pay the withheld income tax to HMRC, quarterly.

In addition to receiving interest, the loan notes can be flexibly redeemed by the loan note holder. On a redemption of loan notes a capital gain is not realised on the loan notes (as they are redeemed at cost), but the unrealised gain on the shares that were exchanged for the loan notes is brought into charge. However, if not all of the loan notes are being redeemed, the full deferred gain does not come into charge, but a proportion of it equivalent to the proportion of the loan notes that are being redeemed. For example, if a loan note holder held £1m loan notes and he redeemed £100k, only 1/10 of the deferred gain is brought back into charge.

Each taxpayer is entitled to an Annual Exemption of £12,300 for Capital Gains Tax. Therefore, at least £12,300 of loan notes could be redeemed annually before incurring tax. Aggregating this with the maximum tax-free interest that can be received, a taxpayer could receive income of up to £30,870 before incurring any tax. Spreading the loan notes between spouses can increase this up to £61,740.

Should further income be required by the loan note holders, any gains brought into charge would be subject to the lower Capital Gains Tax rate of 10% (to the extent they have any unused Basic Rate Band) and 20% thereafter.

A Family Buy Out can therefore present much more benefit than gifts or growth shares. However, that is not to say such a transaction is right for every family investment company.

A fundamental aspect to a Family Buy Out is succession of the business. Succession does not necessarily mean 100% disposal of the business, but it is recommended that control (>50%) of the business changes from the current shareholders. Without a proper hand over of the business, the share capital reorganisation rules may not apply and (in the worst case) HMRC could apply the Transactions in Securities rules.

It is possible to receive clearance from HMRC that the share capital reorganisation rules will not be prevented from applying and that HMRC will not look to apply the Transaction in Securities rules before a Family Buy Out is undertaken, and we would recommend this is sought in any case.

Therefore, a Family Buy Out provides investment company owners with a further option to consider when assessing their estate. Depending on their circumstances it can be effective tax planning that realises a desire for wealth succession while managing lifetime and estate exposure.