Matt Pitcher is a financial consultant at Towry Law.
Given the extent of tax changes proposed under the UK's latest budget, how can high net worth individuals at the helm of family businesses best manage their wealth in a changing tax landscape?
The expectation for the 2004 budget and finance bill was that the chancellor would become more aggressive towards inheritance tax (IHT) avoidance. As predicted the chancellor implemented a broad ranging attack on trusts allowing the settlor to continue to benefit from an asset they had 'gifted'. This legislation is wide in its scope, retrospective in some of its effects, and therefore rules out many existing avoidance schemes.
The Inland Revenue also announced that, in the future, if firms construct certain types of tax avoidance structure they must take the concept to the Revenue first for approval. The anticipation is the loophole will be closed before the approval is ever granted.
This leaves everyone, including business owners, questioning what they can still do to mitigate against tax on their death. As the only avoidance methods are the ones existing already within the legislation it is important to know their scope and how they apply to your assets and business.
The first and most important factor to consider when assessing tax and your ability to avoid it is your future plans. Any well-run business or individual will have a business plan – a roadmap of where you want to be in five or ten years' time. Too many individuals and businesses do not consider making this kind of forward planning but it is the only starting point to ensure you put together a sound financial planning strategy. Without knowing where you (or your business) want to be in the future it is impossible to plan for tax, financial or legal milestones along the way.
If you are considering passing on a business then it is important to consider whether you wish it to pass to the family, employees or even an outsider. You may even want to sell out of the business. The aim of exploring some of these issues is to try and model a variety of 'what if?' scenarios. In reality there is seldom a perfect solution. By making a choice, which is the most appropriate based on what you know at the time, you should prevent your family and business being left in financial crisis.
Inheritance tax is not a large revenue earner for the Exchequer but it is one of the most cost-effective taxes to collect and its value is rising sharply. By only gradually increasing the allowances for inheritance tax while asset values, particularly property, rise strongly this tax is becoming an issue for an ever-larger proportion of the population. Unfortunately it tends to penalise SMEs more than big businesses or the very rich.
The inheritance tax relief available to business owners is generous, however, providing your business qualifies for it. On the death of the business owner where the family is to inherit, relief is given to remove the value of business assets if they qualify as 'relevant business property'. The deceased must have held them for at least two years prior to death. Business property relief is available at a rate of 100% for most businesses, unquoted shares or shares quoted on the unlisted securities/alternative investments markets and unlisted securities which gave the deceased control of the business. Relief at 50% is available for listed shares which gave the deceased control of the company or land, buildings, plant or machinery which were used wholly or mainly in the business.
Business owners should examine whether their business qualifies for this relief and make any necessary changes. The issue of control of the company is an important one. 'Control' is the holding of shares or securities which give the person control of the majority of the voting powers affecting the company as a whole. In this respect non-voting shares even when owned with shares that give control cannot be counted. It may be appropriate to reorganise the share capital within the business to ensure that it reflects the legislation. However, if your company is listed, it may not be appropriate to start giving away your shareholding to family members in the hope of avoiding IHT only to lose business relief when your own shareholding loses its majority control. If shares are transferred then the new owner must hold them for two years to qualify.
Most businesses themselves will qualify for the maximum relief. Exceptions to this rule are businesses which wholly or mainly deal in securities or property, businesses not carried on for gain, and businesses subject to a contract for sale or being wound up. The exception to the latter is where a company is being restructured and is continuing to trade.
One important exception to business assets which qualify for relief are those defined as an excepted asset. This is an asset which is not used for the business purposes in the two years prior to death. This may include assets such as a cash surplus which has accrued in the business with no clearly defined purpose (or personal assets such as a yacht or foreign property).
Capital gains tax
If a business owner decides on sale of the business rather than retaining control until death then capital gains tax is likely to come into play. The whole process of selling a business is likely to be one of the most stressful events a business owner ever has to confront. There are legal and regulatory issues for the seller to consider and then the buyer will need to carry out a health check on their prospective purchase before taking on any potential liabilities. The tax efficiency of the business is likely to be an important issue for both buyer and seller.
Capital gains tax has an equally generous business relief but again care must be taken to ensure the business assets qualify. Business asset taper relief (BATR) reduces the chargeable amount by 50% if the asset has been held for one year and 75% if the asset has been held for two years or more. This compares favourably with the non-business asset relief which only reduces after the third year and where maximum relief is 40% after 10 years.
For a company to qualify for BATR a majority of its revenue and assets must be used for trading purposes.
Cash is not king
We have seen that holding cash or investments within a business can drastically effect the reliefs available for both IHT and CGT. However, it can be expensive to distribute cash from the business and time can also be an issue.
Companies pay corporation tax on their profits at rates varying from as low as 0% to 30%. However, if salary is paid or if taxable benefits in kind are provided, there is a tax charge at up to 40% on whoever receives it, as well as national insurance (NI) for both the company and the employee to pay. The salary and/or benefit in kind (BIKs) and employer's NI reduce the profit, so corporation tax is also reduced, but the overall tax (and NI) cost can be as high as 47.7%. If a dividend is paid there is a tax cost of up to 25% for the person receiving it.
To avoid this problem it is often sensible to move cash out of a company via some form of pension planning. Pension funding is generally the most tax efficient solution to the problem. The tax cost of taking money out of a company and putting it into a pension fund is normally zero for both the company and the shareholding director. Also the removal of surplus cash from a company can restore the valuable inheritance tax business property and capital gains tax business asset taper reliefs.
Time is a consideration and to get the full benefits of business relief, the company cannot have held any significant non-qualifying assets within the last 10 years of ownership (or the period of ownership after 6 April 1998 if it is a shorter period).
Regular reviews are vital to keep a company's position under control. It may well be necessary to extract cash from a company every year to keep the balance of company money within the limits for CGT and IHT purposes. In reality, it will be necessary to take money out of a company by a mixture of routes, including salary/BIKs, dividends and pension funding. The calculations can be time consuming, especially if you are looking at a number of different combinations. This is where professional advice is required.
The UK government's pension simplification proposals are due to come into force on 6th April 2006. They include proposals for radical changes. Perhaps the most important to business owners is the replacement of a percentage contribution based on age with an upper limit of annual salary or £215,000 per annum in the first year. This opens up wider possibilities for business owners to increase their own drawings from the business and at the same time extract large amounts of value from the business while benefiting from full tax relief.
One area that is often neglected during the business succession planning process is personal financial planning.
Capital gains tax is fairly easily avoided by individuals on everything other than second properties. Inheritance tax on the other hand is more complex. There is no substitute for professional financial advice but it is worth noting that there are still trust solutions available for liquid assets allowing some retained benefit for the settlor. Also, with all the changes to the pension legislation many people need to review their policy to ensure their plan or current payments are still appropriate.