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Sheltering Investments from Inheritance Tax (IHT) - Owner Managed Businesses (OMBs)
09/07/2005, by Mark McLaughlin CTA (Fellow) ATT TEP, Tax Articles - Business Tax
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Tax Adviser by Julie Butler, FCA

Julie Butler, FCA, of Butler & Co, offers an inheritance tax planning suggestion for owner managed business proprietors.With property prices having increased so much in recent years and with most houses exceeding the Nil Rate Band for IHT there is great concern over sheltering private investments (and possibly property) from inheritance tax in the small family company.

Inheritance tax (IHT) business property relief (BPR) is a complete exemption from IHT and can be secured on circumstances where it might not be expected to be found – in the Owner Managed Business (OMB).

Investments, property and portfolios

Historically claims for BPR have not been based on how much work is put in by the taxpayer over the years to generate the wealth which is now to be taxed.

S.105 (3) IHTA 1984 states:

‘consists wholly or mainly of one or more of the following. That is to say, dealing with securities, stock or shares, land or buildings or making a holding investment.’

Case history has focused on the latter element of the ‘making a holding investment.’

The basic rule for investments and IHT is straightforward:-

The business does not qualify for business property relief if it consists wholly or mainly of…making or holding investments.

So how can an OMB be used to shelter securities, land and ‘holding investments’ for IHT purposes?

The taxpayer owns a family trading company (an OMB). When the taxpayer dies the taxpayer’s shares can be passed onto the next generation completely intact. That is because there will be no IHT to pay on these shares, thanks to 100% business property relief (BPR).

The taxpayer also owns a substantial portfolio of quoted shares. Unfortunately, these will eventually fall into the IHT net outside the OMB.

The taxpayer can consider the transfer of this portfolio of shares into the OMB. It is likely that there will be little or no Capital Gains Tax (CGT) to pay on the transfer because, as a result of the stock exchange ups and downs of recent years, the portfolio has a large risk of a profit. (Alternatively, if a few of the shareholdings do show substantial inheritance gains, perhaps these could be left out of the transfer so as to avoid the CGT that would otherwise arise). The other side of the transaction is the director’s loan account. This does leave a director’s loan account to draw from tax free.

Protection for Existing OMB Investments

It could be that investments are not currently held outside the company. However, the company has surplus funds which have been generated at the retained profit tax rate of only 19%. Investments can be purchased by the company or it could be that investments have already built up.

The portfolio (or so much of it as is transferred to the company) or other investments become eligible for business property relief (BPR) in full in the correct circumstances.

Investments inside an OMB

When it comes to shareholdings held in family companies (OMBs) the IHT business property relief (BPR) rules are surprisingly generous. Provided that the business of the company is one of mainly trading – in particular, it does not fall foul of the ‘wholly or mainly investment’ rule mentioned above – relief is given in full at 100%.

It is essential to ensure that the trading side of the company’s business remains more valuable than its investment side. But that’s all. If the company is 60% trading and 40% investment, the family company’s share qualify for 100% business property relief. Most importantly, the entire value of the shares qualifies, not just 60% of their value. However, the Capital Gains Tax (CGT) rules may restrict this to up to 20% of the whole for planning purposes.

Capital Gains Tax (CGT)

CGT may restrict this advantage by up to 20% of the whole of the business for planning purposes. Having investments in the OMB can cause problems if the shares will be gifted (and holdover relief utilised) or sold (and BATR utilised).

Having investments in the OMB can cause problems if the shares on the family company will be gifted.

• CGT ‘holdover’ relief. This relief applies when shares in a family trading company are given away. (Without the relief, the shares are deemed to be disposed of at market value and, as a result, a substantial CGT charge could be triggered.) However, if the company owns some non-trading assets – such as stock exchange investments – the amount of ‘holdover relief’ is reduced proportionately.

• CGT business asset taper relief (BATR). A small amount of non-trading activity is permitted – up to 20% - but that’s all. So, if 40% of the value of the company is represented by investments, the proportion of the shares that qualify for BATR.

The key can be to restrict the holding of investments to less than 20% to protect the potential IHT and CGT relief.

Cash Balances

Is the IHT relief achieved on cash balances? Generally speaking, cash on deposit does not rank as part of a trading business. So business property relief is likely to be denied on the proportion of the value of the OMB’s shares that is represented by cash on deposit.

So what are the considerations?

If the value of the investment transferred into the OMB causes the 20% test to fail, then business asset taper relief (BATR) will indeed be forfeited.

Two Year Ownership Rule

What of the two year rule for IHT?

When the taxpayer transfers investments into the company, presumably business property relief for these investments does not kick in immediately because of the two year rule?

There is the IHT rule, which says that business property relief does not apply until an asset has been owned for at least two years. The asset here is the shareholding in the ‘mainly’ trading company. So, provided that the shareholding in the trading company has already been owned for at least two years, then relief for the value of the investments which has the increased value of the company shareholding becomes available immediately.

BPR applies to the whole of the company provided it meets the trading criteria and the two year rule can be overlooked.

Controlling existing problems

Many OMB can build up investments without realising that they are investments. Classic examples would be a farmer that starts to let out more and more cottages – see Farmer (Farmer’s Executors) v IRC (1999) STC (SCD) 321. In this case BPR was allowed on 22 let cottages. This was not a limited company and the theme was a unified management. Five areas looked at here were capital employed, time spent by employees, and consultants and the level of turnover.

Other examples are where former trading premises are let, e.g. manufacturing business with more away from space lets premises as ‘an investment’. Could this mean that BPR has lost because they push the OMB into making a holding investment company?

A key factor here is that as a result of s.160 FA 2003 let property qualifies for BATR from 6 April 2004. This could place the OMB in a dilemma. Leave the let investments property in the limited company to achieve IHT shelter but forsake future BATR?

What of the position of SDLT?

Tax Planning Opportunity

It is not often that the opportunity arises to secure a complete exemption from IHT on pure investments – such as a portfolio of stock exchange securities.

It is essential to ensure that the value of the investments does not outweigh the trading activity. The company must at all times remain a ‘mainly’ trading company – the value of that activity must always be more than 50% trading rule.

In summary, if OMBs do decide to look at the investment angle the directors must monitor development. If the value of the investments increase substantially in value, the trading company could suddenly become an ‘investment’ company. Die at the wrong time and the next generation will find that they have inherited a ‘mainly investment’ company instead of a ‘mainly trading’ company and that you have skilfully converted an asset, which attracted 100% business property relief, into one that attracts no relief for IHT.

The key appears to be the 20% rule, thus protecting IHT reliefs and BATR.

April 2005

Julie Butler

Julie Butler F.C.A., Butler & Co, Bowland House, West Street, Alresford, Hampshire, SO24 9AT. Tel: 01962 735544. Email; j.butler@butler-co.co.uk.

Julie Butler F.C.A. is the author of Tax Planning for Farm and Land Diversification ISBN: 0754517691 (1st edition) and ISBN: 0754522180 (2nd edition) and Equine Tax Planning ISBN: 0406966540. To order a copy call Tottel Publishing on 01444 416119.

As featured in April 2005 Tax Advisor.

About The Author

Mark McLaughlin is TaxationWeb's Co-Founder, Director and Technical Editor. He is a Fellow of the Chartered Institute of Taxation and a member of the Association of Taxation Technicians and the Society of Trust and Estate Practitioners. He lectures on tax subjects, is co-author of Tottel's IHT Annual and Ray & McLaughlin's IHT Planning, and Editor of Tottel's Tax Planning and Annual series. Mark's work has also been published in Taxation, Tax Adviser, Tolley's Practical Tax, Tax Journal and Simon's Weekly Tax Intelligence.

Since January 1998, Mark has been a consultant in his own tax practice, Mark McLaughlin Associates, which provides tax consultancy and support services to professional firms. He publishes a regular 'Tax Update' e-Newsletter for clients and other professional firms. To receive future copies, contact Mark via his website.

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