Practical guide: are family investment companies still efficient?

Recap - changes

From April 2023, the dwindling dividend allowance and altered personal tax bands at the upper end increases the income tax payable on large dividend incomes from share portfolios. As the rate of corporation tax (CT) increased to 25% on April 2023, how does this affect the optimum strategy for reducing revenue taxes overall while protecting capital wealth from expensive inheritance tax (IHT) charges?

Family investment companies (FICs) will generally not benefit from the small company tax rate because they are deemed to be close investment holding companies, i.e. owned by a few people with the primary motive of investing. FICs will therefore pay CT at the 25% rate, regardless of the level of profits.

What’s a FIC?

A FIC is a private company which is owned by different generations of the family and makes investments using the family’s wealth.

It’s much easier to allocate portions of wealth to family members through shares than splitting up, say, a property portfolio.

Inside the company, accumulated profits are taxed at a much lower rate and the company claims tax relief for management expenses which are incurred in the business of making investments (for HMRC guidance see here). The disadvantage of a corporate structure is the potential double taxation of most types of income, i.e. the company is taxed and then any income paid out to individuals is taxed again.

Shares in the FIC itself won’t qualify for the useful IHT exemption of business property relief (BPR). Hence any share portfolios which include alternative investment market or enterprise investment scheme companies should not be transferred into the FIC.

Personal vs FIC

If an individual holding the underlying shares is likely to pay income tax at the higher or additional rate in 2023/24, they will suffer the dividend higher rate (33.75%) or the dividend additional rate (39.35%) respectively on dividend income in excess of their £1,000 dividend allowance (which falls to just £500 in 2024/25).

By comparison, an FIC would pay no CT on its dividend income, allowing it to roll up the investment income and create an asset of significant value which can be passed on to the younger generation. However, other profits received by the FIC are liable to CT.

Any CT deduction for interest paid on mortgaged properties will be unrestricted (unlike if the property business is held personally).

Control

The directors tend to be the donors of the assets, so they can retain control while enabling other family members to become shareholders and thereby share in the wealth.

It’s also possible to issue different classes of share, perhaps including preference shares or alphabet ordinary shares, which separate voting rights from rights to income and capital. The donors can therefore remain fully in charge of the company’s investment policy while dividends may be payable at different times and rates to various shareholders, depending on the type of share held.

The articles of association should contain pre-emption rights so that shares in the FIC are first offered for sale to other family members, including the potential for matrimonial breakdown.

Case study - the Barnards

The Barnard family consists of two parents and four children. The parents retain vital control by holding the majority of the ordinary A shares (by reference to par value), while the right to income is dispersed among the younger generation through B shares:

 

Shareholder	Ordinary A	B shares
Mr Barnard	£130,000
Mrs Barnard	£130,000
Julian	£10,000	£50,000
George	£10,000	£50,000
Anne	£10,000	£50,000
Richard	£10,000	£50,000
Total	£300,000	£200,000

Limited or unlimited?

The family will also need to decide whether to set up the FIC as an unlimited company, which protects the family’s privacy as no accounts are required to be published at Companies House. However, if there is any chance that the FIC will trade or hold property (as opposed to just a stocks and shares portfolio), the limited liability afforded by the corporate veil is vital, as seen in Prest v Petrodel Resources Ltd and others [2013] UK SC 34.

An unlimited company can convert to limited status and vice versa, but only once.

Transferring the assets

Once the company is formed, the subscriber shares will be issued in return for cash, when no tax charge will arise as the FIC has no assets at that time.

Further share issues can be financed by gifts of cash from the donor to the children, which will escape IHT so long as the donor survives seven years.

Any investments subsequently transferred into the company will be subject to CGT and either stamp duty (on shares) or stamp duty land tax (on property) as a transfer at market value between connected parties.

To save transaction costs when a sale of certain assets is likely, it’s better to transfer investments to the company first and then sell.

The current market value of the assets transferred into the company, plus the associated tax charges of transferring them in, can be left outstanding on directors’ loan accounts. The FIC can then gradually repay the loan over several years, which will offer a tax-free injection of cash to the donors. For IHT purposes, the value of any property transferred to the company has now been replaced by the directors’ loans so there is no reduction in the value of the donors’ estates.

Extracting income

The basic idea of most tax-efficient extraction is to use up everyone’s personal allowance and basic rate tax bands by paying out sufficient income. If higher levels of income are required, careful consideration should be made of the twin challenges of the high marginal rate created by the abatement of the personal allowance (which starts when income hits £100,000 in 2023/24) and the additional rate band (which starts at £125,140 in 2023/24). If a regular income is required, the payment of a small salary to each director (broadly up to the level of the personal allowance of £12,570), along with employer pension contributions (limited to £60,000 p.a. but not assessable as income) and taking the rest as dividends, is a tried and tested strategy.

Salaries for family members who have less involvement in the business is more problematic because of likely HMRC challenge.

When considering any income extraction policy, the legal, commercial and practical implications are very important, not just the tax consequences.

What about trusts?

Trusts can still complement tax planning involving an FIC. For children, it would be best for a discretionary trust to be set up which itself becomes a shareholder of the FIC. This avoids any settlement argument from HMRC, which might seek to tax the parents (but not grandparents) on the income of minor children, and allows those who have not yet been born to be beneficiaries of the trust. A 20% IHT charge can be avoided on set up if a cash sum is settled which is under the combined nil rate bands of the donors (£325,000 each). However, there will be an IHT charge on exit and also every ten years at a maximum rate of 6%.