I am sure many people are familiar with the concept of a Family Investment Company (FIC).
They were seen as the new alternative to trusts when a young Gordon Brown, prior to his successful period as British Prime Minister, ‘simplified’ trust taxation with effect from March 2006.
From this time, virtually all new trusts would become subject to the Relevant Property regime for Inheritance Tax (IHT) purposes. In other words, tax on entry, tax every ten years, and tax on exit regardless of the type of trust unless one could make use of particular exemptions.
FICs – What was the song and dance about?
Broadly, the idea was thus.
Form a new family Company, with the, say, Parents as Directors. They would exercise control of the assets and make day-to-day investment decisions similar to the Trustees of a Trust. The Children would get shares, with a high degree of flexibility over the rights to capital and income.
Any value which passed in to the shares of the Children would result in a Potentially Exempt Transfer (PET) and, as such, would not suffer an immediate charge to IHT.
FICs were, and are, in their element when the founders are transferring cash. Otherwise there can be CGT problems (in the absence of any available relief) and, in the case of property, Stamp Duty Land Tax (SDLT) will be relevant.
Where this cash is invested in equities, then the dividends on those equities could be received by the FIC free of tax. This enable gross reinvestment of such income. Even where the income is not dividend income, then the 20% rate of corporation tax (which will fall further to 18% over coming years) means that there will be more to reinvest in the investment business using this route. Of course, one should not forget that if one wishes to personally extract value then there will be a second layer of tax on the funds that are drawn upon.
For the avoidance of doubt, the rest of the relevant property regime does not apply to Companies, so there is an absence of any 10 year or exit charges.
Dividend tax rules
So we come on to the new dividend tax rules announced at the Summer Budget 2015. These will take effect from 6 April 2016.
The effect of the changes:
- Scrapping the 10% notional tax credit
- Tax-free dividend allowance – £5k
- 7.5% if falls in the basic rate band
- 32.5% if falls within the higher rate band; and
- 38.1% if falls within the higher rate band
So why such a monumental shift? Although there have been discussions for many years regarding the unification of income tax and National Insurance Contributions (NICs), these specific changes came truly out of left field. It was surprising for at least the following reasons:
- The proposals were not in the original Budget this year. There were some Summer Budget announcements where it was obvious to see they were Conservative manifesto promises and measures the Lib Dems would not have been prepared to back whilst in coalition Government (for example, the changes to the nil rate band for families with large properties – but with limited other assets). However, this seems to be one policy for which Lib Dem support would not be lacking;
- Secondly, it comes in a context of various consultations to IR35 etc – one assumes that this was the real mischief being targeted.
The effect of the dividend tax changes – a case study
Let’s say Mr X has Company (XTC Trading) worth £5m. He is the sole shareholder in the Company and sole Director. It makes profits of £1m per annum.
Up until now, as is typical of SMEs, he has taken a small salary of £12,500 per annum and paid himself dividends of between £300k – £400k per annum. This year he has paid himself a dividend of £350,000. He has other income – including his salary, a consultancy fee and property income – which already takes him in to the 45% tax bracket.
For the current year, his tax bill in respect of his dividends is:
Going forward, his tax bill in respect of his dividends will be:
This is a significant increase in the income tax payable by Mr X. I am sure he is relieved that the Conservatives introduced the income tax ‘lock’ guaranteeing no tax rises!
What action might he take now?
Consider maximising dividends prior to the 6 April 2016. This might include clearing out the Company’s distributable reserves.
One could of course loan the money back to the Company to provide working capital if cash was required in the business.
What might he take going forward?
One might also consider putting in place a Family Investment Group (FIG). This would involve Mr X establishing a new holding company. He might then consider selling his shares in XTC Limited to the new holding company.
On the Sale of the shares, the consideration is left outstanding. This creates a loan account in Mr X’s favour for £5m. Mr X may draw down on this loan free of further tax in the future.
The sale, assuming the Company qualifies for Entrepreneurs’ Relief, would crystallise a tax liability of £500k (assuming no base cost of the shares for CGT purposes). If that sale took place in December 2015, then the CGT would be due then this would be due by 31 Jan 2017. If the Company carried on its present level of profitability it could have potentially have paid down (to Mr X) £1-1.2m of this loan account. Therefore client would be ‘in the money’ and able to pay the CGT.
As discussed earlier, XTC Limited can pay up dividends to FIG without corporation tax. Alternatively, FIG could then invest – directly or indirectly – in to another commercial project.
Is there a risk of Transaction in Securities anti-avoidance legislation biting? These provisions try to prevent one converting profits which would be subject to income tax in to a more favourable capital treatment? This would need to be reviewed, and addressed, on a case-by case basis.
From an IHT perspective, is there a risk that the group is no longer a trading group? This could be the case where the new project is a non-trading project and its value becomes proportionally significant in respect of the overall group. This could be addressed internally. Alternatively, it could be used by sheltering the value of the group (or parts of the group) within a structure.