Transactions, Inheritance Tax (IHT), Capital Gains Tax (CGT), Corporation Tax & Income Tax – Owner Managed Companies
It is relatively common for owners of family and owner managed companies to enter into transactions with their company. The capital gains tax, corporation tax and income tax implications of a transaction between a company and its shareholders are usually the main areas of concern for business owners and their advisers. However, such transactions could have Inheritance Tax (IHT) implications which frequently get overlooked. While in some cases, IHT might not be a major concern due to the availability of reliefs and exemptions, ignoring the IHT implications of transfers involving owner managed companies could prove to be costly.
Transfers made by ‘Close’ Companies
What is a ‘close’ company?
A close company is defined as a company under the control of five or fewer ‘participators’ or of any number of directors who are ‘participators’. A ‘participator’ is a person who has a share or interest in the income or capital of the company. Most owner managed and family businesses will fall within this definition.
The general rule
Under the main charging provisions, IHT on a lifetime transfer is charged only if there is a transfer made by an individual as a result of which his estate immediately after the transfer is less than it would have been prior to the transfer.
In the absence of any additional legislation, an individual could pass value out of his estate by affecting a transfer via a company which indirectly affects the value of his estate, resulting in the individual avoiding a liability to IHT. An individual who exercises control over a company could shift value from his shareholding to that of another person, or use the company to make a gratuitous transfer in favour of an intended beneficiary.
The rule applying to close companies
In order to prevent the avoidance of IHT by entering into such transactions involving companies, specific rules apply to close companies which extend the IHT provisions to transactions where a close company makes a transfer of value.
Therefore, an IHT charge could arise where a close company makes a transfer of value (e.g. a gift) that results in a fall in value of the property owned by the company. In such a case, IHT is charged such that each participator is treated as making a transfer of value of the amount apportioned to them, in accordance with their rights in the company immediately before the transfer.
It is important to note that as the transfer of value is made by the company rather than an individual, it is treated a Chargeable Lifetime Transfer and not a Potentially Exempt Transfer.
Amount apportioned to the participators
The amount of the transfer treated as being made by each participator is their respective proportionate part of the total transfer, which is calculated in accordance with the participator’s rights and interests. The proportionate transfer of value in excess of the participator’s nil rate band (£325,000 for 2020/21) is liable to IHT at 20%.
It is unlikely that the preference shareholders, who are entitled to dividends at a fixed rate which carry no interest in capital other than a right to repayment at par, will be disadvantaged as a result of the company making a transfer of value. Therefore, in most cases, in calculating a participator’s proportionate interest, preference shares are not taken into account where the transfer made by the company has in immaterial effect on the value of those shares. However, rights to the company’s assets in the event of a winding up are included when establishing the rights and interests of a participator in a company.
Whose liability is it?
While the IHT charge is primarily the liability of the company, the individual participators (and those who benefit from the transfer) could be liable if the IHT remains unpaid by the due date.
Limitations and exceptions to the IHT charge
As a general rule, the entire value transferred as a result of a transfer of value made by a close company is apportioned to its participators. However, there are certain exceptions where no apportionment is required to be made, which are set out below.
- The transfer of value is attributable to a payment, or a transfer of assets, which is taken into account in calculating the profits for income tax or corporation tax purposes (or would be taken into account if the exemption in relation to UK company distributions did not apply) in the recipient’s hands.
- No amount is apportioned to a non-UK domiciled individual to the extent that the transfer of value is attributable to a property situated outside the UK.
- If the amount apportioned to a shareholder is 5% or less of the company’s transfer, the IHT chargeable in respect of the transfer is not added to the individual’s cumulative total of transfers for IHT purposes. In addition, if the company defaults in paying the IHT, such a shareholder cannot be held liable and the liability remains with the company.
- In certain circumstances, it could be possible to argue that the transfer was part of the commercial arrangements to secure the transferee’s services and hence did not confer a gratuitous benefit.
The IHT annual exemption (£3,000 for 2020/21) can be deducted from the value of the amount apportioned to a participator, assuming it has not already been used in the relevant tax year. However, other exemptions such as marriage exemption, small gifts exemption and gifts out of income exemption are not available as they do not apply to deemed transfers. The spouse exemption would be available in most cases.
Alteration of Share Capital
A charge to IHT may also arise in relation to a close company where there is an alteration in a close company’s share or loan capital or an alteration of any rights attaching to shares or debentures of a close company.
If as a result of the alteration, there is a loss in value to the participator, it is treated as a transfer of value in the company. Therefore, the relevant participator will be treated as making a chargeable lifetime transfer at the time of the alteration.
Transfer of value to a company
In addition to transfers of value made by close companies, transfers of value from an individual to a company (e.g. a gift) is also treated as a chargeable lifetime transfer for IHT purposes, subject to any available exemptions or reliefs.
A chargeable lifetime transfer to the company in excess of the transferor’s nil rate band (£325,000 for 2020/21) is liable to IHT at 20%. Additional IHT may become due if the transferor dies within seven years.
The IHT charge is based on the reduction in value of the individual’s estate as a result of making the transfer. However, where the individual making a gift to the company is a shareholder, this reduction may be offset by any increase in the value of the individual’s shares as a result of the transfer/gift of asset.
The IHT implications of transfers to and from companies often tend to be overlooked. However, in addition to the income tax, capital gains tax and corporation tax implications of such transfers, it is important that consideration is given to the IHT implications as ignoring the IHT position can prove to be costly for the company (and potentially the shareholders).