If growth was to arise inside a discretionary trust, what are the IHT implications?If capital growth occurs within a discretionary trust, then the trustees need to be mindful of a potential periodic charge (principal charge) which arises when the trust reaches its 10-year anniversary (of the date on which the trust commenced) where the trust fund must be assessed to see if any IHT is due. This happens on every 10th anniversary of the trust until all the assets of the trust have been distributed to the beneficiaries. If appropriate, Business Property Relief (BPR) and Agricultural Property Relief (APR) available on relevant investments held by the trustees can be deducted to arrive at the chargeable value. Further details including information on exit charges are available here. |
IHT & Estate Planning
What is a family investment company and how does it compare to a discretionary trust solution?
Last Updated: 6 Apr 24 9 min read
Family investment companies can be used by High Net Worth individuals for inheritance tax (IHT) planning purposes.
Contents
1. Key Points
2. When to use a family investment company
3. How might such a strategy work?
7. Summary
Key Points
- The individual typically subscribes for shares in a non-trading company.
- The company’s profits will be subject to corporation tax.
- Control can be exercised through carefully drafted articles of association.
- It’s useful to compare family investment companies with discretionary trusts (excluding the settlor as a potential beneficiary) which have traditionally offered flexibility for IHT planners
When to use a family investment company
High Net Worth individuals with large estates might consider using a UK resident family investment company as part of an IHT planning strategy. Those with a modest potential IHT liability are unlikely to use a family investment company due to the legal and professional costs involved.
How might such a strategy work?
The individual client subscribes for voting shares in a company. These give control of the company at shareholder and board level. The client can also subscribe for non-voting shares, there may be multiple classes, which can be given to children and other family members. These non-voting shares may pay dividends in the future or may give rights to capital on the winding up or disposal of the company. If different beneficiaries have a different class of shares, then the directors can decide what type of dividend they pay to each class of shares – that might mean every family member receives the same or it may mean that the directors can choose to pay different amounts of dividends to each recipient based upon their particular requirements.
Over time therefore the client gives away shares in the company to family members (see the “Keeping control” section below). These gifts will be transfers of value. Alternatively, the client might lend money to the company in order that he/she can receive future tax free loan repayments.
So, a situation is being created where the client retains the shares with power, i.e. the voting rights but no rights to income or capital. But in contrast the children, grandchildren etc. will have all the rights to income and gains but no voting rights. The client and perhaps others may of course draw salaries if desired.
The client might also transfer assets into the company but needs to be mindful of potential CGT, IHT and stamp duty land tax consequences. Also, the founder may lend cash to the company which can be repaid tax free in due course. Although the value of the loan continues to be an asset of the founder's estate, most of the income and capital growth will be attributed to family shareholders.
The company will invest in various financial instruments including shares, OEICs, deposits, and capital redemption bonds. The company could also invest in property – both residential (buy to let) and commercial. A life assurance bond would only be appropriate if there was an insurable interest between the owner (the company) and the life assured (a director presumably).
If the company’s investment strategy succeeds and capital growth is achieved, then the value of the company will increase. In contrast to a discretionary trust, there are no ’10-year anniversary charge’ implications for a family investment company.
Further tax considerations
When the client subscribes for shares in the company, that is typically not a transfer of value for IHT purposes. The client’s estate will not have fallen in value if cash has been replaced with shares of the same value.
If a client made a lump sum gift into a discretionary trust, what IHT consequences would arise?Non-exempt gifts into a discretionary trust are classed as chargeable lifetime transfers (CLTs). When setting up a new trust, the settlor must take into consideration any previous CLTs (e.g. gifts into discretionary trusts) made within the previous seven years. If this total does not exceed the client’s nil rate band (NRB) there will be no entry charge. If the CLT exceeds the client’s available NRB there is an immediate charge of 20% on the excess, assuming no relief such as BPR is due. If it is a couple who are setting up the trust you double up the NRB. Remember that settlor(s) cannot benefit so as not to trigger IHT gift with reservation issues. Further details on discretionary trust entry charges are available here. |
Following the establishment of a family investment company, subsequent outright gifts of shares (in the family investment company) to family members will be PETs (Potentially Exempt Transfers).
Note incidentally that the outright gifts mean that the recipients will have the gifts sitting in their personal estates for IHT purposes. In saying that, shareholders with a minority interest will have the value of that shareholding discounted for IHT purposes reflecting the size of their shareholding and their inability to sell the shares or demand income from the company.
It might, in some circumstances, be desirable to transfer shares into discretionary trust in which case the transfers would be CLTs. Outright gifts are however more likely.
The gifts of shares in the company will also be disposals for capital gains tax (CGT) purposes. So it might be appropriate to gift shares shortly after the company is formed while capital gains are relatively modest. Note that if shares are gifted into a discretionary trust the gifts qualify for ‘chargeable transfer’ CGT hold-over relief.
The company will not be a trading company and therefore ‘gifts of business assets’ holdover relief will not be available.
On the client’s death any shares in the company still held at date of death will be subject to IHT. Business Relief for IHT purposes (BPR) will not be available since the company will be non-trading.
If a client who has set up a discretionary trust dies, what are the IHT implications?If the settlor dies within seven years of making a gift into a discretionary trust, there may be further tax to pay. The gift is measured against the settlor’s NRB available at death and if this is exceeded a calculation is done based on the full death rate of 40%. Remember any failed PETs are included in the calculation. Gifts eat into the settlor’s NRB in chronological order. Also, what if a potential beneficiary of a discretionary trust dies? There are no IHT implications when a potential beneficiary dies as none of the trust fund falls inside the estate of a prospective beneficiary. Instead, the trust fund is subject to the discretionary trust relevant property regime referenced above. |
Company issues
The company could be unlimited. There may be little point in limited liability if the company only holds investments and there is no borrowing. Unlimited companies do not have to file accounts with Companies House.
The company’s profits will be subject to corporation tax. Dividend income received by the family investment company is corporation tax exempt. Certain capital gains, subject to corporation tax, made by the company may benefit from indexation allowance up to December 2017.
Corporation Tax increases
Spring Budget 2021 introduced a three-pronged approach to corporation tax in the future. Subsequently, the 23rd September 2022 “mini-budget” reversed these changes but these were then reinstated (and confirmed in Autumn Statement 2022) so we are left with the changes as originally planned and these are:
- Corporation tax is 19% for the financial years starting 1 April 2020, 1 April 2021 and 1 April 2022.
- From 1 April 2023, the headline (i.e. main) corporation tax rate increased to 25% applying to profits over £250,000.
- A small profits rate (SPR) was introduced for companies with profits of £50,000 or less so that they continue to pay Corporation Tax at 19%. Companies with profits between £50,000 and £250,000 pay tax at the main rate reduced by a marginal relief providing a gradual increase in the effective Corporation Tax rate.
The SPR does not apply to close investment-holding companies. An example would be a company controlled by a small number of people which doesn’t exist wholly or mainly for the purpose of trading commercially or investing in land for (unconnected) letting. A Family Investment Company might therefore be an example of a company not eligible for the SPR.
The decision makers will decide if the company should distribute income to shareholders or retain and reinvest the after tax profits.
The company will (presumably) pay dividends from time to time. The distribution of dividends can be controlled by having different classes of shares (see below). The recipients of such dividends may be able to use their dividend tax ‘allowance’. In 2022/23, 2023/24 and 2024/25 the rates of tax on dividend income above the dividend nil rate are
- 8.75% for dividends in the basic rate band
- 33.75% for dividends in the higher rate band
- 39.35% for dividends in the additional rate band
The dividend nil rate is £500 from April 2024.
If a discretionary trust has been set up, how are investments taxed?In 2023/24, trustees of a discretionary trust paid tax on the first £1,000 p.a. slice of trust income at just 20%. Dividend income was taxed at 8.75%. In Budget 2023, the chancellor announced the removal of the default basic rate and dividend ordinary rate of tax that applied to the first £1,000 slice of discretionary trust income from 2024/25 onwards. There are also measures in 2024/25 to simplify low income (up to £500) trusts and estates. From 6 April 2024, trusts and estates with income of all types up to £500 do not pay tax on, or report, that income as it arises. Where the settlor has made other trusts, the amount is the higher of £100 or £500 divided by the total number of existing trusts (subject to some exceptions). Once the £500 limit is exceeded the trust rates of tax apply to all income remembering that the £1,000 standard rate band is being abolished from 2024/25. In 2023/24 where the trustees’ annual income exceeded £1,000, the excess was chargeable at trust rates i.e. 45% for non-dividend income and 39.35% for dividend income. Beneficiaries will be subject to tax on trust income distributed to them, or for their benefit, by trustees and will be able to recover from HMRC any difference between the tax paid by the trustees and their own rate of tax. When the trustees distribute income, the trustees need to account for tax at 45% on the income distributed. The beneficiary will be in receipt of trust income, not savings or dividend income. Therefore, neither the beneficiary’s personal savings ‘allowance’ or the dividend ‘allowance’ will be available against that income. Where the settlor has retained an interest, the income arising is treated as the settlor's income for tax purposes. A settlor will have retained an interest if the property or income may be applied for the benefit of the settlor, a spouse or civil partner. Regarding CGT, the rate for trustees is 20%. There is however a 24% rate (2024/25) for gains on residential property not eligible for private residence relief. The Annual Exempt Amount (AEA) is generally half the exemption available to individuals unless a number of trusts have been created by the same settlor. In which case the exemption is further reduced subject to a minimum exemption of one fifth of the available amount. In his Autumn Statement 2022, the Chancellor announced that the CGT AEA for individuals will reduce from its 2022/23 level of £12,300 to £6,000 from April 2023 and to £3,000 from April 2024. Given that beneficiaries of discretionary trusts have no entitlement to income, then the trustees might consider investing in non-income producing investment bonds. And it is the fact that withdrawals can be made from investment bonds without any immediate tax consequences which commends them for use by trustees of discretionary trusts. Further details contained here. |
Keeping control
Control can be exercised through carefully drafted articles of association and through the structure of share capital. For example, different classes of ordinary shares (e.g. A, B and C shares) could have different entitlements to voting, dividends, and capital on winding up. The ability to transfer shares but retain voting rights, for example, may be appealing to the client. As stated above, these gifts of shares will represent transfers of value for IHT purposes, and disposals for CGT purposes. So for example, the client might hold A shares with the right to appoint directors, right to vote but with no entitlement to dividends or return of capital. Children and grandchildren might then receive B shares which have no voting or control rights but full entitlement to dividends as approved by the client. In short, the client is passing on the economic interest but retaining control of assets, investments and dividends.
If a discretionary trust is set up, what control do the trustees have?Regarding the rights of beneficiaries, there are two main types of trust – those where the beneficiaries have an enforceable (‘vested’) interest, and those where they only have a prospective interest – and there are sub-categories of each of these types. If an individual has a prospective interest only – that’s a discretionary trust where there are no actual beneficiaries, only potential ones, and that can include (yet) unborn children, grandchildren etc. A discretionary trust is therefore extremely flexible, and the trustees are very much in control regarding who benefits, when they benefit, and how much. |
Summary
There are many possible variations on planning strategies using trusts and family investment companies. In certain situations, clients might use both, but they need to be mindful of the costs involved in using a corporate solution. A family investment company is less likely to be used for non HNW clients, but a discretionary trust can work well for, relatively speaking, more modest sums within discretionary trust NRB limits where lifetime tax, 10th anniversary charges and exit charges can legitimately be avoided. Finally, remember that a client who has made no previous CLTs can gift £325,000 (£650,000 for a couple) into a discretionary trust and then repeat the exercise 7 years later without incurring lifetime IHT.
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