Using a Trading Company
Save tax by investing in property via a company
In this article, I will look at some of the advantages of making investments through a company, as well as some of the pitfalls to watch out for.
Capital Gains Tax (‘CGT’)
The biggest potential drawback in holding any form of non-trading assets through a trading company is that the company may lose its trading status for CGT purposes.
This does not affect the company itself (although, as we saw last month, there can also be an extra Corporation Tax cost if a company holds too many investments other than rental property), but it can lead to substantial increases in the company owners’ CGT bills on a sale or transfer of their company shares.
Two major CGT reliefs, in particular, are only available where the company has trading status: holdover relief and entrepreneurs’ relief.
Holdover relief allows a company owner to transfer their shares to another individual, or a trust, free from CGT. The relief cancels out the usual rule that such transfers are treated as taking place at market value for CGT purposes. Full relief only applies to gifts, but partial relief may be claimed for sales at below market value.
The relief is most often used for passing on company shares to the next generation, or for putting them into trust for a wider class of beneficiaries. It’s a useful relief, so losing it could be a bad idea!
Where entrepreneurs’ relief is available, the CGT rate applying to the first £10m of capital gains arising on a sale of the company’s shares is reduced to just 10% (instead of 28%). That’s a potential saving of up to £1.8m for an individual company owner; or up to £3.6m for a couple.
Losing out on entrepreneurs’ relief because you held a few investments through the company could therefore be a pretty costly error.
At this point, I should point out that most rental property is classed as an investment, and not a trading asset, for CGT purposes. Although rental properties do not generally affect the company’s Corporation Tax rate, they most certainly can affect the owner’s CGT rate. Qualifying furnished holiday lets are an exception, however, as these are treated as trading assets for CGT purposes.
So, How Many Investments Can The Company Hold?
As we can see, holding investments through a trading company can lead to substantial increases in the owners’ CGT bills on a sale or transfer of company shares. There is a little leeway, however, as the company only loses its trading status for CGT purposes when it has ‘substantial’ investment activities.
The meaning of ‘substantial’ in this context has never been properly defined but HMRC take it to mean over 20%. But, over 20% of what – that’s the problem!
The harsher interpretation favoured by HMRC is that trading status is lost when a company’s non-trading investments and its related activities exceed 20% of any of the following measures:
- Total assets
- Turnover (i.e. sales)
- Gross profit
- Net profit
- Director’s time
- Employees’ time
When similar issues have been examined in the courts, however, the favoured interpretation has been to look at all of these factors together and form a view based on the overall picture. This may be a bit ‘woolly’ and difficult to interpret with any sort of accuracy, but it is certainly a lot more generous than HMRC’s view.
Generally speaking, keeping the total value of non-trading assets under 20% of the total value of all of the company’s assets should therefore be enough to safeguard the company’s trading status, but the other factors listed above should also be borne in mind.
Subject to meeting certain other qualifying criteria, the shares in a trading company can usually be passed on free from Inheritance Tax due to business property relief (see our December 2010 issue for more details).
If the company also holds some investments, this may reduce the amount of business property relief available, or even make the company totally ineligible for the relief. On the other hand, however, if you plan it carefully, a trading company can also be used to shelter investment assets from Inheritance Tax.
To qualify for business property relief in the first place, the company must not be engaged ‘wholly or mainly’ in making investments. Investments for this purpose would include rental property: even most furnished holiday lettings (except where the lettings are generally very short term – no more than a fortnight – and the company’s staff are actively involved in the holidaymaker’s activities).
What this means in practice is that a company only loses its trading status for Inheritance Tax purposes if its non-trading investments and related activities exceed 50% of the measures described above.
This is a much more generous rule than the 20% used for CGT purposes and it means that there is scope to do some extra Inheritance Tax planning with a trading company. How far you can push that planning, however, depends on whether you also need to keep one eye on the CGT position. In other words, is a sale or lifetime transfer of the company a possibility which you need to plan for, or are you certain that you will only pass on your shares on your death?
As a company’s shares can still qualify for business property relief with up to 50% of its activities being investments, you might initially think that you could simply put a whole load of investments in the company and still qualify for the full inheritance tax exemption.
Sadly, that is not the case. Where a company holds investment assets that are not part of its main business activities, the shares in the company will only attract partial relief.
Tommy owns 60% of the share capital in Pinball Limited, a trading company operating amusement arcades. The company has total assets valued at £1m, net of liabilities. However, this includes an investment property worth £300,000 which is unconnected to the company’s trade.
The total value of Tommy’s shares is £600,000. However, 30% of the company’s value is attributable to a non-business asset. Hence, Tommy’s business property relief must be restricted to £420,000, leaving £180,000 (or 30%) chargeable to Inheritance Tax.
There is, however, still a way to shelter investments from Inheritance Tax through a trading company. This is done by ensuring that the investments are part of the same business as the company’s trade. In other words, the investment activities must be integrated into the company’s business in such a way that they become part of a single business.
Pinball Limited sells its original investment property and starts to invest in a portfolio of new properties which it rents out to other amusement arcade operators and other related trading businesses.
The company accounts for its rental activities as part of the same business as its own trade and integrates them into its main business in every way possible.
Some years later, the company has total net assets worth £2m, which includes rental properties worth £900,000. Tommy’s shares are now worth £1.2m and will be fully exempted from Inheritance Tax by business property relief. (Tommy’s shares would probably not qualify for any of the CGT reliefs discussed above, however.)
It is not even necessary for the investments to be used in such a closely related activity: although this is certainly helpful. What does matter though is that the company’s investment business ‘arm’ is an integral part of the company’s overall business and it is important to reflect this in the company’s records, including management accounts, directors’ board minutes, cashflow projections, etc.
Remember also that the company must still be wholly or mainly engaged in trading activities (i.e. more than 50%); and that more than 20% investment activity could lead to a lot of extra CGT for the shareholders!
Saving Corporation Tax
Last month, we looked at the possible downside of putting too many investments into a trading company and how this could give rise to extra Corporation Tax if it became a Close Investment-Holding Company (‘CIC’).
If you can limit the amount of investments so that the company does not become a CIC, however, then you may actually save Corporation Tax by putting those investments into a trading company rather than setting up a separate investment company.
Let’s say that you already have a trading company making an annual profit of £250,000 and you want to make some investments through a company which will yield profits of £50,000.
If you put your investments into a separate company, it will be a CIC (assuming the investments are not rental property) and will pay Corporation Tax at 26%.
Your trading company will then also suffer marginal rate Corporation Tax (27.5%) on the top £100,000 of its profits (as you will have two companies which must share the small profits rate band of £300,000).
Your two companies will therefore pay a total of £70,500.If you had simply made your investments through your existing trading company (and it did not become a CIC), you would pay just 20% (the small profits rate) on all your profits, i.e. £60,000: a saving of £10,500!