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Inheritance tax planning for investment companies

/ 26 November 2023

Sam Inkersole

Where shares in an investment company are held by parents with adult children, it can appear at first glance that little can be done to protect against inheritance tax (IHT) arising on the market value of the shares in the company when the parents pass away.

The parents, who hold the shares, may need income from the company to supplement their other income in retirement, but may not want to have the current or future growth in value of the shares in their estate.

Depending on the value of the company, and the value of the other assets held by the parents, a two-pronged approach may be needed to:

  • freeze the future growth in value of the shares held by the parents; and,
  • remove some of the shares from the parents’ estate for IHT purposes.

This will use growth shares and gifts to a discretionary trust, outlined further below.

What are growth shares and why would they be helpful?

Growth shares is the name given to shares which only gain value once the company’s value reaches a certain threshold (known as the hurdle rate). As such, they are useful for freezing the value of other shares in a company at a certain value and therefore the value of the shares in the shareholders’ estate.

It is important that the hurdle rate is sufficiently high (i.e. above the current company value) to ensure that the subscription price of the growth shares, being the market value of the shares, is low enough to minimise any taxes on the implementation of the planning.

How are growth shares implemented?

The first step would be to undertake a valuation of the company in which growth shares are being proposed to be implemented. Once the value of the company is determined, the market value of the growth shares needs to be calculated (noting that the value cannot be £Nil given the ‘hope value’ attributable to the shares).

Before the growth shares can be issued, the articles of association of the company will need to be updated to enable this new class of share to be issued. Generally, legal input will be needed here to ensure the articles are drafted appropriately. At this point, it would also be worth revisiting the articles more generally to determine whether additional provisions should be included in them (i.e. to specify what sorts of activities can be carried out by the company, or, to restrict who is able to hold shares in the company).

The growth shares are then issued at their market value to the new shareholders, who pay cash for the shares.

What is a discretionary trust and how does it work?

A discretionary trust (DT) is a legal arrangement whereby the trustees hold assets for the benefit of the beneficiaries. As the trust is ‘discretionary’, the trustees of the DT have discretion as to which beneficiaries of the DT obtain income from the DT. If the trust deed allows, it is possible for beneficiaries to be added or removed, which makes a DT a very flexible arrangement.

It is important to note that where the settlor is also a current or potential future beneficiary of the DT, there are a number of rather severe tax implications. As such, we generally do not recommend that the settlor is a beneficiary of the DT.  Spouses or civil partners and unmarried minor children of the settlor would also normally be excluded from the class of beneficiaries.

By planning carefully, making a gift of shares to a DT could result in an immediate reduction in the value of an individual’s estate for IHT purposes. This is explored further in the example below.

How are gifts to a discretionary trust taxed?

Where shares in an investment company are gifted to a DT, two taxes come into play: IHT and capital gains tax (CGT).

IHT at a rate of 20% arises on the gift to the DT as the gift is treated as a chargeable lifetime transfer. However, where the individual has unused IHT nil rate band (NRB) available, then no IHT will arise on the gift to the DT. As such, this means that an individual can gift £325,000 of assets to a DT every 7 years (being the period before which the individual regains their NRB). A couple can therefore make a gift to a DT of up to £650,000 every seven years.

Prima facie, CGT would also arise on the gift to the DT. However, subject to certain conditions on types of beneficiary being met (as above), the application of IHT to the gift means that it is possible to hold-over the gains so that no CGT arises.

Are there any future taxes arising on a discretionary trust?

There are three types of tax which will apply to the DT over time: income tax, CGT and IHT.

Where the DT gets income or generates gains from the assets it holds, the income is subject to:

  • income tax at trust rates (39.35% for dividends and 45% for other income); or
  • CGT at 20% or 28%, depending on the type of asset disposed of.

The DT pays this tax over to HMRC annually, but when the net amounts are distributed to the beneficiaries of the DT, the beneficiaries get a credit for the tax which was paid to HMRC by the DT. Depending on the other income the beneficiaries have, it could mean that the beneficiaries end up in a tax reclaim position.

IHT applies to the DT in two instances:

  • 10-year charge – occurs where the value of the assets in the DT is greater than the IHT NRB (of £325,000): broadly the excess is taxed at the rate of 6%.
  • Exit charge – applies where an asset is transferred from the DT to the beneficiaries. Again the rate of IHT can be up to 6% of the value of the asset distributed to the beneficiary, but the calculation is very complex.

How this planning can be joined together: an example

A property investment company has 100 ordinary £1 shares and is owned 50:50 by a married couple, Alan and Beth, who are in their 60s. The current market value of the shares held by Alan and Beth in the company is £1.8 million.

The couple have two adult children; Carla and Dan. They want to reduce the IHT exposure they currently have on their estates, using growth shares and discretionary trusts.

Growth shares

(In this example, they do not have voting rights)

A growth share valuation is undertaken with a hurdle rate of £2.1 million; the current market value of 100 growth shares is £20,000. Carla and Dan each subscribe for 50 shares, paying £10,000 each.

It would have been possible for Alan and Beth to subscribe for the shares at nominal value and then gift the shares to Carla and Dan, but this would have incurred CGT at rates of up to 20% on the difference between the subscription price and the market value of the shares. It would have also been a potentially exempt transfer for IHT purposes.

At this point, if the value of the company exceeds £2.1 million, the value above this hurdle rate will go into the estates of Carla and Dan. As such, the estates of Alan and Beth are frozen at £2.1 million (in respect of the shares they hold in the property investment company) only if the value of the shares increases from their current value of £1.8 million.

Gifts to a discretionary trust

We now know that the capped value of the shares is £2.1 million (being £21,000 per share). As such, Alan and Beth can each gift 13 shares to a DT (with a total maximum value of £273,000). This means that the value in the DT would be capped to such a level that the 10-year charge and exit charges are unlikely to apply.

If they were to do this, there would be no IHT or CGT arising on the gift and their combined voting rights in the company would fall from 100% (being 100 shares) to 74% (being 74 shares).

As a result, it may be possible to argue that the value of the shares in their estate is no longer directly proportional to the value of the company, as Alan and Beth no longer have absolute control over the company. A discount could be applied to the pro-rata value of the shares held by Alan and Beth, which would immediately reduce the value of their estates for IHT purposes.

You’ll note that the total maximum value gifted is less than the £325,000 NRB. This is due to the fact that on a lifetime transfer you have to perform a before-and-after calculation. Given that Alan and Beth would have crossed the 75% threshold before the settlement but not after the settlement, the value of the immediately chargeable transfer must be increased due to the loss of absolute control over the company.

For more information on tax-efficient estate planning, and on the tax implications of your situation, please get in touch with your usual BKL contact or use our enquiry form.

Sam Inkersole

Senior Manager, Tax

T +44 (0)20 8922 9285
E sam.inkersole@bkl.co.uk

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