How family investment companies are taxed

Background

This article considers the tax treatment of family investment companies (FICs), in relation to how they are taxed:

1. On their profits
2. When profits are distributed
3. When wound up.

We also consider how Inheritance Tax applies to FICs.

What is a family investment company?

A privately held company which holds investments as opposed to any kind of trading business. It is called a “family” investment company as all the shares are usually owned by members of a family or by trusts set up for the benefit of that family.

What do FICs hold?

FICs usually hold cash, listed company shares and/or properties. They usually generate income received by way of interest payments, dividends or rental income.

How family investment companies are funded

FICs are usually funded by way of loans from the founding shareholders. For example, a FIC may be set up with an issued share capital of £10. Following the creation of the company, one or more of the directors (who are usually also shareholders) may loan a large sum into the company as a director’s loan.

This loan is usually made interest-free, as the aim is to maximise the profits in the company that can be rolled up and re-invested, with a view to minimising the tax liability on the individual shareholders.

Repayment of loans out of capital or profits is tax free

If the FIC later repays some or all of these loans to the shareholders, whether out of capital or net profits, this is free of income tax. The company’s profits may be subject to Corporation Tax, but that will depend on the source of that income.

Taxed as a company

Aside from repayment of directors’ loans, other profits in an FIC are taxed under the usual company rules. The usual sources of income for FICs are dividends, rental income, capital gain and interest.

Subject to Corporation Tax

Company profits are subject to Corporation Tax. This is currently at 25% (as from 6 April 2023). Many small companies will remain subject to the lower 19% rate, but FICs will be subject to the higher rate of Corporation Tax, regardless of their level of profits. Rental income, interest payments and capital gains are taxed at this rate, but dividends received by a company are treated very differently.

Dividends received by companies

A key advantage of FICs, as compared to other methods of holding investments, is that dividend income received by an FIC (like other companies) is not subject to Corporation Tax. The rationale is that dividends are paid out of a company’s post-tax profits, which have already been subject to Corporation Tax by that company. As such, those dividends should not be taxed further until distributed. However, this beneficial treatment may be at risk of a further tightening of the tax rules.

Tax treatment of dividend payments by an FIC

When dividends are paid out of an FIC, they are usually taxed in the hands of the recipients, whether they are individuals or trustees. Individuals benefit from a dividend tax-free allowance, which has recently been reduced to £1,000 per year (though this is set to reduce further to £500 from 6 April 2024), and above that amount any dividends are taxed based on the individual’s marginal tax of income tax. Non-taxpayers are not subject to dividend income tax until their total income takes them into the basic tax band level. Basic taxpayers are taxed at 8.75%, and higher taxpayers at 33.75%. Additional rate taxpayers and trustees are taxed at 39.35%. If all FIC income is paid out as dividends, the overall level of tax is similar to that if the investments were held personally.

More tax efficient when profits rolled up in the company

The tax efficiency of FICs arises from tax-free dividends being received by the FIC and then being reinvested.

Based upon the current rates and rules of tax, the following table shows how much net cash could be extracted from an FIC, as compared to holding investments personally, if all of the FIC profits were reinvested, and then extracted after 10, 20 or 30 years. This is shown for various rates of dividend yield and capital growth. This table does not take into account the CGT annual allowance.

As can be seen, with a low yield or short timeframe, holding investments personally is likely to be more tax-efficient, but even with yields of 3%, the FIC structure results in 10% more net proceeds after 30 years. With a 6% yield, after 30 years, the net amount is almost 50% higher.

How Inheritance Tax applies to FICs

As FICs are investment companies, no Inheritance Tax (IHT) relief is available, and the full value of the company’s shares will be subject to IHT. However, if an individual owns a minority holding of the FIC, which does not give them voting control, this can affect the share valuation (for IHT purposes). In determining ownership proportions, holdings by spouses and civil partners are amalgamated, but there is no amalgamation for other individuals, or across multiple trusts (even if those trusts have the same settlor, the same trustees and the same beneficiaries). This means that fragmenting ownership across different family members and by using multiple trusts, can fragment ownership such that the total value of the shares is significantly below the net asset value of the FIC. For example, if an individual owns a minority holding of an FIC of below 10%, this may give rise to a discount in value of up to 75%. This should give an immediate reduction in IHT, which can be a useful planning tool.

In addition, the shares of an FIC can be structured so that a particular class of shares has a minimal initial value but will receive the growth in value on a winding up of the company. These ‘growth shares’ can be given away whilst they have negligible value, enabling the growth to be kept outside the person’s estate. This is a particularly useful planning tool, where it is intended for the profits to be gifted away. Assuming that the FIC doubles in value over a 15 year period, this could result in a £400,000 Inheritance Tax saving after 15 years, for each £1m invested.

Tax position when the FIC is wound up

Eventually, when it is decided to wind up the FIC, the increase in value in the shares would usually be subject to Capital Gains Tax (unless certain anti-avoidance provisions apply). In order to ‘cash out’, the investments within the FIC would need to be disposed of. This would give rise to Corporation Tax on any capital gain. If the cash proceeds were then distributed among the shareholders, the gain (which would usually be almost the entire value) would be subject to tax in their hands. Alternatively, some of the investments could be distributed to shareholders in specie, subject to the usual rules (about distributable reserves). In any event, tax is likely to be payable by both the FIC and by the shareholders.

Non-tax advantages

Regardless of the tax advantages, FICs are often set up for other reasons, such as to enable individuals to gift investments whilst retaining control, without the restrictions which trusts arrangements are subject to.

Also, passing shares in FICs can often provide substantial asset protections advantages, such as being able to restrict how those shares can pass, and how and when they can produce an income.

Overall, FICs provide a multitude of advantages over personal holdings of investments, but advice should be sought as to whether they are suitable for your particular circumstances.