Overview of How Family Investment Companies Are Taxed

Mondaq gives an overview of the tax implications for Family Investment Companies.

Family investment companies (FICs) are privately owned companies that hold investments instead of engaging in trading business. They are typically owned by family members or trusts set up for their benefit. In this article, we will explore how these companies are taxed, including their profits, distributions, and wind-up process. We will also delve into the implications of Inheritance Tax on FICs.

FICs primarily hold cash, shares of listed companies, and/or properties. The income generated by these investments is usually received in the form of interest payments, dividends, or rental income.

Funding and Tax Treatment on Repayment of Loans:
FICs are typically funded through loans from the founding shareholders, who are also directors of the company. These loans are often interest-free, maximizing the company’s profits that can be reinvested. When these loans are repaid to the shareholders, whether from capital or net profits, it is tax-free.

Taxation as a Company:
Apart from the repayment of directors’ loans, FIC profits are taxed under the usual rules applicable to companies. This includes dividends, rental income, capital gains, and interest. These profits are subject to Corporation Tax, which is currently 24% (as of April 6, 2023). Although many small companies fall under the lower 19% rate, FICs are subject to the higher rate of Corporation Tax, regardless of their profit level.

Tax Treatment of Dividends:

A key advantage of FICs is that dividend income received by them is not subject to Corporation Tax. This treatment acknowledges that dividends are paid out of the company’s post-tax profits, which have already been subject to Corporation Tax. Dividends paid by an FIC are usually taxed in the hands of the recipients, whether individuals or trustees.

Individuals benefit from a dividend tax-free allowance, currently reduced to £1,000 per year and set to decrease further to £500 from April 6, 2024. Dividends above this allowance are taxed based on the individual’s marginal tax rate. The rates for basic taxpayers, higher taxpayers, additional rate taxpayers, and trustees are 8.75%, 33.75%, and 39.35%, respectively, with non-taxpayers not subject to dividend income tax until their total income reaches the basic tax band.

Tax Efficiency and Comparison with Personal Holdings:
Utilizing FICs can provide tax efficiency by reinvesting tax-free dividends. Comparing net cash extracted from an FIC to personal investments after 10, 20, or 30 years, the former results in higher net proceeds, especially with higher dividend yields. For example, with a 6% yield, the net amount from an FIC after 30 years could be almost 50% higher than that from personal investments.

Inheritance Tax Implications:
As FICs are investment companies, no Inheritance Tax relief is available, and the company’s shares are fully subject to Inheritance Tax. However, owning a minority holding in an FIC without voting control can affect the share valuation for Inheritance Tax purposes. Fragmenting ownership across different family members and utilizing multiple trusts can significantly reduce the total value of the shares for Inheritance Tax purposes. This strategy can lead to a discount in value of up to 75% for a minority holding below 10%. Such fragmentation can be a useful planning tool to reduce Inheritance Tax.

Additionally, FIC shares can be structured to allocate the growth in value to specific classes of shares upon winding up the company. These “growth shares” can be gifted while having minimal initial value, allowing the growth to be kept outside the individual’s estate. This planning tool can result in significant Inheritance Tax savings in the long run.

Tax Position During Winding Up:
Upon deciding to wind up the FIC, the increase in share value is usually subject to Capital Gains Tax. Disposing of the investments within the FIC results in Corporation Tax on any capital gain. If the cash proceeds are distributed among the shareholders, these gains are subject to tax in their hands. Alternatively, some investments can be distributed to shareholders in specie. In any case, both the FIC and the shareholders are likely to have tax liabilities.

Non-Tax Advantages:
Aside from the tax advantages, FICs are often set up for other reasons, such as enabling individuals to gift investments while retaining control and benefiting from asset protection advantages. Passing shares in FICs allows individuals to dictate how and when those shares can pass and generate income, providing substantial asset protection advantages.

Family investment companies offer numerous advantages over personal investments in terms of tax efficiency, control, and asset protection. However, it is crucial to seek advice to determine whether an FIC is suitable for individual circumstances. Understanding the tax treatment of FICs, including how profits are taxed, the implications on dividend payments, and the impact on Inheritance Tax, can help individuals make informed decisions and optimize their investment strategies.