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Keeping your options open


Key points

  • Clients often prefer a company to a trust as it is a structure with which they are familiar.
  • Trusts are flexible structures – which also makes their creation more complex than FICs.
  • FICs are also flexible with many ways of setting one up – all offer tax planning advantages – and they can be tailored to the client’s needs.
  • Both trusts and FICs have pros and cons when it comes to IHT.
  • A good solution may be to use a blended trust/FIC approach to estate planning.

While trusts have been around since the 16th century, the family investment company (FIC) challenger to the throne has also now been around for a few years; certainly long enough for HMRC to have a specialist unit to deal with them.

Introducing the contenders

When we think of all the things Henry VIII brought us – including the most painful way to get rid of a spouse (and by this we mean divorce, obviously) – trusts are probably not the first thought. However, dating back to the Statute of Uses in 1535, trusts have been around for quite some time, for the simple reason that they are so, well, useful.

Despite having a bad rap in more recent years, tarred with the tax avoidance brush, the main purpose of trusts is to protect assets, be that from disgruntled spouses, creditors or even the whims of the beneficiaries themselves, and this is the defining characteristic that is the trust’s raison d’être. Nowhere else is the separation of legal and beneficial ownership sufficient to offer such robust protection in most cases.

Where an individual has significant cash balances, usually above the inheritance tax nil-rate band, and a desire to undertake inheritance tax planning, the FIC can be an attractive solution. The basic concept is to use a limited company to attempt to mirror as closely as possible the features of a trust – ie separation of control and ownership – although it is not possible to achieve the protections of a trust completely. With a FIC, cash can be given to individuals directly to invest in the FIC and funded through loans made to the company by the donor, although it is often desirable to combine some ownership through a trust too.

Clients often prefer a company to a trust because it is a structure with which they are familiar having run their own trading company. Privacy can be achieved through the use of an unlimited company if desirable.

Arguing about flexibility

Family investment companies aim to reproduce the benefits of a trust in a more user-friendly way, so perhaps that proves trusts are king. Some say that trusts are complicated, and they can be without the aid of a suitably expert trusted adviser, but that is a consequence of their flexibility. If wished, it can be arranged that beneficiaries of a trust are entitled to benefit only when they reach the age of 27 and are married. However, trusts are currently the only mechanism by which it is possible to gift or leave assets to people who do not yet exist. Indeed, the ability to secure assets for future generations is what necessitated the rules against perpetuities. Since the Perpetuities and Accumulations Act 2009, non-charitable trusts can only run for a maximum of 125 years, which is still quite a lot of potential people.

Having said that, FICs can be flexible too. There are a number of ways of setting one up and, while they all offer tax planning advantages, they can be tailored to the client’s situation. For example, FICs can be set up by parents making gifts of cash to children who then subscribe for shares in a FIC, as a mixture of ordinary shares and preference shares. Assuming a £2m FIC, the share capital might look like:

  • Parent: £60,000 ordinary shares.
  • Child 1: £20,000 A ordinary shares and £950,000 A preference shares.
  • Child 2: £20,000 B ordinary shares and £950,000 B preference shares.

Overall the parent has retained control through the voting rights and is also likely to be a director of the company and so controlling the day to day investment decisions. The parent might also decide to make loans to the company if they wish to increase the investment in the company without making a gift.

In this scenario, the value of the preference shares is fixed, but the parent has gifted the cash away so the value is no longer part of their estate (subject to the seven-year cumulation period for lifetime gifts), and the children will also participate in 20% each of the capital growth of the company.

An alternative route might be for the parent to fund the FIC by using a cash loan that is left outstanding. The authors have seen examples where the share rights are adjusted such that the parents hold share classes which just have voting and income rights but minimal capital rights with a view to limiting the capital value for inheritance tax purposes while retaining control, but the children subscribe for shares with full capital rights. In principle, this would mean that the full amount of capital growth in the FIC would accrue outside the parent’s estate, but in practice HMRC will be likely to argue the retention of control through voting rights has a value in and of itself, such that the shares are worth 20% to 25% of the value of the company. Valuation principles are outside the scope of this article but are a serious consideration.

In this latter iteration, on day one, the parent has not actually disposed of anything as they have merely substituted the cash value they held with an equivalent loan amount. This can be advantageous as this gives the parent more flexibility if they did not want to gift away the full amount immediately but wanted to wait and see for a few years. If a loan is in place it can be repaid from FIC profits and provide a tax-free ‘income’ to the parent. If they later decide to gift the loan to children or other family members it will be a potentially exempt transfer (PET) at that point.

Considering inheritance tax

It is indeed the loss of access to the funds gifted that can cause people to be wary of trusts, and in any FIC the parent/settlor can retain an interest in both income and capital should they so wish.

However, while the settlor, who places the assets in trust, cannot benefit from the trust without risking losing all the tax benefits of trusts, once assets are in trust they are immediately outside the inheritance tax chargeable on the estate of the settlor. That is as long as the settlor survives seven years from the date of the gift. If the settlor dies within seven years, the value of the gift is taken into account when assessing the death estate, and additional tax may become due from the trustees although a tapering relief applies to reduce the amount of tax payable provided at least three years have elapsed between the date of gift and the date of death. The same treatment applies to PETs which are fully exempt from inheritance tax only if the parent survives seven years from the date of the gift.

It is getting the assets into trust that is the issue. Since the 2006 reforms almost all gifts into trust are chargeable lifetime transfers, meaning that the maximum amount that can be settled by an individual settlor is equal to the nil-rate band (currently £325,000, doubled if a couple are both able to make a gift). This is not an amount to be sniffed at, but it does limit the amount that can be protected from future inheritance tax liabilities. That said, the availability of valuable reliefs such as business property relief or agricultural property relief can extend the amount that can be protected by a trust infinitely, as various categories of qualifying assets qualify for 100% relief from the charge on creation of a trust.

Where funding FICs is by way of gift rather than loan, the initial gift is a PET and so outside the chargeable lifetime transfer rules of the trust. There is no restriction on the size of a PET, which is a distinct advantage compared with a trust where amounts above the nil-rate band will be taxed at a lifetime inheritance tax rate of 20%. The parent needs to survive seven years from the date the gift is made for it to be outside their estate. Tapering of any tax arises after three years. In FICs funded by loan, there is no immediate gift because the value of their estate remains the same, and the inheritance tax advantage is earned over time as profits accrue.

The immediate problem with the FIC is that the cash gifted to the children, which is now invested in shares, or shares with capital value held in their name are in their estates for inheritance tax and matrimonial purposes. This is the price of transferring substantial amounts of cash compared to the amounts that can be transferred to a trust. The drafting of the articles of association is important, and familial protections can be built into the articles restricting the transfer of shares outside family bloodlines. It is important to note that it is not possible to exclude the value of the assets for matrimonial or other purposes but the articles may forbid a transfer to non-family members or even force a transfer if a marriage breaks down.

Where minors are involved, it is not normally possible for them to own shares in a FIC directly as they are unable to enter into a contract and so a bare trust arrangement may be used with the parent holding the shares as nominee. The problem is that a bare trust leads to absolute entitlement at the age of 18. In most cases that is not desirable although where there are preference shares, these cannot normally be redeemed without the trustees’ approval. On that basis a protection could be built into the articles to not to allow the redemption of preference shares before 25 years of age.

Protecting income

So while the structure of a FIC is simpler than a trust, the company articles can end up being very complicated. But what about income? Are FICs more efficient in terms of generating income and preserving overall wealth for the family?

Since the rules were overhauled in 2006, most trusts are relevant property trusts, which means there are fewer inheritance tax advantages of trusts, as most are now subject to periodic ten-year charges (and proportionate charges in between anniversaries) at a maximum of 6%. Nevertheless, a charge of 6% every ten years is often considered preferable to a 40% hit every time someone dies. UK resident trusts without an interest in possession currently pay income tax at the highest rates of tax to the extent the starting rate band is exceeded, but this is only a cost to the extent that income is accumulated. If income is paid to beneficiaries the overall rate will not exceed the rate of income tax paid by the beneficiary. Offshore trusts can still offer significant tax advantages but under current rules, only when the settlor and beneficiaries have the correct non-UK credentials.

Trusts with a tax liability are obliged to register with the trust registration service (TRS), although there is currently no function within the existing system for trusts without a liability to register. HMRC has reported that it is working on this, and it is hoped this will be live in 2022. This system is a limited record; under the Fifth Money Laundering Directive ((EU) 2018/843)) (5MLD) it is currently available for search only by some bodies and is not open to the general public.

Trusts also have to complete self-assessment tax returns, in a similar way to individuals, and prepare R185 forms for beneficiaries if income has been paid, but this is hardly more onerous than individuals’ own self-assessment obligations. In some circumstances, a trust may not have to complete a tax return at all, if all income is mandated directly to beneficiaries with a life interest, but a FIC will be required to undertake filing obligations every year, even if the company were dormant!

A FIC can present an attractive investment accumulation vehicle due to the lower rates of corporation tax compared to tax rates in a trust, although it is worth noting that a trust could achieve similar by investing through a company owned by the trustees. The current rate of 19% will rise to 25% in 2023 as close investment holding companies, which most FICs are, will not benefit from the small company rate in the 2023 increase. Companies are required to file annual accounts for public record at Companies House, together with details of the person(s) with overall control or significant influence over the company. In addition, FICs will be required to file corporation tax returns for each accounting period.

Dividends paid between companies are currently exempt from UK corporation tax, such that it may be possible for a FIC to achieve gross roll up on income if invested in stocks and shares. Similarly, when comparing the rates of corporation tax to rates of personal income tax, paying tax on rental income profits at 19% or even 25% compares favourably with 40% or 45% rates of tax. That said, this does not take into account additional tax on income if wishing to pay profits as dividend income from the company. This means FICs may be more suited to capital growth rather than providing an income to family members on a full extraction strategy.

Further, FIC shares cannot benefit future generations in a way that trusts can over a period of up to 125 years. Put simply, if a person does not exist, they cannot own part of a FIC even under a bare trust. To do this, or to provide a more flexible way of protecting FIC shares from the more junior owners themselves, a hybrid trust and company solution might be suitable, where the parent could maintain control through being a trustee of a trust which owns ordinary shares in a FIC.

Combination of the two

Given the advantages and disadvantages, and limitations of both, perhaps the answer is not so black and white. It is possible to combine the best features of trusts and family investment companies to provide a tailored solution for clients. Perhaps shares that are designated for children or more junior members of the family can be held in trust to protect the growing value from wayward teenagers or greedy spouses. Alternatively, trusts could make investments through a FIC to enjoy some of the roll-up tax advantage and to add greater flexibility in making future capital gifts.

Using trusts and FICs in combination can also enable the transfer of value to future generations, not possible when using FICs in isolation. Perhaps, rather like King Henry VIII, when looking at trusts and FIC planning, it is not so much that it is necessary to make a single choice, it is possible to keep one’s options open with two different choices in the tax planning toolkit.

By Sam Hart and Craig Simpson

Originally published in 17 June 2021’s Taxation magazine

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