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Tax efficient investment: It's a family affair

Recent increases in Income and Capital Gains Tax (CGT) rates for individuals has caused many people to seek advice from their Independent Financial Advisers (IFAs) as to solutions that will allow them to invest more efficiently. This growing demand has been further exacerbated following the changes to inheritance tax laws brought about by the Finance Act 2006, which made it more difficult for clients to place assets in trust without a 20 per cent upfront inheritance tax charge.

Amanda Simmonds, director in the Private Client team at business law firm DWF, explores the potential for a Family Investment Company (FIC) to provide the solution that IFAs are looking for.

Family investment companies

A FIC is simply a private company where the shareholders are all members of the same family, whose constitution can be drafted to suit the family’s needs.

FICs have, for several years, been emerging as a simple and effective form of investment, and following the recent changes to taxation rates and rules mentioned above, they have become increasingly popular as a tax efficient vehicle to accumulate wealth.

FICs can provide clients with many benefits, from lower rates of taxation to different classes of shares that can facilitate easier estate planning. It is therefore unsurprising that IFAs are turning to the structure to provide an effective and flexible option for their clients.

Financial benefits of a FIC

A FIC is taxed in the same way as a standard company. This means that a FIC will currently pay corporation tax at 26 per cent - which will reduce to 24 per cent by April 2013 - on its income. This rate of tax is significantly lower than the top band of income tax, or that applicable to a trust fund, which will incur a 50 per cent tax rate on its income. The difference between the tax rates can potentially mean that a FIC has over 20 per cent of extra income to reinvest.

FICs are also very efficient structures for clients who want to invest in other companies, as dividend income received by the FIC from UK companies and most non-UK domiciled companies should be exempt from corporation tax.   

Also, a FIC can still claim CGT indexation allowance, which is aimed at removing any gain due to the effects of inflation when CGT is calculated.

Investment management fees should be a tax deductible expense for a FIC. An individual investor is not permitted a similar tax deduction.

Estate planning benefits of FICs

FICs are ideal structures for protecting wealth and passing it down through the generations. They allow families to define how each member will benefit through the voting and income rights attached to individual shares, as well as through shareholder agreements.

Furthermore, FICs avoid many of the on-going Inheritance Tax (IHT) charges that are applicable to trusts. Gifts of shares in the FIC to other family members will not require IHT payments, provided that the donor survives seven years.

Downsides

IFAs should be aware that FICs are not without potential pitfalls. FICs should be considered a long term investment as the benefits gained through reinvestment of income at lower tax rates are offset by high income tax rates upon extraction of income. Shareholders who extract profits from the FIC as dividends will pay income tax on those dividends at their marginal rate, which means that the income generated by the FIC may be taxed twice.

Therefore, FICs are most beneficial for clients as part of a long term investment plan. With a longer timeframe, further planning can be done to minimise tax charges on individuals, and shareholders can also consider options such as loaning money to the FIC for tax efficient cash extraction at a later date.

There can also be opportunity costs involved with a client’s decision to invest in a FIC. In certain circumstances a variety of tax reliefs may be lost when a client invests via a FIC rather than investing directly. For example, Entrepreneurs' Relief allows a lower rate of CGT (10 per cent) to be paid by people who have been involved with a company for a year and have a five per cent or more shareholding – this could be lost if the client does not invest directly. FICs are also unlikely to be ‘qualifying companies’ for the purposes of the Enterprise Investment scheme, a scheme which provides generous tax reliefs for investors in small, higher risk companies.

Furthermore, direct investment into certain assets can allow an IFA’s clients to benefit from IHT Business Property Relief or CGT Principal Private Residence relief and CGT annual exemptions. In current market conditions, the latter could be better than CGT indexation.

The solution is for IFAs to advise clients carefully on what assets to hold in a FIC and to ensure they use the structure for long term reinvestment of income. A FIC is not simply an alternative to investing in an ISA, pension scheme or in investment bonds. All are tax efficient investment tools in their own rights, and the optimal investment strategy for a client who wants to invest their wealth in the most tax efficient way may combine different investment vehicles.

A panacea for IFAs? 

A FIC is not a silver bullet. For long term investment, where the client desires flexibility in how family investment is passed down amongst family members, an FIC could be an ideal solution – but it does require careful consideration from the client’s IFA and his other advisers.

For shorter term investments, IFAs should ensure their clients are aware of the direct investment reliefs that they could be forfeiting, as well as the short term difficulties they face should they wish to extract profits in a cash efficient way.

This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.