Family Investment Companies can help dodge the ‘death tax’ bullet

By Howard Bilton – Chairman and Founder of The Sovereign Group

Family Investment Companies can help dodge the ‘death tax’ bullet

No tax is popular but ‘death taxes’ –death duties, inheritance tax or estate tax – are generally more unpopular than most. Not only are they regarded as a form of ‘double taxation’ because the assets have already been taxed at least once but they can be highly destructive if they force the sale of family businesses, estates and houses.

Many countries, including Australia, Canada, Russia, India and Norway, have abolished death duties in recent decades. In the UK, however, Inheritance Tax (IHT) has become an increasingly lucrative source of government income. As property prices have increased, the number of estates liable for IHT has grown too. In 2018/19 HMRC reported that it had taxed 5,081 transfers on death and netted receipts of £5,384,000,000 in tax.

This article focuses on the options for UK-based families, but many of the suggested solutions can be equally as effective and useful for residents and citizens of other countries

The current UK IHT regime is an amalgamation of the old capital transfer tax and estate duty regimes, so it targets both gifts made during lifetime as well as bequests made on death. The rate of tax might also be considered penal. It is currently 40% on the total value of the estate of a deceased after exemptions, primarily the first £325,000.

The number of estates investigated by Her Majesty’s Revenue and Customs (HMRC) for underpayment of IHT is also on the rise. If an investigation finds that IHT has been underpaid, the estate may have to pay all of the tax owed plus a penalty, which could be up to 100% of the tax at stake in the estate.

Despite this IHT, is sometimes described as a ‘voluntary tax’ on the basis that it can largely be avoided through relatively simple tax planning – but there are traps that will catch the unwary or poorly advised.

The most obvious way to avoid IHT is simply to spend it all before death. This would be fine if you know precisely how long you were going to live. That is generally an unknown. Although purport to be able to tell you if one is brave enough to have a look. And it is not really a solution if you want to leave something to your heirs.

In the UK transfers between spouses, whether during lifetime or on death, are tax free as long as the giver is domiciled in the UK. They also do not attract Capital Gains Tax (CGT) provided the spouses live together (TCGA 1992 Section 58). This works to an extent, but the exemption only delays the IHT until the death of the surviving spouse when any remaining assets will be taxed.

Outright gifts reduce the value of the estate and can be made tax-free to other individuals under the Potentially Exempt Transfer (PET) regime. Three key conditions must be met:

  • Both parties must be natural persons. There is no exemption on gifts to companies or trusts (other than to a disabled person’s trust);
  • The assets transferred must either form part of the donor’s estate or increase the value of the giver’s estate;
  • The donor must survive the gift by seven complete calendar (not tax) years. Failure to do so triggers an IHT charge on a sliding scale with the taxable value being reduced by 20% per year from the third year onwards.

Trusts were traditionally a highly effective in eliminating IHT but this is generally no longer the case. If an UK-domiciled person transfers assets to a discretionary trust there is now an immediate charge to lifetime IHT of 20% of the value of the capital transferred. Additionally, the trust will be subject to a periodic IHT charge of around 6% of the capital value every ten years.

The exception is for non-UK domiciled persons (non-doms). Non-UK assets can be transferred into trust prior to a non-dom becoming ‘deemed domiciled’ – thus applies to non-doms who have resided in the UK for 15 out of the last 20 years. This will be an Excluded Property Trust (EPT). Assets within that trust remain outside the UK IHT charge provided that they stay within the trust. UK assets – except residential property – can also be transferred to overseas companies and the shares of those companies can be settled into the EPT.

Increasingly, wealthy UK individuals are turning instead to a Family Investment Company (FIC). These are sometimes called ‘common law foundations’.
This is a relatively simple solution by which assets are transferred to an overseas or UK company. The rights and obligations attaching to the shares of the company are separated into shares that only carry voting rights, shares that carry only income rights (dividends) and shares that carry only rights to the underlying assets (capital).

A FIC enables the transferor(s) – generally the parent(s) – to retain the voting shares and therefore maintain control over the assets and the affairs of the company. It is also possible to retain some or all of the income shares in order to receive dividends and an income during lifetime.
The capital shares, however, are immediately or progressively given away to family members. The gift of the capital shares would qualify as a PET so the transferor must survive for seven years for the gift to be tax free.

It is possible to provide for different levels of dividends to be declared across different classes of shares but it is not possible to declare different levels of dividends on shares within a particular class. Every family member holding shares of a particular class is entitled to a pro rata share of the dividend.

In the right circumstances, FICs can undoubtedly provide an attractive and reasonably flexible alternative to trusts.

The transferor and participating family members will all need to ensure that their wills are correctly aligned with the provisions of the corporate documents governing the FIC, so that they can avoid creating difficult issues for surviving family members to deal with.

In short FICs are a simple and effective alternative to trusts or foundations which can often now be viewed highly suspiciously by tax authorities and have adverse tax consequences.

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