UK Inheritance Tax (IHT) is a major issue for individuals who are UK-domiciled or who hold assets within the UK. This will include many expatriates even if they have been non-UK resident for many years. IHT applies at a rate of 40% on the total value of a worldwide estate above the tax-free threshold of £325,000 (the ‘nil-rate band’).
‘Potentially Exempt Transfers’ (PETs) enable an individual to make gifts of unlimited value that become IHT exempt provided that the donor survives for seven years. Care must be taken that the transferor does not continue to receive a benefit from the gifted property or the ‘Gift with Reservation’ (GWR) rules can apply and the property will still be liable to IHT on the transferor’s death.
Many individuals seek to minimise their IHT exposure and do not envisage needing the capital in their own lifetime but, at the same time, are unwilling to give assets away and rely on family members to maintain them. A ‘Family Investment Company’ (FIC) provides a mechanism for retaining control of assets while their value, or most of it, is transferred. In addition to IHT benefits, FICs can also offer substantial income and capital gains tax benefits.
Shares generally have three distinctive characteristics: voting powers; the right to receive income in the form of dividends; and the right to capital (e.g. ownership of the underlying assets). It is, however, possible to create shares that carry only one or two of these characteristics and it is this flexibility that enables an FIC to minimise IHT exposure.
A FIC is a private company. The structure of a FIC can have many variations but, in a typical scenario, an individual could transfer assets into a FIC in return for its shares, which might be divided into three different classes:
- Class ‘A’ shares that carry votes, but no right to capital or income
- Class ‘B’ shares that carry rights to income and capital, but no votes
- A ‘Golden Share’ that carries management rights in respect of directors, shareholders and the share structure.
The founding shareholder (the founder) will transfer cash and/or other assets into the company in exchange for all the issued shares. The rights attaching to the ‘Golden Share’ would be entrenched in the Memorandum and Articles of Association (M&As) of the company from the outset.
The ‘Golden Shareholder’ would generally be an independent professional trustee, such as Sovereign, which would have the power to dismiss and appoint new directors and would have to authorise a disposal of shares or a change in the share structure.
The FIC relies on four key principles to mitigate the UK tax exposure:
- The transferor will inject capital (cash or other assets) into the company as share capital in exchange for shares. The shares he/she acquires should broadly have the same value as the capital contributed. There is therefore no loss to their estate for IHT purposes.
- The gift of the shares to other the family members should qualify as a PET and therefore should not fall within the founder’s estate after seven years from the date of the gift.
- There should not be an issue under the GWR rules because the arrangement should be treated as a carve-out, which means the founder is taxed only on the value of the shares that he/she retains (subject to surviving for seven years).
- Transferring shares to other individuals reduces the value of the shares retained as a direct proportion to the whole value of the issued shares.
A further substantive advantage of an FIC is that it removes the need for the costs and delays associated with the probate process after death. An FIC enables the transferor to arrange their affairs while they are still able to supervise the process rather than leaving it to executors.
Sovereign has developed two types of FIC: an onshore model that is suitable for UK residents; and an offshore version that can be used by expats residing overseas, typically in countries with a source-based tax system such as Hong Kong and Singapore.