In this issue’s technical article, John Woolley looks at the taxation considerations of investments by private limited companies
Successful private companies will often retain cash within the corporate structure to meet the costs of future business expansion/development. This is particularly the case at the moment because of the large differential in the rates of corporation tax (19%) and income tax/NICs – top rates of 38.1% (dividends) and 47% (remuneration). Tax-efficient removal can be achieved by making pension contributions for directors but this means the cash is effectively lost to the company.
In time this can lead to substantial amounts being held on cash deposit by the company which – at the present time – will be yielding a very poor return. This can lead to consideration of investing cash that is not required for business purposes at the current time or the foreseeable future. In this respect, asset-backed (equity-linked) investments may look attractive and two, in particular, have been used by companies in the past – the capital investment (single premium) bond (investment bond) and collective investments, most commonly unit trusts or open-ended investment companies (OEICs).
The way these investments are taxed when owned by companies has changed significantly during the past 10 years and this may have affected the balance as to which investment might be appropriate to a company. For those companies that have already invested, it may be time to reconsider their suitability.
In more general terms, it is of course also important to consider how any investment may impact on entrepreneurs’ relief on any capital gains and/or business relief on any inheritance tax liability of the director/shareholder, in relation to the sale of their shareholding or on their death. This aspect is not affected by the type of investment but it is important to consider it when discussions on company investments are taking place. While these points should be taken into account, we do not consider them further in this article.
1 THE TAXATION OF INVESTMENTS HELD BY PRIVATE LIMITED COMPANIES
o understand how the tax changes affect corporate investment decisions, it is necessary to consider the background to this topic.
(a) Position before 1 April 2008
Prior to 1 April 2008, investment bonds, both life assurance/capital redemption bonds, and onshore/offshore, held by companies were taxable under the chargeable event regime – the same regime that applies today for individual investors. In other words, a tax charge would arise when there was a chargeable event – say on full surrender. Any resulting gain would have been subject to corporation tax for the company in the financial year in which the chargeable event occurred.
The loan relationship rules can have a potentially wide application to many of the investments available to companies
(b) Position from 1 April 2008
With effect from 1 April 2008, investment bonds (onshore and offshore) held by companies were no longer taxable under the chargeable event regime. Instead, they are treated as loan relationships (Corporation Tax Act 2009, Part 5) and, as such, taxed under the loan relationship rules.
Broadly speaking, the fundamental rules taxing loan relationships provide that income, gains and losses of a company arising from loan relationships are subject to corporation tax as income. Gains and losses are those that arise from “related transactions”. Related transactions are defined in Section 304 of the Corporation Tax Act 2009 as “any disposal or acquisition (in whole or in part) of rights or liabilities under the relationship and … include sale, gift, exchange, surrender, redemption or release”. The loan relationship rules can have a potentially wide application to many of the investments available to companies, including most investment-based life assurance policies and certain collective investment schemes.
Where a company is investing funds in loan relationships, any income and gains will be treated as non-trading income. This can give rise to a non-trading credit (gain) or a non-trading debit (loss). Credits and debits on non-trading loan relationships are aggregated to arrive at an overall profit, or loss, on loan relationships within an accounting period. How those loan relationship credits and debits will be dealt with in the company’s accounts then depends on whether the company can use the fair value basis or historic cost basis to account for its investments.
Before 1 January 2016, this depended on whether the company was a “small company” or not. Under the Financial Reporting Standard for Smaller Entities, a small company could elect for the historic costs basis. For these purposes, a small company was one that satisfied two of the following three conditions:
- Turnover is £6.5m or less
- The balance sheet total is £3.26m or less
- The average number of employees is 50 or fewer.
The choice of fair value or historic cost basis could have a big impact on the tax consequences as, if the historic cost basis was chosen, the carrying value of the investment bond in the accounts (to determine whether, from year to year, there had been an increase in value) would always be the amount of the original investment and so the taxation of investment gains could be deferred until surrender or encashment.
Collective investments that are non-interest distribution funds are not treated as loan relationships
c) FRS 102 – the position from 1 January 2016
For accounting periods starting on or after 1 January 2016, Financial Reporting Standard (FRS) 102 applies to all companies, even those qualifying as “small companies”. Under FRS 102, investment bonds, onshore or offshore, and certain unit trusts/OEICs do not fall within the definition of a “basic financial instrument” and, as a result, most will now be accounted for under the fair value basis of accounting.
This means that all companies (with the exception of ‘micro-entities’ – see below) have lost the ability to use historic cost accounting for the majority of investments.
An exception exists in the shape of a collective investment fund where 40% or more of the fund is not invested in fixed-interest/debt-based assets. In this article we refer to such a fund as a non-interest distribution fund. Because such a fund is not taxed under the loan relationship rules, it is not subject to the fair value basis of accounting. Instead, UK dividends are not taxed on the company and capital gains are only taxed when realised.
(d) FRS 105 – The micro-entities exemption
FRS 105, which applies for accounting periods beginning on or after 1 January 2016, introduced rules in relation to the FRS applicable to the micro-entities regime. A company qualifies as a micro-entity if it satisfies at least two of the following conditions:
- Turnover: not more than £362,000
- Balance sheet total: not more than £316,000
- Average number of employees: not more than 10.
Under Section 9 of FRS 105, investments by micro-entities can be accounted for on the historic cost basis, provided the company elects for this treatment. In other words, as long as the company can be treated as a micro-entity company, the historic cost basis can apply to all new investments and continue to apply to existing (pre 2016) investments. This means that for such companies, investment bonds (UK and offshore) and all unit trusts/OEICs can be held on the balance sheet at cost, with profits/gains not brought into charge to tax until full or partial encashment/disposal.
Companies that are not micro-entities (or micro-entities that do not elect for the historic cost basis to apply) will be taxed on the fair value basis.
(2) What is a loan relationship?
It will be apparent that whether an investment is treated as a loan relationship or not plays a key part in how that investment is taxed. So what is a loan relationship? Loan relationships are, broadly, money debts arising from a transaction for the lending of money and so include:
- Bank/building society loans
- Bank/building society deposits.
However, certain investments by companies are deemed to be loan relationships, as follows:
- Authorised investment funds (eg UK unit trusts and OEICs) that pay interest distributions. This type of fund will make interest distributions where, broadly, more than 60% of the fund is invested in fixed-interest/debt-based assets. In this article we refer to such a fund as an “interest distribution fund” and those that do not satisfy this criterion as “non-interest distribution funds”.
- Offshore collectives that pay interest distributions.
- Investment life assurance contracts (whether onshore or offshore).
(3) Historic cost and fair value basis of accounting in more detail
- Historic cost
Here, the investment asset is shown on the company’s balance sheet at its original cost. The loan relationship (investment) stays on the company’s balance sheet, broadly at its original cost and no gain or loss (credit or debit) will be brought into the company’s profit and loss account. Therefore, where the investment is an investment bond, a gain or loss can only arise when a related transaction takes place (see earlier) at which point the entire gain (or loss) will fall into the company’s profit and loss account and be subject to corporation tax. For a collective investment, this will be when the investment is encashed.
- Fair value
Under this basis of accounting, assets or liabilities are shown in the company’s balance sheet at ‘fair value’. Fair value, in relation to a loan relationship, is the market value of the asset. For an investment bond, (onshore or offshore), the fair value would be its surrender value. For a collective investment, it will be its encashment value.
The difference between the amount of the original investment and the surrender/encashment value (and in subsequent years the increase in surrender/encashment value from the end of one accounting year to the next), will be the non-trading credit (or debit) that will arise in the company’s profit and loss account. This in turn will represent the amount that will be subject to corporation tax in respect of a gain or treated as an offsetable loss. A gain or loss could arise when a related transaction takes place (see above). The historic cost basis therefore offers tax deferral.Appreciating the difference between these two accounting bases will be a fundamental consideration when selecting appropriate new investments and deciding whether, from a tax perspective, to retain existing investments that were acquired before 1 January 2016.
2 NEW INVESTMENTS MADE BY COMPANIES
- Company not a micro-entity
For the shareholders of a company that is not a micro-entity who are looking to invest corporate funds for the medium to long term, from a tax perspective the non-interest distribution unit trusts/OEICs are likely to deliver the most tax-effective solution because they offer tax deferral on investment growth. On the other hand, with investment bonds, the application of the fair value basis of accounting will mean there will be no possibility of tax deferments on unrealised gains.
Collective investments that are non-interest distribution funds are not treated as loan relationships.
UK dividends paid in respect of the fund are not taxed on the company and capital gains are only taxed
It should be noted that each unit trust/OEIC held by a company will be individually assessed to ascertain whether it qualifies as an interest distribution or non-interest distribution unit trust/OEIC. Care therefore needs to be exercised on this when constructing a portfolio for a corporate investor.
- Company is a micro-entity
Here, the historic cost basis of accounting is still available and therefore there is no overriding tax reason for these companies to invest in non-interest distribution collectives. Investment bonds will continue to be able to give investment growth with tax deferral and control over the timing of any tax charge.
In the case of both interest distribution collectives and non-interest distribution collectives, UK dividend income paid in respect of the fund to the company will be tax-free and, in both cases, indexation allowance will no longer be available on corporate investments (either directly or via the insurance company in the case of investment bonds).
3 CORPORATE INVESTMENTS HELD ON 1 JANUARY 2016
So, for ‘new money’, the most tax-efficient choice (and certainly for companies that are not micro-entities) would appear to be collective investments that are non-interest distribution funds. For those companies that held investments on 1 January 2016 and were already adopting the fair value basis for investment bonds, broadly speaking, neither a taxable gain nor loss should arise in respect of investment growth for earlier years as, in effect, the existing treatment continues.
However, as a result of FRS102, a large number of companies that were holding investments that represented loan relationships on 1 January 2016 (and, because they were small companies, were likely to have previously accounted for these using the historic cost basis), would have suddenly had to include a taxable gain or loss in their accounts in respect of investment growth that has accrued from the beginning of the investment to the start of the first accounting period under FRS102. This accounting period would normally be the one beginning on or after 1 January 2016.
The position on this is relatively complex and companies that are affected will need to take advice from their own accountant. In what follows, we set out what we believe is the general position.
Transitional rules have been introduced that ease the position. These provide that historic gains or losses can be brought into account for tax purposes during a period of 10 years on a straight-line basis, starting with the first accounting period commencing after 1 January 2016.
Companies will therefore need to identify whether there are any historic gains or losses that need to be brought into account when changing to the fair value basis. The position may well depend on whether pre-1 January 2016 investments (UK or offshore) were in interest distribution or non-interest distribution collective investments, or investment bonds.
4 Pre 1 January 2016 investments and dealing with previous historic cost gains
We will now look at the impact of the 2016 accounting provisions on common sorts of investments that were held on 1 January 2016 for companies that do not qualify as micro-entities.
Any annual growth in value for accounting years beginning on or after 1 January 2016 will be brought into account under the fair value basis.
As regards UK investment bonds that were effected pre 1 January 2016 and for the years before 2016 were brought into account under the historic cost basis, the transitional rules mean that one tenth of the gains that have accrued from the beginning of the bond to the start of the first accounting period under FRS 102 will now be brought into account for tax purposes each year for 10 years, as a valid change in accounting basis has occurred.
However, the way the tax charge operates for the ‘pre-2016 investments gains’ differs between offshore bonds and UK Bonds, as follows:
(a) Offshore bonds
Any inherent pre-2016 gains previously dealt with under the historic cost basis will now be brought into account in equal amounts during 10 years. This means that for offshore investment bonds ‘in profit’, annual tax charges could start to arise. And as there will normally have been no tax that is deemed to be paid within the fund, any gains liable to corporation tax (year on year, or on actual encashment) will not carry a tax credit. A decision will need to be made as to whether it is worth keeping the investment bond or not, in light of the loss of tax deferment capability.
Northgate Waistcoats – Offshore bond
Northgate Waistcoats invested £200,000 into an offshore investment bond in February 2013.
As a small company, it adopted the historic cost basis of accounting for its accounting years ending 31 December 2014 and 31 December 2015 – when it was worth £250,000. The bond is worth £270,000 at the end of December 2016. Northgate Waistcoats does not satisfy the conditions for a micro-entity.
In the accounting year ending 31 December 2016, the taxable amount will be:
Fair value increase for 2016 £20,000
10% of increase to 31.12.2016 over the original acquisition value £5,000
Taxable amount £25,000
(b) UK bonds
When the gain is calculated, the tax that has already been deemed to have been paid within the UK life fund will be available to offset against any liability that may arise, but only on full encashment (pro rata on partial encashment). This means that if the company retains the investment bond and so decides each year to pay corporation tax on one tenth of the earlier investment gains dealt with on the historic cost basis prior to 1 January 2016, they will not be able to offset the basic rate tax deemed to be deducted within the life assurance funds on those earlier gains until the investment bond is encashed. In other words, should the company elect to retain the investment bond and pay corporation tax on accumulated gains made before 1 January 2016, it will not be able to offset the tax deducted within the life assurance funds on these gains until the investment bond is encashed. In practice, this means retention of the investment bond will result in a higher immediate tax liability than if the investment bond were fully encashed, although the position will – to a degree – be neutralised on final encashment.
For this reason, many companies may decide that the investment bond is no longer an appropriate investment for them.
(c) Offshore and UK bonds
On final encashment of the UK or offshore investment bond, any pre-2016 gains that have not been brought into charge to tax post-2016 will be brought into charge to tax.
(d) Unit trusts and OEICs – interest distribution funds
As explained earlier, an interest distribution collective investment is a unit trust or OEIC holding investments more than 60% of which are fixed-interest/debt-based assets (such as interest-bearing cash deposits, securities or corporate debt). These investments make interest distributions. These investments are deemed to be loan relationships and, as a result, will also need to be revalued each year; with any increase in value from the valuation on the first day of the company’s accounting period to the last day of the accounting period, being a non-trading credit that is subject to corporation tax. In the event of losses arising (non-trading debits), these can be offset against non-trading gains.
A “small company” that elected for the historic cost basis on these investments, and those investments gave rise to gains in accounting periods ending before 1 January 2016, will now find that one tenth of these stored-up gains will be taxed in accounting periods starting on or after 1 January 2016.
Another issue to consider is that of the taxation of the capital gain on encashment of the investment. It used to be the case that, in calculating the taxable capital gain, a deduction would be made for indexation allowance. This is no longer the case for periods of ownership from 1 January 2018 and so, by definition, is not available on disposals of investments purchased on or after 1 January 2018.
(e) Unit trusts and OEICs – non-interest distribution funds
Because a non-interest distribution collective investment is not subject to the loan relationship rules post 31 December 2015, gains will continue to be taxed under the CGT chargeable gains legislation as for earlier gains and not be subject to annual revaluation, regardless of whether the company holding the investment is a micro-entity or not. Interest will be taxed on the arising basis and any gains or losses will be calculated on the basis of a CGT chargeable gain, and assessed to corporation tax. Therefore, these investments will continue to provide tax deferral for a company until an encashment of unit/shares takes place.
As mentioned above, in calculating the taxable capital gain on encashment, a deduction for indexation allowance is no longer available for periods of ownership from 1 January 2018 and so,by definition, is not available on new purchases of investments.
Eastgate Waistcoats – UK bond
Eastgate Waistcoats, a company in an identical position to Northgate Waistcoats (above), makes exactly the same investment with the same investment returns – but it invests in a UK investment bond.
The taxable amount at the end of 31 December 2016 will be: Fair value increase for 2016 £16,000 (1) 10% of increase to 31.12.2016 more than the original acquisition value £5,000 (2)
Taxable amount £21,000
(1) £20,000 less 20% credit for internal corporation tax on fund.
(2) No corporation tax credit until final encashment of bond.