Mark McLaughlin points out that some ways of investing in the business are better for inheritance tax purposes than others.
Business property relief (BPR) is valuable for inheritance tax (IHT) purposes. It broadly reduces transfers of certain types of business property by a specified percentage. For example, shares in an unquoted trading company can qualify for BPR at 100% if certain conditions are satisfied. One of the BPR conditions is a minimum period of ownership requirement. BPR is generally unavailable unless the relevant business property has been owned by the transferor for a minimum of two years.
By contrast, if a shareholder has made a straightforward cash loan to the company, there is generally no prospect of BPR on those funds upon the individual’s death.
Tax alchemy
The two-year ownership requirement for BPR purposes is only a general rule. There are certain exceptions, one of which is for ‘replacement property’. This provision treats the ownership period test as being satisfied, broadly where: the property replaced other business property eligible for BPR; the original and replacement property were owned for periods totalling two out of the five years immediately preceding the transfer; and the property was relevant business property (apart from the ownership test) at the time of replacement and transfer.
The replacement property rule is potentially useful in certain circumstances. For example, whilst cash loans do not generally qualify for BPR, there is a provision allowing unquoted shares to be identified (under special rules for reorganisations) with other qualifying shares already owned in the company. If an existing shareholder has a shorter life expectancy than two years, it might be possible for the company to offer all shareholders additional shares under a rights issue, and for the company to repay or convert the individual shareholder’s loan to enable additional shares to be allotted under the rights issue.
If the original shares qualify for BPR (including the two-year ownership requirement), the additional shares acquired under the rights issue would potentially qualify for BPR as well.
Be careful!
However, there are potential pitfalls. For example, the rights issue procedure must be executed correctly and documented properly. Otherwise, the additional shares may be treated as a new subscription, which would require those shares to be held for two years.
In Executors of Mrs Mary Dugan-Chapman and Anor v HMRC (2008) SpC 666, the deceased (MDC) was allotted one million ordinary shares in a company on 27 December 2002, just two days before her death. The question was broadly whether those shares could be identified for BPR purposes with other shares in the company which she held for at least two years prior to her death. HMRC argued that the shares were not the result of a rights issue, but a simple share subscription. Unfortunately, there was insufficient evidence or documentation to support the executors’ argument that there had been a rights issue.
However, 300,000 shares acquired by MDC on 23 December 2002 (i.e., six days before her death) acquired under a rights issue following the conversion of a loan account of £300,000 that MDC held with the company qualified for BPR.
Practical tip
In addition, the company must have a commercial need for cash generated by the rights issue; otherwise, any surplus cash may be an ‘excepted asset’, restricting the BPR available. The directors should ideally document a commercial need for the funds.
