Making Family Trading Company Investments IHT Efficient

Mark McLaughlin looks at the often-contrasting treatment of cash loans and family trading company shares for inheritance tax purposes. 

Many family and owner-managed trading company owners invest in their businesses through a combination of acquiring shares and making cash loans. The company might use the funds for the same business purpose, but the inheritance tax (IHT) implications of the shares and cash loans will often differ, depending on the availability of business property relief (BPR) on the shares. 

BPR is an important relief for IHT purposes. It broadly reduces transfers of value 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 conditions for BPR is a minimum period of ownership requirement. As a general rule, no BPR is available unless the relevant business property has been owned by the transferor for a minimum period of two years. 

For IHT lifetime planning purposes, this two-year qualifying period compares favourably with the seven-year period required for potentially exempt transfers to become exempt. It makes investments in assets qualifying for BPR potentially attractive to individuals whose life expectancy is likely to exceed two years, but is unlikely to exceed seven years due to age or ill health.

As mentioned, the two-year ownership requirement for BPR is only a general rule. There are certain statutory exceptions, one of which is for ‘replacement property’ (IHTA 1984, s 107).

 

The BPR ownership rules for replacement property can be quite helpful in certain circumstances. For example, there is a provision allowing unquoted shares to be identified (under the capital gains tax rules for reorganisations in TCGA 1992, ss 126-136) with other qualifying shares already owned in the same company. Thus, if (say) shares are acquired under a rights issue, they are treated as having been acquired at the same time as the original shares. 

By contrast, if a shareholder makes a straightforward cash loan to the company, there is generally no prospect of BPR for that investment on the individual’s death. If the funds were instead used to subscribe for additional unquoted shares, BPR may become available once the shares have been held for at least two years (subject to the other relief conditions being met). Alternatively, if the additional shares are acquired under a rights issue, the effect of the above replacement property rule is that the normal two-year ownership requirement does not need to be met for those shares to qualify for BPR (IHTA 1984, s 107(4)).

In Executors of Mrs Mary Dugan-Chapman and anor v Revenue & Customs Commissioners (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 in this case 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 raised a determination effectively denying BPR on the one million shares, arguing 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 a rights issue had actually taken place. The appeal was dismissed.

However, 300,000 shares had been allotted to MDC on 23rd December 2002 (i.e. six days before her death). Those shares were acquired under a rights issue following the conversion of a loan account of £300,000 that MDC held with the company. HMRC agreed that those shares qualified for BPR. 

As indicated, cash loans do not generally qualify for BPR. However, if a shareholder in a family or owner-managed businesses has a shorter life expectancy than two years, instead of subscribing for additional shares in the company and the shareholder hoping to survive for two years, consideration might be given to the company offering the shareholders additional shares under a rights issue. Provided that the original shares qualify for BPR, the additional shares acquired under the rights issue may qualify for BPR as well, if the two-year ownership requirement has been satisfied. 

However, the above case underlines the importance of proper documentation to demonstrate that the additional shares were acquired under the rights issue, as opposed to a further share subscription. In addition, a rights issue must comply with company law.

Even if the shareholder successfully acquires additional shares under a rights issue which qualify for BPR, the company must be able to show a business need for the funds. Otherwise, the money subscribed for the new shares is likely to be an ‘excepted asset’, on which no BPR is available (IHTA 1984, s 112).