Alan Pink offers some pointers on the all-important choice of investment in a company.
The difference between a share in a business and a loan to a business is probably as old as free market capitalism; that is, as old as money itself.
Fundamentally, anybody contributing financially to an enterprise has the choice of whether to opt for a fixed loan arrangement or an equity share in the business. Inevitably, where you have such an important distinction, the tax implications are going to be different depending on which you choose; hence the need for this article.
Tax isn’t everything!
In a perhaps surprising admission for a professional tax adviser in public practice I would, first of all, make the point that tax considerations aren’t the only ones you should consider in looking at an investment proposition in a company and deciding whether to loan money to that company or have shares in the company issued to you in return for your cash. In fact, in most cases I’d probably go further than that and say you should consider the commercial issues first, and only move on to tax after you’ve satisfied yourself commercially.
The commercially important points of distinction between the two sorts of investment are:
- The comparatively greater risk to your investment if it is equity rather than loan;
- The perceived ‘strength’ of a company balance sheet funded by shares; and
-
The less formal method of recovering your capital where this is expressed as a loan rather than shares.
The effect on tax
Moving on from the important commercial considerations to the tax effects, the first point to make is that it is crucial to determine whether the person making the investment is going to be a company or an individual, before going any further with a consideration of the tax consequences.
This question (i.e. should I invest as an individual or through a limited company?) is one that you may well be deciding on a priori grounds, as in the following example.
Example: Personal or company investment?
Mr Battenberg runs a successful printing business and pays a lot of income tax on the dividends and director’s remuneration he receives from his printing company, Battenberg Limited.
Some of this income finds its way behind the bar of his local, The Red Lion. Whilst chatting to a fellow regular, it transpires that this individual is planning to set up a new brewery business, which will need £250,000 of investment to get off the ground. After the third pint, Mr Battenberg decides that this is a very good idea, and promises to inject the necessary capital into his friend’s embryo business.
There’s just one slight complication, which is that Mr Battenberg hasn’t got this money himself in his own personal bank account. The company has ample funds, indeed about twice that amount spare. So, Mr Battenberg reckons that he can take out a dividend of about £400,000 from the company and, after paying higher rate tax, will still have enough money left over to invest in the brewery.
His accountant points out to him, though, that, if Battenberg Limited itself makes the investment, he won’t have to incur the approximately £150,000 tax bill along the way. The money comes out of the company in the form of a loan (or an investment in shares) and not in the form of taxable income to Mr Battenberg.
Company investors
So, let’s suppose that the decision has been made to make the investment through a limited company. Which direction do the tax considerations point?
Firstly, a simple loan from your company to the investee company can be easily repaid tax-free. By contrast, if looking at disposing of shares, on the face of it the company may stand to crystallise a capital gain on return of the shares. However, in most cases, this gain will be tax-free in any event, either as a deemed distribution or as a gain covered by the ‘substantial shareholdings exemption’. So the taxation on a return of funds probably isn’t a relevant consideration in many cases.
However, looking on the dark side (and one has to consider good and bad outcomes together), a reduction in the value of your loan because the investee company doesn’t do well will be an immediately allowable deduction in your investing company’s books, under the ‘loan relationships’ rules; with the important proviso that this doesn’t apply if the investor and investee are ‘connected’.
On the other hand, favouring a share format for the investment, where the investor is a company, is the possible availability of group relief or consortium relief.
Where you meet the criteria, which are broadly 75% ownership of the shares for group relief, and ownership of the shares in common with a number of other company investors in the case of consortium relief, any losses made by the investee company can be surrendered by that company up to the investor company or companies, and used to claim immediate relief against the investor company’s profits.
More indirectly, what might well favour a share investment rather than a loan, in the case of a company investor, is the impact of the investment on the tax status of the investor company itself. At the time of writing, I don’t know what’s going to happen to entrepreneurs’ relief, but if it continues to exist (or something like it), you may prefer to have your investment in the form of shares in a subsidiary or joint venture company because these don’t impact on the ‘trading’ status of the investor company if it is trading otherwise.
A loan, on the other hand, as in the case of Battenberg Limited above, could be treated as an investment activity, which probably fouls up the availability of entrepreneurs’ relief on any future sale of Battenberg Limited. A similar consideration applies to inheritance tax business property relief, although the rules are somewhat more benign here.
Individual investors
As I’ve said, the considerations if the investor is an individual are significantly different. It’s true, you generally get interest relief on any loan you’ve taken out to invest in a close company, whether the format of your investment is loan or shares. But in other ways, the differences are very marked.
First and most simply, the income derived from your investment will be taxed differently (i.e. as interest if you are a loan creditor, or as dividends if you are a shareholder). In practice, the effective overall rate of tax between these alternatives may be significantly different.
Most likely, the decisive factor of an individual investor, though, is the question of whether or not an investment in shares will qualify for enterprise investment scheme (EIS) relief. If you are a minority investor (i.e. no more than 30%), the rewards for claiming EIS relief are amazing, where the nature of the company’s trade makes this available. Firstly, you get 30% (or 50% if it is a small start-up) immediate income tax relief based on the amount invested. Secondly, any capital gains after a qualifying period of normally three years after the investment, on selling the shares, are exempt. Finally, relief is available against income (not just capital gains) if things go wrong and you make a loss on your investment.
This last relief, against income, can, of course, be very valuable as it can effectively give you relief at 45% if you pay income tax at that rate. And the loss relief isn’t actually confined exclusively to EIS companies, although all must still carry on what are known as ‘qualifying’ trades for the purpose.
Practical tip
Don’t let the tax tail wag the commercial dog, but look hard at what you want to achieve commercially from your investment. Secondly, decide whether the money you are using to invest could come from a company you control, or must come out of personal funds. Only when these two questions have been asked and answered should you consider the different tax implications of equity and loan investment.
