What To Do With A ‘Cash Mountain’

Alan Pink considers the tax issues and options where a large cash balance builds up within a limited company.

As a tax adviser in public practice, one of the most frequent tax problems which comes across my desk is that of the trading company which builds up a large surplus of cash, which is not needed for the purposes of its business. The reason why such cash balances build up is quite simple, and is always the same; the alternative of paying out the cash to the shareholders as dividends would give rise to substantial income tax charges on those shareholders, of an amount which the individuals concerned are reluctant to pay out. 

Apart from the obvious disadvantage of the cash being un-utilised for any useful purpose, there are potential tax problems with allowing this situation to build up, which I’ll come on to explain now.

On the face of it, it’s a problem that the more cash you build up in the company’s bank account, the less of the company’s value relates to its trading activities. This could be seen as a major problem from the capital gains tax planning point of view because entrepreneurs’ relief, which generally gives a 10% rate on any sale or winding up of the company, only applies where the company qualifies as a trading one. Could the existence of a large cash balance, which is nothing to do with the trade, therefore endanger the availability of the relief? Without entrepreneurs’ relief, the tax is likely to be twice as much, being charged at a 20% rate. 

Fortunately, the general view amongst tax practitioners at the moment is that a large cash balance, where it has built up as a result of trading profits which have simply not been distributed, should not usually endanger the company’s trading status for entrepreneurs’ relief purposes. Things do get a little bit sweatier where the cash isn’t simply deposited at its bank, earning a miniscule interest rate, but I’ll come on to that.

The first point to be clear on when considering the inheritance tax impact of building up a large cash balance in the company is that, normally speaking, trading company shares will be eligible for 100% relief against the tax; so that if you die owning the shares in a private trading company, their value (even if very substantial) will not be charged to tax in any circumstances. 

However, this basic rule is susceptible to exceptions. One of these exceptions is where the business of the company is ‘wholly or mainly’ acquiring or holding investments. A cash balance, of course, is an investment (even if not a very interesting one), and if the scale of the company’s activities were such that the holding of the cash balance was more than 50% of its overall undertaking, you could lose relief completely – even for the element of the company’s activities which was genuinely trading. 

A lesser danger than this, but still one which could be quite painful in its consequences, would be if the cash balance was not so great as to endanger the company’s overall trading status, but HMRC nevertheless was able to argue that the cash balance was not required for the purposes of the trade. In this situation, the ‘excepted asset’ rule would kick in. Under this rule, business property relief would be given at 100% for the value of the shares with the exception of the value attributable to the cash balance. So, if, for example, a company ran a trade which was worth £1 million lock, stock, and barrel, but the company also held a cash deposit of (say) £500,000 surplus to its trading requirements, only two-thirds of the value of those shares would be eligible for the inheritance tax relief. 

The most obvious way of avoiding this cash building up would be to pay it out, from time to time, to the shareholders by way of dividend. We’ve already discussed though how this could be seen as being undesirable because of the resultant higher rate personal income tax charges. Instinctively, business owners feel that they would rather have the cash, even stuck inside the company, than pay up to 38% or so of this to HMRC. 

Another alternative option would be making pension contributions. On the face of it, this is a very attractive option. A company will normally receive corporation tax relief for making the contribution, and the funds contributed will then be available for investment in a completely tax-free environment; there is no tax on either investment income or capital gains realised by pension funds. However, there is inevitably a price to pay for these benefits, and in the case of pension funds, this price is the very circumscribed investment options for the pension trustees (for example, investment in residential property is verboten), and the fact that amounts put into pension funds are potentially limited under restrictions on pension contributions.

I’m concentrating in this article on the tax disadvantages of holding cash balances within the company; however, in reality arguably the worst result of hoarding cash within the company is the fact that you are not using it for more effective investment projects. Investment in property, for example, may well be regarded as very greatly preferable to simply leaving money lying around on bank deposit. Property, unlike bank deposit amounts, may well increase in capital value, perhaps substantially; and the rate of income return is also likely to be many times better. 

If you do invest the company’s cash in property or other investments, however, you are seriously endangering the company’s trading status for entrepreneurs’ relief purposes (see above); and you’re also more likely to step over the dividing line between companies which qualify for inheritance tax business property relief and those which do not. 

If you want to have your cake and eat it – that is, if you want to invest the cash more effectively but at the same time preserve, if possible, your tax benefits from trading status, consider the option of loaning the funds to a parallel investment company. The loan to the investment company would, it’s true, constitute an ‘excepted asset’ for inheritance tax business property relief purposes. However, the loan in itself would be unlikely to constitute an investment activity at all, let alone one which was substantial enough to endanger the trading status of the lending company – either for capital gains tax or inheritance tax purposes. 

As a refinement to the simple loan to a parallel investment company, the loan could be to such a company which was then a member of a limited liability partnership. This company could then invest in properties or other income and capital growth yielding assets, with the income and the capital growth arising outside the corporate envelope. There could be huge attractions in this, from the point of view of the way the investment income and the capital growth are taxed.

At the risk of seeming negative, I’d like to conclude this survey of cash in trading companies by warning against two strategies for extraction of the cash which I have seen frequently advocated in practice, but which, frankly, in my view just don’t work – or wouldn’t work if HMRC became aware of them.

The first idea is that of selling your company, cash and all, to another company you own. You would have thought that this would be a brilliant way of getting your hands on the value of the trading company at capital gains tax rates. The holding company would buy the shares in the trading company from you and would then owe you the value agreed between you. This value could be paid by way of a dividend up from the trading company to its new holding company, which then uses the money to pay you off. If the trading company qualified as a trading company for entrepreneurs’ relief purposes, you are, therefore, effectively getting its value out at no more than a 10% tax rate. 

The big problem with this is that HMRC has thought of it! Rules which were originally introduced as long ago as 1960, known as the ‘transactions in securities’ anti-avoidance rules, will definitely apply to this sort of planning, and the result will be that the available reserves of the trading company would be treated as chargeable on you as income – with potentially disastrous tax consequences. 

My second ‘don’t’ relates to the idea of winding up the company in order to extract its cash surplus. Even assuming that the company has no chargeable assets, the winding up of the company simply to extract its value cheaply from the tax point of view is likely to be caught under the recently introduced ‘anti-phoenixism’ rules, whose effect, again, would be to charge the amount you take out of the company on its winding up as income.